I did not choose my creative financing toolbox. My creative financing toolbox chose me.
My business partner and I began full-time real estate investing right out of college with no assets, no regular job, and little consistent income. But we still wanted to buy, sell, and eventually keep properties.
So, we were forced to look beyond the traditional path of walking into a bank and applying for a loan. We learned to use creative tools, such as seller financing, private loans, self-directed IRA loans, lease options, and more.
Ironically, after almost 14 years of investing in real estate, we still choose to use creative financing to purchase real estate. Just this year, we’ve used seller financing, private loans, and self-directed IRA loans to make several purchases.
We can get bank loans now, and occasionally, we do when it makes sense. But creative financing is still our preferred source to finance investment real estate.
In this article, I’ll tell you why we prefer creative financing, and I’ll open our toolbox to share nine of our favorite creative financing tools (aka the power tools). I hope that you’ll add some of them to your own creative financing toolbox so that you can build more wealth and create more passive income for yourself.
A picture of a traditionally financed closing
Buyers must understand each piece of a typical transaction to understand creative financing and explain it to a skeptical attorney, real estate agent, or seller.
The diagram above shows the relationship between all of the parties of a typical closing. There are four primary entities involved:
- The seller
- The buyer (you, if purchasing an investment)
- The bank (lender)
- The closing agent (an attorney or title company)
In this example, the buyer and seller signed a purchase and sale agreement at some point before closing. The price was $50,000. Also, before closing, a loan commitment agreement was made between the buyer and the bank. The loan was $40,000, and the buyer provided $10,000, or 20%, as a down payment.
The closing attorney or title company uses these pre-closing agreements to oversee the closing transaction (aka escrow) to ensure the other three parties are treated fairly per the terms of their contracts. The items actually exchanged between the parties include:
- Money — from the bank to the buyer (a loan)
- Two contracts, a promissory note, and a mortgage (or deed of trust in some states) — from the buyer to the bank
- A deed — from the seller to the buyer
- Money — from the buyer to the seller
For those already investing, this may seem basic. But it’s important to start here before doing transactions that are a little more creative because these creative tools use the same basic format.
Now I’ll unpack my favorite creative financing power tools from my toolbox.
Power tool #1: Seller financing
In the picture above, what is the main difference between a seller financing transaction and a transaction with a bank loan? Obvious, right? There is no bank!
In fact, technically, there is not even a loan. The seller never gives the buyer any money as a bank would. Instead, the seller agrees to let the buyer pay the purchase price over time with monthly installments (i.e., an installment sale).
In exchange for this owner financing arrangement, the seller (not a bank) receives the promissory note and mortgage as security.
The beauty of this arrangement is that there are only two parties: the buyer and the seller. The seller does not have loan committees, underwriters, or Fannie Mae–conforming rules. The buyer makes an offer to the seller, the two negotiate, and if it makes sense for both parties, they move forward.
But how common is seller financing, really? Ben Leybovich, a well-known creative financing writer here on BP whom I respect, once wrote that seller financing is rare and usually only used on ugly pig properties. While I normally nod my head at Ben’s articles, I shook my head and chuckled at this one. Maybe Ben has been looking under the wrong rocks.
Indeed, seller financing is not as common or easy to obtain as traditional tools. It is also true that seller financing does not make a bad deal magically turn into gold. But do not let its difficulty dissuade from its ultimate value.
Seller financing is an incredible tool that is well worth the effort. And it is one of the clearest win-win transactions in the entire real estate business.
For example, my business recently bought an income property using seller financing with a 10% down payment (yes, in a hot market, and yes, in a desirable location). Once stabilized and rented, this property will likely make us over $1,000 per month in net income for decades to come. And that does not include the benefits of future capital gains.
What’s more? The seller and I are pals. He is happy as a clam in water because he loves monthly checks without the hassles of being a landlord. I have saved him the trouble of putting a big chunk of his money into investments like stocks or bank CDs that he doesn’t like or understand. And he receives a much larger income than he would with most traditional investments.
Who is the only party not happy with the transaction? I guess it’s the bank, who didn’t get my seller’s money in a CD so they could loan it to me at a higher interest rate!
More on creative financing from BiggerPockets
Power tool #2: Private loan from a self-directed IRA
As you see above, this creative financing tool is structurally very similar to closing with a bank loan. The only difference is that the lender is a self-directed IRA (individual retirement account) and not a bank.
