Chapter 6:

Real Estate Financing

Regardless of what some late-night infomercial may lead you to believe, there is no such thing as free real estate. Real estate is a commodity, and it must be paid for. As a real estate investor, one of the most important roles you will play will be putting together your deals using a variety of different financing tools. This chapter will teach you the ins and outs of the methods available to fund your real estate investments.

In This Chapter, You'll Learn About:

Understanding Real Estate Financing
Cash Purchases
Conventional Mortgages
Portfolio Lenders
FHA Loans
203K Loans
Hard Money
Private Money
Home Equity Loans and Lines of Credit
Partnerships
Commercial Loans
Other investment Tools

A bank is a place that will lend you money if you can prove that you don

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—Bob Hope

Understanding Real Estate Financing

This chapter will discuss the many different types of real estate financing that are available. In chapter 3, we looked at the different investment vehicles in real estate (such as single family homes, commercial real estate, apartments, and more), as well as some of the different strategies (buy and hold, flipping, and wholesaling) you can use to make money in real estate.

This chapter is designed to help you put those strategies to use in reality. If you have any questions about any of these financing techniques, try searching the BiggerPockets website for more information.

Finally, the following list is by no means comprehensive, but it provides an overview of some of the financing methods used by real estate investors. This information will help you combine an investment vehicle, strategy, and financing method in order to tackle a real estate investment.

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No Money Down?

Do you need a lot of money to invest in real estate?

The short answer is no. The longer answer is more complex. There are numerous strategies that investors use to invest in real estate without having a lot of cash. Some deals can be done without using any money—period!

Below you'll find several strategies for financing your real estate deals, but if you want more in-depth information, we invite you to pick up a copy of The Book on Investing in Real Estate with No (and Low) Money Down, sold here on BiggerPockets. This book was written by Brandon Turner, co-host of the BiggerPockets Podcast, and contains numerous tips, ideas, and strategies for investing in real estate using other people's money (OPM). If you’d like a copy of this book, head to BiggerPockets.com/NoMoney today!

With that, here’s a summary of the financing methods available for your real estate deals:

  1. All Cash—Many investors choose to pay in cash for an investment property. According to a joint study by BiggerPockets and Memphis Invest, 24 percent of U.S. investors use 100 percent of their own cash to finance their real estate investments. To be clear, even when investors use terms like “all cash,” the truth is, no cash is actually traded. In most cases, the buyer brings a check (usually certified funds, such as a bank cashier’s check) to the title company, and the title company writes a check to the seller. Other times, the money is sent via wire transfer from the bank. This is the easiest form of financing, as there are typically no complications, but for most investors (and probably the vast majority of new investors) all cash is not an option. Additionally, the return given from a cash deal will not be the same when leveraged. Let’s explore this further with an example.

    Real Life Example: John has $100,000 to invest. He can choose to use that $100,000 to buy a house that will produce $1,000 per month in income—$12,000 per year. This equates to a 12 percent return on investment.

    John could instead use his $100,000 as a 20 percent down payment on five similar homes, each listed at $100,000. With an $80,000 mortgage on each house, the cash flow will be approximately $300 per month, per house, which equals $1,500 per month—$18,000 per year. This equates to an 18 percent return on investment, which is 50 percent more profitable than buying just one home.

  2. Conventional Mortgage—As the example above illustrates, financing your investment property may produce significantly better returns than paying in cash. Most investors choose to finance their investments with a cash down payment and a traditional conventional mortgage. Most conventional mortgages require a minimum of 20 percent down but may extend as high as 30 percent for investment properties, depending on the lender. Conventional mortgages are the most common type of mortgage used by home buyers and generally provide the lowest interest rates. Click here to find interest rates in your area.

    To learn more about mortgage financing and what you qualify for, check out the BiggerPockets Mortgage Loans Page.

