Real Estate 101: Financing

The following is a guest post by FMF reader Apex. He has been investing in rental real estate for more than four years and is authoring a Real Estate 101 series, posting every Friday, based on his experiences.  (To read the series from the beginning, start here.) The series is designed to give prospective investors the basic tools they need to succeed.

The number one roadblock preventing most people from expanding in real estate is access to capital.  Real Estate is a capital intensive business.  Everything in the business revolves around access to capital. 
 
It was one of the 6 reasons I listed in the first column in this series about why you should not invest in real estate.  It was also listed as one of the first steps along the path in the third column on where to start.  Many people want to get started in real estate but do not have enough capital to even get started.  Others can pull together one or two deals but then they hit the capital roadblock as well.  They want to expand into more properties but they are stuck perhaps for years trying to get the capital for their next deal.  Regardless of where you are on the real estate journey, most everyone hits the capital roadblock sooner or later.
 
There are two different sources of money that you will use when investing in real estate, your money, and other people’s money (a.k.a. OPM).  The percentage of each of these sources of money that you use will determine your leverage ratio also know as a debt to equity ratio.  This ratio is determined by dividing the total amount of borrowed funds you have by the total value of all the properties you own.  For example, if you owned 4 properties worth $125,000 each and had $300,000 of borrowed money your debt to equity ratio would be $300,000 / $500,000 or 60%. 
 
Your Money
 
While it is possible to use only your money, it is almost always impossible to use only other people’s money.  In order to get access to other people’s money, you have to have some of your own money to start with.  There are many ways to get your own money.  It usually starts with a decent paying job from which you save a good portion of your money.  It could also involve getting a second job or second source of income.  If you have owned your own house for a number of years you could extract equity from it by doing a cash-out refinance.  It can come from selling things you can live without.  It can include downsizing your car, your house, and your lifestyle.  It can come from virtually anywhere.  You simply have to decide how badly you want it.  If you are driving a new model Lexus but can’t find the cash for a down payment, then you have made lifestyle choices that have prevented you from getting where you want to get. 
 
In my first column I finished the section on capital with this sentence: Unless you are already cash rich, expect to feel somewhat poorer for a while.  If you are unwilling to feel somewhat poorer for a while, then you are the reason you are unable to find the capital to get started in real estate.
 
Other People’s Money
 
Your own capital will only get you so far and for most people that isn’t very far at all. Your money is limited. Other people’s money is vast.  When your money is gone, there is no way to replace it quickly, thus most expanding real estate businesses depend on access to a considerable amount of other people’s money or OPM. 
 
You get OPM by simply borrowing money from whatever sources are available to you.  Getting some OPM might not be too difficult but the more debt you take on, the harder it is to get more.  Those who will be borrowing the money to you will be scrutinizing your debt carrying capacity.  They will be examining your income streams, business model, taxes, and credit ratings in detail.  Eventually many will simply refuse to give you any more money until you can improve your financial standing in their eyes.
 
Because of this there are two primary rules that I consider essential when acquiring financing.

• Rule #1: Get the money for as long as possible.  You know you are going to need more money to purchase future properties so why would you want to be required to pay this money back any sooner than absolutely necessary?  That would just require you to get even more money later.  That may be difficult or impossible to do, and of course borrowing new money always has a cost.  As such you should prefer terms on your loans that are as long as possible.  If you need access to more money in the future, the last thing you want to do is take out a 15 year mortgage on a property you are buying today.  This will require larger payments resulting in significantly reduced cash flow.  If your business is generating less cash that will extend the amount of time it takes to generate enough cash to purchase your next property.  This is why I always prefer 30 year mortgages even if the interest rate is slightly higher.