Most retirement accounts invest in traditional assets like mutual funds or bonds. But a self-directed IRA is a way to use retirement savings to invest in alternative assets like real estate, notes, tax liens, and more. Specialized custodians who allow self-direction hold the assets and process transactions and keep records for the IRS.
The point of this tool is to borrow the IRA funds from other individuals, not from the investor’s own IRA. Investors need to be very careful not to engage in IRS-prohibited transactions. Loaning money to yourself or your business is clearly off-limits.
But as long as the investor follows the rules, they have enormous opportunities to find sources of funds for their real estate deals. Even a number of years ago, in 2012, total IRA accounts in the United States totaled over $5.68 trillion!
Investors should look at their local network. Chances are there is someone who has funds available and would be willing to become an IRA lender. Some of the best candidates are other real estate investors who cannot loan that money to themselves. This kind of deal gives them the perfect opportunity to invest in local assets that they know and understand.
This has been the tool that I use the most often from my creative financing toolbox. Like seller financing, it is a win-win arrangement. It gives investors the funds they need, and the IRA lender receives a solid return and good collateral.
Power tool #3: Private loans (outside of an IRA)
I didn’t include a diagram here because it is the same process as the previous tool. The only difference is that the private lender uses funds outside of an IRA.
Who would have that kind of money? More people than you think.
The most likely candidate is an individual with a large net worth. And if you understand the principle of books like The Millionaire Next Door: The Surprising Secrets of America’s Wealthy, this person WON’T be the one driving the expensive car or wearing fancy clothes. So, don’t underestimate anyone you meet!
My favorite way to find these individuals is at real estate networking events like BiggerPockets meetups or a local real estate club. Attend these events and get to know people. Find the experienced old guys and gals in the back of the room. Ask questions. Make friends. Once you get to know people, they may be willing to loan money.
Borrowing from high-net-worth individuals also brings more benefits than just getting the money. In addition to the loan, borrowers can learn from their expertise and experience.
A couple of my own private lenders became mentors and close advisors. While they may have been interested anyway, the fact that I had their money made them VERY interested in my success. Their tips, feedback, encouragement, and friendship over the years have been an essential part of my own success on their deals and others.
While I have never used short-term hard money loans, I would lump hard money lending into this same creative financing tool. Hard money loans, or asset-backed loans, are an alternative to traditional bank financing. And while the cost is generally higher than normal, the availability and speed of funds make them very helpful to many investors.
Power tool #4: Master lease with option to buy
The tool of master leasing is where we begin to think outside the box even more, so stay with me.
In the illustration above, a burned-out landlord named Jane owns a quadruplex building. Jane has let the building get run-down, and she has not even filled two vacancies from bad tenants who recently moved out. She’s just too tired.
Jane then gets a letter from an energetic entrepreneur named Chris, who offers a creative solution to her problem. Chris offers to lease her building for five years for the same amount she currently receives in rent from two tenants ($1,000 per month). He also offers to perform immediate cosmetic repairs like painting and carpeting that will cost him $5,000.
Jane will continue to pay for taxes and insurance and handle any major capital expenses (roof, heat and air systems, structural issues). Chris will be responsible for all vacancy costs, turnover costs, maintenance costs, etc.
Because Chris’s lease gives him the right to sublease all four units to sub-tenants, his gross rent collected in this case is $2,000. As you can see in the picture below, if his vacancy and maintenance expenses are $400 per month, he receives a positive cash flow of $600 per month—or $36,000 over the next five years!
Stacking up a few deals like this could make for very lucrative side income for Chris, or he could really ramp it up with more deals to completely replace his income from a job.
But why stop there? Let’s see if Chris can make it even better using another tool: the option to buy.
If Jane, the burned-out quadruplex landlord, was willing to give Chris, the entrepreneur, a master lease, might she also be willing to give him an option to buy the property? There’s a good chance.
An option would essentially give Chris the right (but not the obligation) to purchase the property for a set price for a certain period of time. In exchange, Jane receives consideration for selling him the option.
In this case, Chris’s consideration is the $5,000 he spends to spruce up the cosmetics of the property. Jane will give him $5,000 credit when he finally executes his option.
Chris’s option strike price is $120,000. Once he gets the building rented and looking good, he will have the chance to make money from the option any time during his five-year option window.
