Real Estate… Answered

Financing is the single most important topic in real estate investing. Choosing the right real estate financing strategy is also essential for long-term success. Do it right and you’ll both minimize your risk and leverage your cash beyond what most people believe is possible. Do it wrong… and you’ll go bankrupt. In this answer, you’ll learn the advantages and disadvantages of each strategy, along with suggestions on where and how to use them.

1) Real Estate Financing from Traditional Lenders

When your average person finances their house, they go to a traditional lender. Bank of America, Wachovia, and all of your regional and local banks are examples of traditional lenders. You can also use a matchmaker called a Mortgage Broker to connect you with other less well-known lenders, such as Washington Mutual, First Franklin, and hundreds of others.

The advantage of using a traditional lender is they’re cheap. If you meet their criteria, most will loan you money at a low interest rate — usually, prime plus one or two percentage points. The downside is they are rigid and slow. You need to have excellent credit, a reasonably long credit history, and verifiable income for a lender to enjoy financing your real estate investments. They’ll also limit the amount of money you can borrow, sometimes regardless of how much you make or can afford.

Despite these limitations, they are still the most popular type of financing. You should use them when:

• The seller can wait at least 30 days for you to close
• You meet their criteria as a strong borrower
• You can afford to make monthly payments

2) Loans from the Seller (Owner Financing)

One of the most desirable forms of financing, owner financing occurs when the seller allows you to take control of the property without paying the complete purchase price. They put a mortgage on your property for a portion or sometimes all of the purchase price. A common example is owner financing the down payment. For example, if a traditional lender is willing to give you 80% financing, you might ask the seller to finance the other 20% through a second mortgage.

The advantages and disadvantages of owner financing depend almost entirely upon the seller. Most of the time, they’re more flexible than banks. They might:

• Let you accumulate interest, instead of making monthly payments
• Look past credit blemishes, if you can provide an explanation
• Give you a lower interest rate than a traditional lender
• Extend your financing to the person that buys from you

The general rule of thumb is to always ask for owner financing, if you see that they’re in a position to provide it. Ask for an interest rate that is locked in for the term of the loan with interest accumulating for at least a year or two. Sometimes, the seller will say no, but you’ll be surprised by how many times they’ll work with you.

3) Real Estate Financing from Hard Money Lenders

Sometimes considered loan sharks, hard money lenders usually specialize in real estate financing for investors.  Typically, they are relatively small real estate investors that have accumulated some cash, but you’ll also come across some larger companies with deep pockets. You can find them at your local real estate investor associations and sometimes in the Yellow Pages.

You’ll benefit in several ways from working with hard money lenders. They typically base their loans on the investment, not the borrower, so you can get approved even if you have bad credit or insufficient income. If it’s a good deal, they also loan you the amount of money you need, rather than the amount you qualify for. The downside is they charge high interest rates, usually ranging from 12-25% with several upfront points. Most also have relatively shallow pockets, preferring to learn no more than a few hundred thousand to even their most reliable customers.

Hard money lenders are best used on real estate investments with short timelines. You want to minimize the amount of time you have to pay that high interest rate. It’s also important that you watch your profit margin; can you pay the hard money lender their fees and still have enough profit left over to make the investment worthwhile? If not, consider other financing options. Another strategy is to use hard money to buy the property and then refinance with a traditional lender to reduce the high fees.

4) Loans from Private Investors

A popular strategy among up-and-coming dealmakers is to start their own private money fund. Investors loan money into the fund in advance, so you can buy properties with cash as soon as they become available. You can pay the investors in a variety of ways, but the most common are an annual interest rate or a portion of the profits.

The best part about private money is its flexibility. You can custom tailor your terms with investors according to the deal. Another huge advantage is your investors have a vested interest in helping you succeed. When you run into a problem (and you almost always will), you can turn to your investor group for help, accessing their contacts or whatever else is required. The downside is you’ll probably give up more of your profits and possibly some of your decision-making power.

If you can arrange it in advance, private money is the best source of financing for deals where you can’t arrange owner financing and you don’t fit the mold for traditional lenders. It’s great for unusual deals, where you need to be especially creative. Still, if you can get owner financing or traditional loans, use them. You’ll save money.