• Rule #2:  Get as much money as you can get.  Maybe you have enough cash to put 50% down on a property.  Maybe you just feel more comfortable only being leveraged 60% instead of 75%.  There can be any number of reasons why you might choose to borrow less than the maximum.  Don’t do it.  If you are borrowing on a given property, borrow the maximum you can get on it.  If you are more comfortable with lower leverage then buy every third or fourth property with cash, but do not take out 50% or 60% loans on a property.  Always take the maximum they will give you.  It is always more difficult and more expensive to get more money out of a property once you have a mortgage on it.  If you purchase a property with all cash you can go back and borrow against it later.  When you do, you should once again borrow the maximum amount that they will give you.  You can manage your own leverage ratios across all your properties to ensure you do not over leverage yourself but do not put smaller leverage ratios on each property.

Where to Get Financing
 
When seeking financing, the best place to start is with traditional banks using conventional financing and government backed loans.  These are known as agency loans and nearly every person who has ever taken out a house loan on their personal residence has this kind of a loan.  They are backed by agencies such as Fannie Mae, Freddie Mac, or FHA.  These loans typically have better rates than those not backed by a government agency and they also have longer terms.  Many agency loans are amortized over 30 years and not required to be paid in full for 30 years.  It’s almost impossible to find a private non-agency loan with those terms. 
 
Luckily investors are able to qualify for these loans if the property has 4 units or less.  For the first 4 properties these loans can be acquired as easily as they can on your primary residence.  You can get up to 10 agency loans but anything beyond 4 gets considerably more difficult and there are currently very few lending institutions who are willing to offer agency backed loans if you have more than 4.  If you have hit your limit of 4 agency loans you will want to contact as many lending institutions and brokers as you can find until you find one that will continue to do agency loans beyond 4 properties.
 
Other financing options include lines of credit on your personal residence or on any investment properties you may have that have appreciated in value.  Lines of credit offer the advantage of allowing you to take out money when you need it and pay it back when you don’t.  They are a great cash flow management tool.  The next financing option is a private or commercial loan that is not government backed.  The terms and rates on these will be less favorable so you need to make sure it does not put your cash flow in jeopardy.  You can also take out loans using other assets as collateral such as stocks, bonds, jewelry, cars, any assets you have that have value in them that you want to extract for the purposes of securing more financing capacity.  You could also consider borrowing from friends or family if you are in a relationship that supports that and understand the relationship risks that can come from that type of arrangement. 
 
It is worth noting that OPM can be as addictive and seductive as the drug those initials sound like, so it’s important to remain disciplined when borrowing money.  Certainly one can put themselves in a highly over-leveraged state doing things like this.  I am not suggesting you should leverage everything you have to purchase real estate.  I am merely pointing out that there are multiple ways to get access to financing and capital.  As long as you keep your debt to equity ratio at a reasonable level and keep your cash flow margin well within the safety range I would not have much concern about any of the steps I have outlined here.  I would feel comfortable with a debt to equity ratio that did not exceed 80% and a cash flow margin that stays above 10%.  If that debt to equity ratio is higher than some people would feel comfortable with, they should choose a lower number that they feel meets their margin for safety.
 
Lack of access to capital is probably the number one frustration of most beginning real estate investors.  Everyone runs up against the money roadblock.  Sometimes the only path is to wait until you can save enough money to go around the roadblock that is right in front of you.  Of course there is always another roadblock after that one.  However, the more cash flowing properties you can acquire the more cash they will throw off.  Eventually they will be the source of removing the capital roadblocks.  But until that time arrives which can be quite a long time for many real estate investors, you need to consider every option for getting access to capital and always be on the look out for new sources of funds if you want to keep your real estate business growing and expanding.

To read the next post in this series, see Real Estate 101: Taxes.

Comments

[Jonathan]

Once again, you hit the nail on the head. So far our 3 SFHs have been purchased through traditional (agency) financing at 80%. Just yesterday in fact we heard about a local 7-unit property where the owner is willing to carry some of the financing. Seller-carry financing, to us, is the gold standard for purchasing a property because of all of the flexibility it can provide, both during and after purchase. But to buy it, we'd not only need a healthy dose of the seller's money but a bunch more (probably from the 3 Fs) for a down payment.

[Apex]

@Jonathan,

Seller-carry financing is something I didn't touch on but it's a great option where it's available. It would be pretty rare with a SFH but a little more common with pure investment properties like the 7-unit property you mentioned. Probably the seller is trying to make the purchase a little easier for someone who is having problems getting the credit to purchase.