Multiple exit strategies with options
A well-crafted option gives Chris at least three profitable exit strategies:
- First, Chris could patiently save a down payment and look for permanent financing and/or partners. This would allow him to buy the building and keep it as a long-term hold investment. Because he has five years to accomplish this, he could shop around until he finds the best terms.
- Second, Chris could use this as the replacement property in a 1031 exchange. This would allow him to sell another rental property he owns, exchange for this property, and defer his taxes on the gain of the sale. Many investors don’t have the perfect property picked out when they execute a 1031 exchange, so this could be a BIG benefit.
- Third, Chris could sell his option to another investor. Let’s say he finds a landlord investor who is willing to buy this property for $160,000. He could simply assign his option contract to him (yes, contracts can be sold), and his fee for the assignment would be the difference between $160,000 and his strike price of $120,000—or $40,000.
So, in addition to the $36,000 Chris earns from operating the rental over five years, he also receives a profit of $35,000 ($40,000 minus the $5,000 initial investment) from assigning his contract.
That’s a total of $71,000! Not a bad payday considering he invested only $5,000, some hard work, and a little creativity.
And perhaps even more exciting than the $71,000 profit, the lease option allowed Chris to use enormous leverage without the typically enormous risk of traditional bank financing.
If things go badly with Chris’s lease option, he has only risked his $5,000 initial investment, his time and energy, and any potential negative cash flow during the five years of his lease. After that, he could legally just walk away.
Try that with a bank loan!
Power tool #5: Master lease + option (with a credit partner)
This tool will provide a different way to use the previous technique. Instead of lease optioning the property from a seller, a borrower lease options it from a credit partner.
Let me explain.
Let’s say an entrepreneur named Karla finds a great rental property deal worth $150,000 that can be bought for $100,000. The only problem is that she doesn’t have the money to close. She knows a private lender named Jim with $20,000 cash, but that’s obviously not enough.
After further questioning, Karla learns that Jim does have excellent credit and can get a mortgage loan. So, the two of them agree to the following:
- Karla, the entrepreneur, assigns the purchase contract to Jim, the credit partner.
- Jim applies for a traditional bank loan and purchases the property for $100,000.
- Karla immediately master leases the property for five years at $525 per month net-net-net rent (i.e., she pays all expenses).
- She also retains an option to repurchase at a higher price ($110,000).
- She manages the rental until future exit strategies are available.
Karla then proceeds to rent to a sub-tenant for $1,200 per month. Her net income looks something like this:
$1,200 – $500 (operating expenses) – $525 (rent) = $175 per month net income
While $175 seems like a nice cash flow, Karla would be wise to set aside a good portion of her cash in reserve for capital expenses and vacancies.
Meanwhile, Jim uses the $525 rent from Karla to pay his $425 mortgage payment, and he still has $100 leftover to put in his pocket.
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Power tool #6: Crowdfunding or P2P
Over the past few years, peer-to-peer (P2P) lending has gone from a cute little niche strategy to something that many successful real estate investors are using to finance deals.
P2P lending is essentially an investment version of crowdfunding. Large pools of people come together online and contribute varying sums of money until the entire deal is financed. The investors then get principal plus interest back in return. This allows someone with limited resources to purchase a piece of real estate.
Power tool #7: Partnerships
Investors can also consider taking on a partner who supplies the money for the deal. As part of the partnership, the investor may find the deal, manage the deal, or provide the knowledge or experience. In return for equity, their partner puts in the money needed to purchase the deal.
This is a very common way to grow and scale by using other people’s money. The partnership can be structured in many different ways, and there isn’t any right or wrong way to structure the equity (but everything has to be legal).
Partnerships have been one of my favorite creative methods of investing in real estate over the past decade because even though I’m good at a lot of real estate things, I have a lot of shortcomings as well. Partnerships can be a valuable tool when investing in rental properties because two people can work together to cover for each other’s shortcomings and do some amazing things.
For example, if one person is great at getting a mortgage but has no time to find or manage deals, they could partner with someone who struggles with getting a loan but has more flexibility and knowledge to handle putting the deal together and managing it. Or perhaps both parties put in 50% of the income and split the responsibilities 50%, making less work and less income for both partners.
Whoever plans to use a partner to invest in real estate must take incredible care in picking the right partner. The investor should never choose a partner based on convenience; rather, the person should be someone the investor would enjoy working with and who has something the investor needs, and vice versa. An investor should pick a partner the same way they would pick a spouse—after a lot of careful consideration.
