With investors battling a tight credit market, the opportunity to obtain financing for investment properties can often times prove more difficult than expected for some investors. Five years ago many of these same investors had no problem walking into their local lender’s office and getting approved for a loan. Nowadays, it seems like underwriters need a blood sample to approve a loan for an investor (even when that investor could pay cash for the house 5 times over).
There are any number of reasons why perfectly good borrowers cannot get approved for conventional financing including:
- Investors with damaged credit because of a previous investment that went bad (i.e. short sale or foreclosure on credit report)
- Investors who are self-employed and don’t show adequate income on their tax returns. (likely because they have a good CPA who writes off much of their income)
- Investors who already have 10 properties with financing (Fannie Mae caps the number of financed properties to 10)
- Investors who don’t have legal residence in the United States but want to invest in U.S. properties.
- Investors who have money in self-directed IRAs and want to use this money combined with leverage (financing) to acquire investment property.
For investors that fall into these categories, it can be frustrating to feel like all of the opportunity for financing is out of reach. I have found however, that rather than simply resigning to an all cash option, these investors are still better off working with private financing, even when the monthly payment is close to break even cash flow (because of high interest and short amortizations).
For example, we work with private financing in Atlanta that requires 50% down at 12% over a 100 month amortization. While this may seem exorbitant, it is interesting to dissect the returns on something like this compared to an all cash purchase.
$975.00 Monthly Rent
Assume roughly 4-months of rent to meet property manager, taxes, insurance, vacancy and other expenses. (this is very conservative, but will work for the simplicity of this example)
Return for cash investor:
$975.00/month x 8-months = $7,800.00 / $80,000 invested = 9.75% (plus rent and property value increases over time).
Return using 100 month financing:
50% down payment
$40,000: 100-month loan has a monthly payment of $634.63 ($7,615 per year)
$975.00/month x 8-months = $7,800.00 – $7,615.00 to pay loan = $185.00 / $40,000.00 = .50%
At first glance, the all cash investment yield of 9.75% is superior to the cash yield of .50% generated from the financed transaction. However, to get a true return calculation on the 100-month financing option, what must also be evaluated is the considerable equity growth from paying the loan.
Year Equity Paid into Loan and expressed as a % of the $40,000 down-payment
1st year $2,975.69 or 7.43% + .50% = 7.93%
2nd year $3,353.08 or 8.38% + .50% = 8.88%
3rd year $3,778.35 or 9.45% + .50% = 9.95% (exceeds all cash return)
4th year $4,257.50 or 10.64% + .50% = 11.14%
5th year $4,795.51 or 11.99% + .50% = 12.49%
6th year $5,405.93 or 13.51% + .50% = 14.01%
7th year $6,091.54 or 15.23% + .50% = 15.73%
8th year $6,861.10 or 17.15% + .50% = 17.65%
For the investor who can trade cash-flow during the early years for equity build up, the 100-month financing option will generate a greater total return over the life of the loan given the stated assumptions.
For investors attempting to generate maximum benefit on the real estate portion of their portfolio, the 100-month financing option offers a greater return during the life of the loan. However, the greatest benefit of the financed transaction is realized after the loan is retired. Using the same $80,000 required for the cash purchase, an investor that used the leverage would have been able to invest and now own debt-free 2 properties resulting in twice the cash flow, twice the assets and twice the upside potential.
Whereas some investors see 12% interest and scour, the proper usage of even slight leverage can make a huge difference in the long run. For those investors that can’t qualify for conventional financing and assume a cash purchase is the only option, perhaps it’s worth considering shorter term private financing to grow your wealth quicker than you could using only cash.