If it happens to be available it is certainly worth taking advantage of if the terms are acceptable.

[Jonathan]

Yeah there's a lot of legwork to do - the property just came to my attention yesterday, and at first blush it's definitely over-priced. We'll have to see how the numbers could work out and come to our own valuation.

[elb]

How does seller-carry work if there is already a primary mortgage in place? Most sellers I've found will offer financing, but my mortgage people won't finance the first mortgage with a seller second, and most sellers don't have the cash to take out their bank and stand in as first lienholder.

I prefer master lease-options as a seller finance. Have you worked with those?

[Jonathan]

elb,

Seller-carry works best when the seller owns a property free and clear and doesn't have a need to "cash out" (receive the full purchase price in cash upfront). When that's the case, the seller opts to accept some combination of a down payment and a note, which the seller then pays over time at agreed-upon terms. Typically, seller-carry and bank financing don't mix.

I am not familiar with master lease-options, though it sounds like a lease-to-buy plan. Am I close?

[Apex]

@elb,

That is the big problem with seller-carry financing. It requires a seller with deep pockets and one who doesn't need their hands on the cash now. Those are pretty rare. Technically if they sell the property to you their mortgage triggers the due on sale clause. So their bank might call their loan if they didn't pay it off.

The master-lease option (lease to own) is not something I have done on either the buy side or the sell side. I would not be opposed but would be very picky about the terms. Often times a lease option is structured to give the seller a somewhat inflated sales price to ensure they make a good profit. Either you buy the property eventually at that price or you lose your option. If you can't get financing to purchase an apartment complex now, why will you be able to get the funds in a few years when the option expires? I don't know what the typical option length is on a master-lease but on rent-to-own its usually only 2-3 years. If you can get a long term option then it might make more sense but how do you set a purchase price that is 10-15 years into the future? If the purchase price is left open then what exactly did your option buy you? The price could later be set at a value that makes no sense or that you have no ability to complete.

I have never even seen what one of these looks like for an investor to purchase. The only lease options I have seen are those for investors leasing to prospective renter/homeowners as a rent-to-buy type arrangement.

Have you done one of these master-lease options? Can you give an example of what the contract/terms/option costs/sales prices looked like?

It's hard for me to say for sure without seeing some examples, but likely I would be somewhat leery of them.

I do not know what the statistics are on master-lease options for investors but for renters the statistics on lease-to-own contracts are that 90% of them never close and the renter simply forfeits their option money. That is one reason why so many landlords love them. They either get a somewhat inflated price for their property or they keep the tenants lease money.

I have had one tenant begging me to do one and I have repeatedly told him no. First I don't want to sell but even if I did, he has trouble making his rent payment ever other month. I know the odds of him completing the deal are close to zero. I don't feel good about taking his option money knowing he will almost certainly forfeit it.

[Apex]

@Jonathan,

That's another potential problem with seller carry financing. It can often be a cover for either an inflated price or inflated financing terms. It's potentially another way to do what some landlords do with the lease-to-own option. Basically get more money than they could from a strong buyer. The buyer knows they cannot get the money to buy the property so they are willing to pay either over market or to pay at market with high financing charges (both of these work out the same by basically allowing the seller to get more money than he/she could from a strong buyer).

Recall my article on making the offer. Properties sell at market prices. If the property is priced at market then it should sell right? Why should the seller need to grease the wheels if the property is priced at market. Because it's not. If it was, a buyer with cash or financing would likely buy it.

If this is the only way you can purchase a property and it still makes financial sense it may be worth doing. Just don't expect the seller to sell at market with market based financing charges. Why should they? The market for investment buyers is strong enough now that it should have plenty of buyers who can provide their own financing if the property is priced at market.

What I have found in real estate and in most things in life, is there is the traditional way that things are done and there are the "unique" ways things are done. The unique ways are usually done to provide people who cannot qualify for the traditional way a path to participate. That path comes with a cost. Other money examples would include things like: credit card financing, peer-to-peer lending, payday loans. These options are not provided at the same cost as traditional means to financing.

