How to get creative with Financing for investing in Real Estate and how being Leveraged helps...Feb 25, 2021
You are psyched about creating generational wealth by investing in rental real estate; but how much money do you really need to get started and what if you don't have tens of thousands of dollars in your savings account?? I'd like to start with the two most common approaches to investing in residential real estate and then discuss other creative financing options.
Most people either use a conventional mortgage ( guaranteed by a private lender or the two government-sponsored enterprises—Fannie Mae and Freddie Mac) to purchase their investment property and others who are debt-averse may pay for the property all-cash.
An all-cash offer does have some advantages in the current market - you could waive inspection, appraisal contingencies and being able to close faster does give you an edge over other buyers who would be taking out a mortgage. This may even enable you to pay a little less for the property. But in my opinion, this is not always the best case scenario as you lose the ability to leverage your money... which stunts your portfolio's overall growth.
Say you have 200,000$ to invest in rental real estate in your market.
If you purchase one property with an all-cash offer, and you have a net cash flow after expenses of 1000$ / month, you are making 12,000$ in cash flow annually - 6% ROI. Now after 10 years, with 3% property appreciation every year, your property is worth 260,000$. Which is your equity in the property.
Suppose you had used conventional mortgages to put 25% down and purchase 4 rentals for 200,000$ each. Suppose each home cash flows 500$/ month. That's 24,000$ in cash flow annually - 12% ROI. Also, every year assume you have 6% debt pay down by the renters and 3% property appreciation, but the 3% property appreciation is actually a 12% ROI for you since you only put 25% down on each property. That's 18% equity increase every year so at the end of 10 years, your equity in all 4 properties combined increases to 560,000$ or a 180% increase in equity. So by leveraging your money, your ROI has doubled and your equity increase is up 6 times. This is without factoring in increased tax savings since you are now depreciating 4 properties and all the mortgage interest is tax deductible.
Now it's important to remember that in most cases, for a conventional mortgage, you’ll need a credit score of at least 620 and a debt-to-income ratio of 50% or less. Also, each individual can only have 10 conventional mortgages in their name, which means that a couple could have 20 conventional mortgages between them before resorting to other options. Multifamily homes with five or more units are considered commercial real estate, and would require commercial loans that are generally more difficult to get, require bigger down payments and often require shorter repayment schedules.
You do have the option of doing Delayed Financing with an all-cash offer - this enables you to get the advantages of an all-cash offer, but allows you to pull out your money within the first six months if you meet certain criteria (unlike a cash-out refinance for which you need to wait six months after getting title). Another consideration would be the BRRRR strategy - Buy, Rehab, Rent, Refinance, Repeat. This is when an investor buys a distressed property, puts more money in to the property to rehab it, forces appreciation of the property to a higher ARV - After Repair Value and then refinances the property to pull out most of the money invested.
But what if you think you don't have enough money for a mortgage down payment? Or if you have less than stellar credit scores or insufficient income to qualify for conventional mortgages?
a. You could try tapping into the lazy equity you have in your primary residence or other rental investment properties your own. This may not be for everyone - but for those willing to grow their portfolio in the current environment with historically low interest rates, there are two ways to tap into the equity in your properties - you could do a cash out refinance or a HELOC (Home Equity Line of Credit). Interest rates are generally lower and closing costs higher for cash-out refinances than for HELOCs. It's best to talk to your loan provider to see which option works best for your scenario depending on your goals and financial situation.
b. House hacking: This is the idea of combining your investment property with your personal residence. For younger investors such as those in college or those in High Cost of Living areas (HCOL), this is a great option to purchase a property using as low as 3.5% down (owner occupied) FHA loan. The property could be a small (four or less units) multifamily property, with the owner living in one of the units. Or it could be a home with one or more bedrooms rented out. The income is used to offset the cost of your mortgage and other expenses allowing people to live in expensive areas for free, and even generate positive income through home ownership. The lender often requires the owner to live in the home for a minimum of one year but there are exceptions to this rule. Now some people are serial House Hackers and they use this strategy to acquire multiple properties with little money down.
c. Hard money or Private lenders and Joint Ventures: If the plan is to use the BRRRR strategy Buy, Rehab, Rent, Refinance, Repeat, then you could borrow from Hard money lenders (higher interest rate) or friends and family (Private lenders) who can be paid back once you refinance the property and pull out your money. Or you could Joint Venture with a partner who brings in the cash, you put in the sweat equity (all the work needed to find the property, rehab it) and co-own the property once the equity is pulled out via refinancing.
d. Seller financing and Lease to buy are creative financing opportunities between the seller and you where you do not have to bring a lot of money to the table in the beginning. The main difference between the two is when ownership is transferred.
e. Investing through your Solo 401 (k) or Whole life insurance policy - Investing in rental real estate through your self directed 401(k), by liquidating your 401(k) assets or by borrowing against your Whole life Insurance policy cash value is a route some take. For someone like me who believes in a hybrid stock: bond: real estate portfolio in retirement, I like keeping my 401(k) in stocks: bonds and I do not believe in Whole life Insurance as an investment vehicle.
f. Portfolio lenders: are an option if you don't qualify for a conventional mortgage due to income requirements or if you have maxed out your conventional mortgages.
g. Bridge loans: As a buyer, if you have a lag between the purchase of one property and the sale of another property, you could use a bridge loan.
That pretty much sums up creative financing options for you. But the take away is that once you set your goals for real estate investing, there are ways to find the financing... You may just have to look harder.
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