  3. Portfolio Lenders—Conventional mortgage loans originate from a variety of sources, such as banks, mortgage brokers, and credit unions. In most cases, these lending sources don’t actually use their own capital to fund the loan, but rather acquire or borrow the funds from another party—or resell the loan to government-backed institutions, like Fannie Mae and Freddie Mac, in order to replenish their own funds. As a result, most lending institutions must adhere to a very strict set of rules and guidelines when it comes to financing an investment. These strict rules can make conventional financing difficult to obtain for many, especially for real estate investors and other self-employed borrowers.

    However, some banks and credit unions have the ability to lend entirely from their own funds, making them a portfolio lender. Because they lend their own money, they can provide more flexible loan terms and qualifying standards. This means that they are able to make loans available at whatever terms they deem acceptable. Oftentimes, a portfolio lender will offer available funds with less restrictive qualifications than a conventional lender.

    Most banks and lending institutions don't advertise portfolio lending, but you can find these individuals through referrals and networking with other investors. You can also simply grab a phone book, call up lending institutions, and ask if they offer portfolio lending.

  4. FHA Loans—The Federal Housing Administration (FHA) is a United States government program that insures mortgages for banks. If you have health or car insurance, you may already understand the concept: pooling money to spread the risk for everyone. FHA loans are designed only for homeowners who are going to live in the property, so you cannot use an FHA-backed loan to buy a property purely as an investment. However, you can take advantage of an exception that allows an FHA-financed home to have up to four separate units. In other words, if you plan to live in one of the units, you could buy a duplex, triplex, or fourplex with an FHA loan.

    The benefit of an FHA loan is the low down payment requirement, which is currently just 3.5 percent. This may help you get started quicker since you won't need to save up 20 percent.

    However, sometimes with a blessing comes a curse. While the low down payment option is great, an FHA loan requires an additional payment, known as private mortgage insurance (PMI). This type of insurance protects the lender and is required whenever a down payment is less than 20 percent. PMI will make your monthly payment slightly higher, thus reducing your cash flow.

    To read more about using an FHA loan to get started, check out an article on the BiggerPockets blog titled “New Investor Strategy: How to Buy Your First Multi-Family Investment Property & Live Rent Free.”

  5. 203k Loans—A subset of the FHA loan, a 203k loan allows a buyer to purchase a house that is in need of some rehab work by building the cost of repairs or improvements into the loan itself. Like a standard FHA loan, a 203k loan still allows for a low down payment. This loan type is also applicable for duplexes, triplexes, and fourplexes (as long as they are owner occupied), and comes with PMI demands for loans below 20 percent.

    Real World Example: John found a small duplex for $100,000 that he wants to purchase. He plans to live in one unit and rent the other one out. The property needs about $12,000 for new paint and carpeting. John can add that $12,000 into the cost of the loan and put 3.5 percent down—a total of just $3,920. Now John can get the new paint and carpet (paid for by the loan), move into his renovated home, rent out the other half, and begin making cash flow and building wealth. John is a happy camper.

  6. Owner Financing—Banks or other giant lending institutions are not the only entities that will finance a property for you. In some cases, the owner of the property you want to buy can actually fund the purchase; in this case you’d simply make monthly payments to the seller rather than a bank. Typically, the only time a property owner will do this for you is if they own the home free and clear, meaning they don’t have an existing mortgage on the property.

    If the seller does have another loan and then sells the home to you, the seller's loan must be paid back immediately or the house will face foreclosure.This is because a legal clause is written into nearly every loan called the due on sale clause. This clause gives the former lender the right to call the note immediately due. If that amount can't be paid, the lender has the right to foreclose on the property. Some investors choose to ignore this clause and still purchase subject to the other loan, risking bank foreclosure.

    If the conditions are right, owner financing can be a great way to gain ownership of real estate without using a bank. Owner financing can also be a good tool for selling your properties in the future, as well, which we'll cover more in chapter 8 when we look at exit strategies.