[elb]

Buy-side, I have found it helpful as a short-term bridge to traditional financing in the following situations: (1) if the property is overall strong but has an issue like foundation that a bank won't lend on, and I don't have enough for an all-cash offer OR (2) the seller is tired of dealing with administrative issues but is not capable of handling things like tenant management / tax appeals, but doesn't want to go through the pain of listing. In all circumstances, I've had the capital available for traditional financing, but not for a 100% cash buy.

Basically, the terms are a 3-year master lease with quarterly payments, which are usually somewhere between a note for the full purchase price and 60-80% of the stated net income.

So, for a $400,000 property that threw off $4,000 gross a mo with $3,000 / mo net income (without debt service), the quarterly payments would be somewhere between $5,000 and $7,500 (roughly 75% of the stated income), with a portion of no less than 50% going to the purchase price (the spread and purchase price reduction are essentially my property management fee). Option price is usually 3-5%, same as hand money in a traditional buy, all applied to purchase price. Let's say further that I have $200,000 available for a downpayment, not enough for a full cash buy.

For my option, I get operational control, management of the property and tenants, and the ability to make repairs with consent of the seller. I then address the issue that is preventing traditional finance or bothering the seller during the term of the lease. Following that, I exercise the option, making the buy with traditional financing.

So, in the previous example, let's say it's a 4-unit with foundation issues and an outstanding tax assessment. I will put down my option of $12,000, make foundation repairs at $20,000, contest the assessment successfully to lower the tax by 20% (I'm a practicing lawyer, so I like to use my expertise there) and then I exercise the option and buy for $388,000 - the purchase price reductions from the leases. So, upon option exercise, I would spend $20,000 + $12,000 plus $96,000 (25% down on the remainder, minus any purchase price reductions) plus closing costs.

Going forward, I usually exercise immediately after repair, but I do have the option to let collect the spread between the master lease payments and the tenant leases until the repairs are paid back.

It's a win-win in that the seller has no further responsibility to the property unless I bail on the option (and if I did so, they would still get the benefit of the repair and the tax reduction), and they get a buyer willing to pay close to their price without incurring the steep discount many cash buyers offer. I get the benefit of being able to acquire and finance a good property that would otherwise be limited to only cash buyers.

That seemed complicated, but it's really not. Anyway, I've had more success with that then having sellers carry paper.

[elb]

"What I have found in real estate and in most things in life, is there is the traditional way that things are done and there are the "unique" ways things are done. The unique ways are usually done to provide people who cannot qualify for the traditional way a path to participate. "

Agreed 100%. The above is not my preference and I don't seek it out, but if my agent comes to me and says "this is a nice 3-plex with a foundation and a roof (or zoning issues, whatever) the seller can't afford to fix," I would rather do the MLO then wait for cash to build up or try to bring in partners.

Most of the time, traditional financing is the best route. Sell-side, I would probably not do a lease-option, but I'm 15 years from selling anything.

[Apex]

@elb,

Thanks for that example. It makes a lot of sense. It is another example of a non-traditional path. The seller can't sell at market because there are issues preventing that. This allows them to get close to market and allows you to get in without having all the cash. It works if the situations are right and you have the skills as a buyer to do what is necessary to make it work.

[elb]

@Apex,

No problem. You are dead-on with your take on financing. What always bothers me is when real estate books / blogs spend so much time on "nothing down" or creative finance techniques as a way to enter the biz. No seller but the most distressed will sell to a newbie investor who is proposing techniques he/she's never used before.

Newbies should save money and build up the 25% down. Or, alternatively, owner-occupy a 2 or 3-plex. Otherwise, sit it out and analyze deals in your head until you get the $.

[Jonathan]

Apex,

We'll do our homework - the only way we would buy the property, seller financing or not, is if it made financial sense. In the experiences of our mentors, seller financing has been incredibly rewarding. If I can either a) set the purchase price, or b) set the finance terms, then I can make a deal that would work. If I can't do one of those things, or find a compromise that makes the investment work, I won't buy the property.

