Cross-Collateralization: How to Buy Property With No Money Down

Buying property on a consistent basis can be difficult. Coming up with the down payment needed to buy a house is probably the number one reason deals don’t get done. Unless you’re raising capital or partnering with others who have money, it can be a real struggle.

But what if you already own some property with equity? What if you find a great deal that can support itself being 100% financed? Well if you answered yes to these questions then I have your answer: cross-collateralization.

Have you ever wondered how some people constantly buy real estate by themselves? They never partner or raise money. Most of the time they’re not making enough cash flow per year to keep ponying up large sums of money for the down payment needed. What gives?

What many outsiders don’t realize is these buyers likely have equity in another property that can be used for that down payment. This is called lendable equity.

What Is Lendable Equity?

Lendable equity is simply the equity you have in another property that you can use to purchase other properties. By utilizing this method, you are cross-collateralizing one property to buy another.

Lendable equity is one of the best-kept secrets for doing no money down deals. I have personally used this method to buy millions of dollars’ worth of real estate without putting any of my own money down.

How To Calculate Lendable Equity

Here’s an example. Let’s say you buy a house for $50,000. You decide you’re going to BRRRR this deal, and you need to put $10,000 into the property. Your after-repair value (or ARV) is now $100,000.

So, you paid $50,000, plus you put in $10,000 worth of repairs. You’re all-in at $60,000. Now you have $40,000 worth of lendable equity, right?

Wrong.

Most banks will lend up to 80% of the appraised value of the home. That means the most you can get for a cash-out refinance on this property is $80,000. And that’s great for you! You just cashed out and made $20,000.

But what if you only took a loan out for your initial investment of $60,000 and left that other $20,000 on “the books”? Well, that $20K is called the lendable equity.

A Look at the Numbers

To reiterate:

Appraised value: $100,000
80% loan to value: $80,000
Initial investment: $60,000
Lendable equity: $20,000

Cross-Collateral Loan: How Does It Work?

Now that you understand the basics, let’s talk lenders. Make sure your lender knows what you’re talking about and what you want to do before you start the refinance portion of your BRRRR.

Most commercial lenders know how to utilize this strategy and can walk you through all the fine details. If they look confused when you explain it to them, go somewhere that knows what cross-collateralization is.

Most banks want a DSCR, or a debt service coverage ratio, of 1.2. What this means is that if your yearly monthly payments are $10,000, the bank wants to make sure you’re bringing in $12,000, or 20% more than the yearly debt. Since you only took out a $60,000 loan instead of $80,000, your DSCR is going to be higher, your loan payment will be lower, and your net profit will be greater.

It is generally best to use this strategy with the same bank as they will have the first lien position on both properties.

So, what do you do with that $20,000 that you left on the books? You go find another deal!

That $20,000 of lendable equity is the same as cash—but better because you’re not paying interest on it since you didn’t do a cash-out refinance. With the lendable equity you have left on your first property, you can go out and buy another property at $100,000 with no money down.

You are able to do this by cross-collateralizing, or leveraging, the equity in your first property. If your second property can support a DSCR of 1.2 when 100% financed, then the collateral needed is in the first property. Now you have two properties with an appraised value of $200,000 and a total loan balance of $160,000, or 80% loan to value.

It’s the same as if you pulled the cash out, but you’re not paying all the interest.

The real secret of this strategy is property number two. If the second property cash flows well and can appraise high enough, you can repeat this process and really snowball your buying power. If the second property cannot support the 1.2 DSCR, more than likely the bank will not lend on it unless the combined properties’ total DSCR is 1.2 (meaning if the first property is at a 1.6 and the second property is a 1.0, then the average of the two properties is 1.3 DSCR).

Of course, depending on the bank, the lender, your investment history, and other factors, this might not be possible for you. It’s always smart to discuss the strategy with your lender before you start the process.

Advantages & Disadvantages of Cross-Collateralization

This process is great for no money down purchases, but it does come with risk. I don’t advise new investors to use this strategy, nor owners of low-cash-flowing properties.

The biggest risk of cross-collateralizing is that the bank is holding two notes that are tied together. This means if you default on one property, they can take both to pay off the debts. Therefore, it can be very risky if you don’t run your numbers or don’t have the proper cash reserves.

By employing this strategy, you are essentially building a house of cards. If one property fails to perform and you default on one loan, you could lose everything that is tied to those mortgages. This could be devastating to your portfolio, especially during a downturn in the housing market.

You can avoid the risk of losing it all, however. Here’s how.

After you close on your second property, wait 6-12 months and then refinance. You can either do this with the same bank or spread your portfolio out with other lenders. Once you refinance and “untie” the two mortgages, you are safe from losing both properties if one fails.

If you improved the second property and increased the value to $125,000, now that property will stand alone.

A Look at the Numbers

Let’s go through an example. An 80% loan to value of $125,000 is $100,000.

Here’s where you start snowballing your purchases. You just refinanced your second property with a bank across town at an 80% LTV. Remember, you have $20,000 in lendable equity on that first property. Now you can go out and find another great deal at a $100,000 purchase price. Just repeat the process like you did with the second property.

With every loan payment, you are paying down principal and increasing your lendable equity, thus increasing your purchasing power. By snowballing these properties, you are putting no money down, keeping your loan payment low, and increasing your cash flow.

The banks love this because it reflects more in their favor with all the equity left on the books. The more comfortable the bank is with your portfolio, the more deals you can close.

The Bottom Line

It’s essential to keep in mind that cross-collateralization is a very risky—yet rewarding—strategy. It is less than ideal for:

New investors
Properties that do not cash flow well or may be riskier than others
A long-term strategy

Remember that you should only have properties tied together on the same mortgage for 6-12 months tops. I suggest as soon as you close the second property you should immediately be working to increase the value so that you can refinance and mitigate the risk involved.

Again, this is a short-term buying strategy and not a long-term plan. It should only be used to get into the deal with no money down, then refinance as soon as possible. You don’t want to build a house of cards and have it all collapse on you because of one bad property or a correction in the market.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.