In the history of the world, perhaps nothing has killed more real estate ambitions than the belief that one does not have enough money to get started.
In fact, I speak with people all the time who don’t realize that investing in real estate without having the full, 100 percent purchase price of a property is totally possible. They look at a $100,000 property and try to do the math in their head, thinking, “Well, if I saved $100 per month from my job, I could start investing 83 years from now. But that’s never going to happen, so I guess investing in real estate is only for the privileged rich.”
Leverage is a financial term that simply means applying a small amount of force to achieve far greater results. With real estate, leverage usually comes in the form of a loan. Although such a loan could come from a number of different sources, the practice is quite similar. A small down payment is supplied by the real estate investor, a lender provides the remaining balance of the property’s purchase price, and the investor pays that lender a small amount each month until the loan is paid off.
For example, I might consider that same $100,000 property but get a bank to lend me 80 percent of the purchase price. They would supply $80,000 via a loan, and I would need to come up with just the $20,000 down payment (plus closing costs, which I’ll cover in a moment).
Let me repeat, using this approach, I only need to save up $20,000 to buy the property, instead of the entire $100,000 purchase price. Yes, I will need to pay the bank a certain amount each month for many years, but if I’ve done my math correctly, I’ll ultimately make far more income each month than I’ll spend on that loan payment. Granted, saving $100 a month, as I mentioned in my earlier example, to save up a $20,000 down payment would still take many years, but other strategies are available for using even more leverage or finding lower-priced properties. I’ll cover these strategies in a later chapter of this book.
Yes, this is pretty basic stuff, but you might be surprised how many new investors fail to realize that this is how the game is played.
Leverage, of course, can be both a blessing and a curse. The more leverage you use, the greater the risk you may be taking. For example, if you paid 100 percent cash for a property, you wouldn’t have a loan payment due each month, so a three-month vacancy on your property wouldn’t hurt as much. Or if you bought a house with just 5 percent down, and the value of that property dropped by 20 percent, you would then be “underwater” on your loan, meaning that you’d owe more money on the house than its worth. This in turn limits your future options and can make selling, refinancing, or doing pretty much anything else with the property very difficult.
In fact, leveraging was largely the core cause of the housing collapse and glut of foreclosures in the market in 2007 and 2008. Homeowner Hank purchased a home for $100,000 using 100 percent financing and putting down $0 on the property. When the value of that property later dropped to $80,000 and Homeowner Hank lost his job, he couldn’t sell the property, because he owed far more than what he could get for it. The bank needed $100,000 to be satisfied, but the most Hank could recover by selling the property was $80,000. As a result, Homeowner Hank—like millions of others—simply allowed the bank to foreclose on and take the house.
What’s the Magic Number?
So, was leverage to blame? Should we pay 100 percent for rental properties? What is the magic number?
I’d like to reframe these questions and force you to think about things in a slightly different light. Rather than discussing how much money to put down for a property, I want to encourage you to think, “How secure can I be?” There are ways of increasing your security when you use leverage, so let me cover the two main points.
First, a property’s down payment is not as important as the deal you get.
To illustrate this, let me ask you a simple question of “which of the following is riskier:”
- You purchase a house for $100,000 and put 30 percent down, thus obtaining a $70,000 loan;
- I buy an identical house for $70,000 with 0 percent down, thus obtaining a $70,000 loan.
So, who is at more risk? Even though our loan amounts are identical, I would argue that you are at the greater risk, because you have more cash invested. I just did the up-front work required to pay $70,000, and you did not. I leveraged my creativity in place of a down payment.
Secondly, when investing in rental properties, knowledge can help decrease the risk involved with leverage. The better you understand the market, your investment, and how to manage that investment, the lower your risk that something will go wrong. For example, if you do the math correctly before you buy an investment property and know that you must account for the property sitting empty a certain percentage of the year, then that vacancy, when it occurs, will not have as negative an effect on your bottom line. It’s just part of the business. Your knowledge can help secure your investment(s) against the things that will go wrong. For this reason, you’ll spend an entire chapter of this book learning how to analyze a real estate investment.
Two Feasible Strategies Using Conventional Loans
Perhaps you can now see why I can’t give a simple answer to the question “How much money does one need to invest in rental properties?” However, I don’t want you to finish this without having a good number in your head, so let me offer two of the most common scenarios.
If you plan to purchase and live in a small multifamily property of two to four units, you could obtain a bank loan for as low as 3.5 percent down through the FHA loan program. This approach, known as “house hacking,” is a great strategy for individuals who are just starting out with real estate and have limited cash and experience. However, to qualify, you are required to live in the property for at least one year.
A conventional loan is a loan that conforms to some strict government guidelines. Most banks want a minimum of a 20 percent down payment for rental properties. A number of banks will allow less, in some cases as low as 10 percent, while other banks will require more, such as 25 percent or even 30 percent. Each bank has its own requirements, but obtaining financing for roughly 20 percent down should be possible, as long as you qualify for such a loan. Understand, however, that the dollar amount or down payment percentage is not as important as the concepts working below the surface.
If you want to read more of what I know about investing with creativity, check out my other book, The Book on Investing in Real Estate with No (and Low) Money Down: Real Life Strategies for Investing in Real Estate Using Other People’s Money.
I have no problem with people who want to use 100 percent cash for their real estate purchases, completely avoiding any kind of loan. I am a big fan of the personal finance advice of Dave Ramsey, who is a staunch advocate for always paying 100 percent cash for any investment property. However, I also recognize that for many people, including me, waiting to invest until all the cash needed has been saved up would require decades of sitting on the sidelines.
If you decide to invest using all cash, I encourage you to pretend that you are not doing so when you are shopping for deals. Having excess money on hand when you’re shopping is dangerous, whether you are at Nordstrom, the supermarket, or looking for rental properties. Being able to pay all cash allows people to be “soft” on the math and pay too much for a property because writing a check is much easier than finding a great deal. Know your numbers, scrutinize each property carefully, and be sure the property you’re targeting will provide a solid return on investment. Remember, price does not equal value. As Warren Buffet says, “Price is what you pay; value is what you get.”
How do you view leverage’s role within real estate investing?
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