[Rich]

Apex, you used the term "cash flow margin" in there without defining it. Could you define it for us so we know what that 10% means? Thanks! :)

[Apex]

@Rich,

Sorry about that. Cash Flow Margin was one of the 4 ratios I covered in Column number 4 on Running the numbers.

http://www.freemoneyfinance.com/2012/10/real-estate-101-running-the-numbers.html

It is defined there but I will define it again here for ease of reference:

Cash Flow Margin = Cash Flow / Revenue

So for instance in that post I laid out an example of a property with monthly revenue of $1400 and cash flow of $425 per month. This creates a cash flow margin of 425/1400 = 30%

The easiest way to think about it is that it is the percentage of your rent money that you get to keep each month after paying all bills.

[jim]

Another good one in the series.

One point I don't see covered: if a property has more than 4 units then I believe you can not get standard financing and generally have to go for commercial or unconventional financing. That can make financing of 5plexes or larger units more difficult. Commercial loans have higher rates and are not generally as easy to get as normal loans. My dad has a 7 unit and had problems getting financing several years back.

Rentals usually have a little higher interest rate than a primary home and its often around 1% more. Lately the spread is not that much and I recently refinanced a rental at 4% / 30 year fixed, no points.
Also it seems lenders generally want at least 25% equity nowadays.

[Apex]

@Jim,

I did mention that you needed to have 4 or less units to get agency financing but you are correct that I did not go into your options for financing a property with more than 4 units. You are correct that it mostly requires commercial loans. I did discuss those a bit too because eventually you need that for houses too. The agencies will only give you so many agency loans. But I did not discuss them in the context of properties with more than 4 units. I don't have any experience with those types of properties but it is clear that financing options are far more limited on any properties with more than 4 units.

Who did you refinance your rental through if you don't mind me asking? Do you have more than 4 loans? I do so I am having a hard time finding anyone who will refinance them because I have to fall under the extended agency rules and very few lenders want to deal with them.

[cwt]

Hey Guys,

I've been following the conversations, and am happy to find good solid information that you can't find in real estsate books, etc.

I have been a landlord for two years with only one property, but it happened by accident because I couldn't sell my condo when buying a house.

I would like to expand in real estate, but with property values dipping, I am under water in my house and barely over on my condo.

Do I need to sit tight and pay down on the se two properties before I can move forward? (it is such a slow process!) Or, do I move forward and try for another cashflow property?

[cwt]

cwt again...

How important is it for me to form an LLC as a newbie?

My accidental landlordship left me with two properties (SFH & condo) in my personal name. Before I move forward in real estate, should I form the LLC and transfer these properties into the LLC? Can you put your primary residence in an LLC?

Thanks for the help.

[cwt]

what? nobody wants to talk to a newbie??

[so]

@cwt

Not enough info as to your overall situation for point #1, and no, for point #2, no LLC at this point.

[FMF]

cwt -

It's also a weekend, so I would check back for comments on Monday afternoon.

[Luis]

@ cwt I'm not sure you would be approved for a loan on another rental even with a perfect FICO score. You can try. I liken being underwater to not having an emergency fund, let that be your risk assessment.

I'd first pay down your property until it is no longer underwater, then analyze if your current property is worth keeping as a rental. I'm guessing if you purchased the property between 2004-2008 then it is not worth keeping. Keep renting your property until you can sell, then sell and start over.

[Luis]

...caveat, "so" makes a good point about not enough information. If you are way in the hole with your finances then you should seek other remediation.

[Apex]

@cwt,

Why do you want to expand in real estate? This is a critical question to answer. Since you said you are a newbie I do not know if you have read the whole series. I suggest you should. Particularly, see my first two posts in this series on why you should not invest in real estate and what the benefits of real estate investing are. Make sure you have the right reasons.

Real estate is not a simple easy path to riches. As someone who is already doing it by accident you should have a little taste of that already.