This is especially true when investing in long-term buy-and-hold real estate because the investor will be attached to this person for many years. After all, it would be hard to end up with a partner for the next 20 years that one doesn’t get along with. The investor needs to be sure that their partner’s goals and work ethic are in near-perfect sync with their own and that each role is carefully defined (on paper) before buying a single piece of property.
A lawyer can write up a partnership agreement to protect both parties because, as my friend Chris Clothier likes to say, “Every partnership will end. You decide at the beginning how it is going to end.”
Power tool #8: Equity
The first, most obvious option is equity in current property or properties. This includes the investor’s primary residence. If there is equity available, the investor can leverage that property to pull out cash.
For example, the investor can use a line of credit, a home equity loan, or a cash-out refinance on the property. Investors can use all of these three things to tap into equity.
A majority of banks will loan from 85% to 95% of a primary residence’s value with a line of credit. For example, if the property is valued at $100,000 and the investor owes $75,000 on their current mortgage, they could potentially receive a line of credit with $20,000 (95% of the home’s value) to draw from.
That may not be enough for a down payment on a property, but everyone will have different amounts of equity available.
If an investor owns their own home, they may be able to use some of the equity in their home to purchase rental properties. Equity means the spread between what is owed on a property and what the property could sell for. In other words, if a property owner owes $80,000 on their primary residence, but it could sell for $200,000, they have $120,000 in equity. This equity can be borrowed against at very low interest rates through a home equity loan or a home equity line of credit at a local bank or credit union.
These loan products are also referred to as a “second mortgage” because the lender will place a lien on the property in second place to the primary loan on the house.
A home equity loan and a home equity line of credit are similar but have major differences.
The home equity loan is typically taken out at once and paid back in installments until it is paid off, much like a typical mortgage or car loan. The interest rate and payment are generally fixed for the life of the loan (but it doesn’t have to be).
A home equity line of credit, on the other hand, is a revolving account that works much like a credit card. Property owners can borrow as much as they want, up to the limit, pay it back, and then borrow again.
They pay interest only on the amount currently borrowed, so they could leave the balance at $0 until they need it. These lines of credit generally have lower interest rates than home equity loans, but those rates are generally variable, and so they can rise or fall.
Power tool #9: Investment accounts
Another way to receive a line of credit is by borrowing against any stock investment accounts. These are non-retirement accounts, and there are rules as to how much has to be in the account to actually open a line of credit. The investment account is used as collateral against the loan.
Since this asset is pretty liquid, the line of credit tends to have a good interest rate. As the investment account balance increases or decreases, the limit available on the line of credit can also fluctuate, which is something to watch out for.
Besides non-retirement investments, investors might have an IRA or a 401(k). An IRA can be set up as a self-directed IRA. Instead of investing IRA funds into the stock market, those funds can be used to invest in real estate.
There are strict rules and guidelines for a self-directed IRA. Some companies provide the setup and management of self-directed IRAs. Personally, I haven’t used one before.
A 401(k) plan usually offers a loan that can be taken from a 401(k). In this case, borrowers are withdrawing money from their 401(k) and must pay it back. There is no tax or penalty since it is a loan and the borrower is not taking the money as income. Payments are taken out of the borrower’s paycheck and applied to their 401(k).
Depending on the plan, there could be interest paid or none at all. The interest is paid to the 401(k), so the borrower is paying themself interest. If an investor is not making a great return on their 401(k), taking a loan may be a good option. The 401(k) plan sets the terms and payments, and while there may be options, they are not negotiable.
What tools are in your toolbox?
As I said way back in the very beginning, these are tools my business partner and I have used over the years in our own business. They have served us well. Our toolbox and our tools are well worn now.
But the point of the article is about you. The question is, can you use any of these tools to build wealth and income for yourself?
My advice is not to fill up your toolbox with too many tools at once. It’ll just weigh you down unnecessarily. And you don’t need to give up your old tools, even the hammer of traditional financing. If it’s already working for you, keep using it.
Instead, decide on one or two of these tools that you’d like to add to your toolbox. Then commit to mastering that tool.
Learn about it. Practice it. Ask questions. Then, as quickly as possible, start using the tool in your real estate investing. I think you’ll become a better and wealthier real estate investor as a result. Best of luck!
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.