  7. Hard Money—Hard money is financing that is obtained from a private business or individual for the purpose of investing in real estate. While terms and styles change often, hard money has several defining characteristics:

    • Loan is primarily based on the value of the property
    • Shorter term lengths (due in 6–36 months)
    • Higher than normal interest (8–15 percent)
    • High loan points (fees to get the loan)
    • Many hard money lenders do not require income verification
    • Many hard money lenders don't require credit references
    • Does not show on your personal credit report
    • Hard money can often fund a deal in just days
    • Hard money lenders understand when the property needs rehab work

    Hard money can be beneficial for short-term loans in certain situations, but many investors who have used hard money lenders have found themselves in tough situations when the short-term loan ran out. Use hard money with caution, making sure you have multiple exit strategies in place before taking the loan.

    To find a hard money lender, try the following tips:

    • Ask a real estate agent
    • Ask a house flipper
    • Check out BiggerPockets' hard money list
    • Newspaper
    • Craigslist
    • Google
    • Mortgage broker
  8. Private Money—Private money is similar to hard money in many respects, but it’s usually distinguishable due to the relationship between the lender and the borrower. Typically, with private money, the lender will not be a professional lender like a hard money lender. Instead, it will be an individual looking to achieve higher returns on their cash. Oftentimes, there is an established relationship with a private money lender, and these lenders are much less business-oriented than hard money lenders. Additionally, private money usually has fewer fees and points, and the term length can be negotiated more easily to serve the best interest of both parties.

    Private lenders will lend you cash to buy a property in exchange for a specific interest rate. Their investment will be secured by a promissory note or mortgage on the property, which means if you don't pay, they can foreclose and take the house (just like with a bank loan, hard money, or most other loan types). The interest rate from a private lender is usually established up front and the money is lent for a specified period of time—anywhere from six months to 30 years.

    A private lender typically does not receive an equity stake in cash flow or future value outside of their predetermined interest rate, but there are no hard-and-fast rules when it comes to private capital. Generally, private money is financed by one investor. These loans are commonly used when an investor believes they can raise the value of the property over a short period of time. They will take on the debt from the private money loan, refinance the property after adding value, and then pay back the private lender. Just like with hard money, private money should only be used when you have multiple, clearly defined exit strategies.

    If you are trying to build relationships for private capital, developing credibility is a must. Whether it’s through blogging about your real estate endeavors, posting your real estate updates to Facebook, talking about real estate investing in casual conversation, or attending your local real estate investment club, you should make yourself visible.

    Ask yourself if you are maximizing your visibility. Are you creating opportunities to highlight your investing experience? You don't need to be a braggart, but next time someone asks what’s new in your life, share a few details about your real estate endeavors. You never know what might transpire.

  9. Home Equity Loans and Lines of Credit—Many investors choose to tap into the equity in their primary home to help finance the purchase of their investment properties. Banks and other lending institutions have many different products, such as a home equity installment loan (HEIL) or a home equity line of credit (HELOC) that will allow you to tap into the equity you've already got.

    For example, an investor may decide to purchase a property, but instead of going through the normal hassle of trying to finance the investment property itself, they instead will take out a HELOC on their own home to pay for the property.

    In order to obtain a home equity loan or line of credit, you must first have equity in your home. Banks will typically only lend up to a certain percentage of your home's value in total. This percentage differs between lenders, but it is not uncommon to find a lending institution that will offer to lend up to 90 percent of the value of your home.

    Real World Example: John's current home is worth $100,000. John visits with his local bank and learns that they will allow up to 90 percent debt on that home. Therefore, John can borrow a total of $90,000 on the house. If he already owes $50,000 on a first mortgage, the home equity line or loan will be capped at $40,000 to ensure the total loans don't exceed 90 percent.

    Using home equity loans and lines of credit has multiple benefits over traditional loans, including:

    The loan is based on the value of your primary residence—not the newly purchased property. This means that the bank that is providing the loan won't typically even look at the new property. They don't generally concern themselves with what your intent is with the money, only your ability to pay it back. As such, the new property can be in terrible condition, and the bank likely won't care.

    When you have a home equity loan or line, the money is yours to do with what you want. It's not dependent on the new property—so you can offer cash when making offers on new properties, and as a result, you will have a higher chance of your offers being accepted.