But if you are up for the challenge, understand what it involves and have the means to move forward then I will give the following advice to you. This advice is based heavily on the 4th article on running the numbers, which is a critical to my advice so if you have not read it please do so.

Your current situation of being under water on your current property is irrelevant to whether or not you should move forward with a new property. Now it may affect your ability to get financing but that doesn't have anything to do with if you should move forward, only with if you have the ability to move forward.

If you can get financing then the question of whether or not you should expand in real estate stands alone and separate from the equity position of your current holdings. The only question that matters is can you purchase a property that you have the ability to manage effectively and that makes a very solid cash flow with the financing costs locked in long term. If those are all true there is no reason not to move forward and doing so only strengthens your position. The extra cash flow from another property can be used to strengthen your financal position. You can use that to pay down debt on the property that is underwater or you can use it to get money to buy yet another property.

Based on what I wrote in this article I would not use it to pay down debt on the underwater property (recall the 2 rules, when you get debt get as much as you can for as long as you can), I would use it to buy another property. The more you have the more cash flow you will have and the quicker your situation will turn positive. The fact that one single property is underwater is irrelevant to your total financial picture.

It is important to think of each new decision with respect to how that particular investment will perform. But it is equally important to think of your whole portfolio in ways that maximizes the performance of the whole and ignore what makes one particular item in the portfolio look better than others.

If there is a bad performer that you can replace with a better performer that is worth doing. But simply paying down debt on an underwater property so that the numbers on that particular property look better does not help you in anyway. In fact it probably hurts you if you could have put that money to more productive use by purchasing another property and continuing to pay the minimum debt service on the one property that is underwater.

I talked about this in the running the numbers column as well. If a property goes underwater but still makes cash flow it does not matter that its underwater? Your particular property may not make money since it was an accident. In that case you will have to assess the benefit of getting it above water so you can sell it and put the money to work elsewhere. But likely that still won't do you much good because you will have to sink a lot of cash in to do that and not get it all back out (since you are underwater). It's probably more productive putting it elsewhere.

Either way the assessments are very simple. Do I make more money (and by money I mean income/cash flow) by putting the money in this existing property that is underwater or by putting the money in something else like a new property that will make good cash flow.

[Apex]

@cwt,

This LLC topic keeps coming up. LLC's are fine (I have one) but they are over-rated. Owning properties in them greatly limits your financing options. None of my properties are owned by my LLC. I just run the daily operations through it on properties that I own personally. It is unclear how much liability protection this actually provide. Perhaps very little. I wouldn't worry much about it. Instead protect yourself with very good liability insurance. High liability on the homeowners policy combined with an umbrella liability policy.

[jim]

Apex, your right you did talk about 4 units being the limit for conventional loans, I had misread you.

I only have 2 loans on our rentals right now.

My Dad is the one who had the 7 unit. He had to get a commercial loan for it. But he had to go from bank to bank to bank to find anyone who would even talk to him, few banks want to do them for individuals investing in rentals. Plus the terms were worse. He paid a premium interest rate and it had a limited fixed term with a balloon payment. That was many years ago though, might be considerably easier nowadays or worse.. I don't know.

[Apex]

@Jim,

Not easier today. I am approaching the place where I will have to get those kinds of loans on any property because I will run out of the ability to get any agency conventional loans. The terms you describe (higher interest, limited fixed term, balloon payment [as well as shorter amortization]) are what I have encountered as well.

It gets harder when the financing terms are both more expensive and shorter terms.

[jim]

CWT, I would not worry about an LLC to start. I don't expect you'd be able to sign over the property & mortgages into an LLC anyway as the banks won't just let you dump them into an entity like that. So they'll be in your name regardless. Also you would NOT want to put your personal home into the LLC as that would backfire.

THe whole point of an LLC is to protect against liability. People worry about multi million dollar lawsuits far too much. Its just not that common. All an LLC will do is separate your rentals from your other personal property. Which is why you don't want your house or other non-rental assets in the same LLC. And if you're a single person running the LLCs entirely then it may not do that either. Courts may disallow the LLC if its obvious you're the person running everything.

I think a good insurance policy is your better bet.