    Home equity lines and loans may have certain tax benefits, like the ability to deduct the interest paid on the loan. See a qualified CPA or attorney for more information.

    Because the loan is secured by your primary residence, the interest rate on a home equity loan or line is typically very low compared to that of hard money or private money. To learn more about what current rates are on these products, visit the BiggerPockets Mortgage Center.

    Real World Example: Sarah, an investor, wants to buy an investment property for $100,000, but she doesn't have any additional money for a down payment. She does, however, have a lot of available equity in her own primary residence (she owes $50,000, but the home is worth $100,000). Sarah opens up a $20,000 home equity loan on her home to fund the down payment, and then gets a conventional mortgage from a bank for the remaining $80,000 owed on the investment property.

    Home equity loans and lines come with both fixed and adjustable interest rates. Consider your goals, timetables, and financials when determining which home equity product you want to use to further your investing career.

  10. Partnerships—We touched briefly on the use of partners in chapter 4, but what we didn't cover is their ability to help you finance a deal. If you want to invest in a property, but the price range is beyond your reach, an equity partner may be a welcome addition to your team. An equity partner is someone who you bring into a transaction in order to help finance the property.

    Partnerships can be structured in many different ways, from using a partner’s cash to finance the entire property to using a partner to simply fund the down payment. There are no set rules with equity partnerships, but each situation and deal requires its own analysis of how the deal will be put together, who makes the decisions, and how profits will be split at the end.

    Depending on the operating agreement signed by both parties, the equity partner may have an active or passive role. The ownership stake provided by the equity partner may allow that partner to actively participate in nearly all aspects of property ownership. Additionally, as a partner, they typically receive in accordance with their ownership percentage a return on their investment that includes cash flow, appreciation, depreciation, and eventual profit when the property is sold.

    Unlike a private lender, an equity partner does not receive an agreed upon interest rate on the loan. Instead, they receive only a percentage of what the property generates. If it makes a lot of money, then their return will be higher, but if the investment loses money, they may have to financially contribute to keep the property afloat.

    Equity partners take a higher risk than a private lender might, but in return, they have the potential to make significantly more if the investment is successful. Also unlike private lending, the equity partner's investment is not secured by a mortgage or promissory note. It is instead secured by an operating agreement between the partners.

  11. Commercial Loans—While most of the options above focus on residential loans, the world of commercial lending may also be a viable option for your investing. In fact, if you are looking to buy a property other than a one- to four-unit residential property, a commercial loan is probably exactly what you'll be needing.

    Commercial loans typically have slightly higher interest rates and fees, shorter terms, and different qualifying standards. In the world of residential lending, the income of the borrower is valued almost above all else; commercial lending, however, places much more scrutiny on the property. The logic behind this is simple: if you own a $10 million apartment building and things go wrong, you won’t be able to make your mortgage payment whether you make $20,000 or $200,000 per year in personal income. The commercial lender will still look at your income, credit, and other personal financial indicators, but this is solely to gain a broad view of your financial prowess. What's more important in the vast majority of cases is the amount of revenue a property generates.

    Additionally, commercial lenders will often extend a business line of credit to finance flips or other investments. Some investors obtain a large business line of credit, which allows them access to cash for house flipping and other real estate ventures.

  12. Equity Indexed Universal Life Insurance (EIULS), Life Insurance, Roth IRAs, and Other Sources—There a multitude of other investment and savings products available for use in real estate investing. We won’t cover each of these in detail here, so be sure to speak to a qualified financial advisor about ways you can use these products in your investing career.

Moving On

One of the most valuable skills to hone as an investor is to find creative ways to continually move forward with your investments. As every deal is different, you will most likely find you use many different financing strategies throughout your career. Therefore, understanding all the different options available is infinitely beneficial.

Another valuable and equally important role you will be playing as an investor is the role of a marketing professional. Chapter 7 will look at the concept of real estate marketing and provide strategies to supercharge your investment opportunities. Marketing is important not only for buying properties, but also for selling and renting.