A Guide To Real Estate Financing
As a beginner investor, understanding how to finance a deal is just as important as finding one. A lack of real estate financing continues to hinder most new investors in today’s market, simply because they are not aware of the different financing avenues. Whether you have access to working capital or not, there are always ways to acquire capital.
Investing in real estate is never a bad idea. It offers potential investors a slew of financial and personal benefits such as increased cash flow, home appreciation and tax benefits. In fact, real estate investment continues to be one of the most popular vehicles in producing financial wealth. According to the IRS, approximately 71 percent of Americans that declared more than a million dollars on their income tax returns in the last 50 years were in real estate. Ironically, beginner investors face the challenge of learning how to obtain real estate investment financing before they can start creating wealth. Read on to learn about some of the most common types of real estate financing options out there, as well as prominent loans for real estate investing.
What Is Real Estate Financing?
Real estate financing is a term generally used to describe an investor’s method of securing funds for an impending deal. As its name suggests, this method will have investors secure capital from an outside source to buy and renovate a property. Not unlike traditional financing, however, real estate financing comes complete with terms and underwriting, not the least of which need to be fully understood before entering a contract.
How To Obtain Real Estate Investment Financing
One of the biggest misconceptions of real estate investing is that you need to have a lot of money to get started, which simply is not true. The secret that many professionals do not understand however, is the fact that there are a multitude of different real estate financing options available to fund every investment. Because the method in which a specific deal is funded can greatly impact its outcome, understanding the financing aspect is imperative.
As an investor, there are a few different ways to go about financing real estate investments. Each one will have its own set of pros and cons, and your financing approach will depend on the property and the situation. For beginner investors, it is important to remember that not all real estate investment financing options are created equal. What works for someone else may not necessarily work for you, but the trick is understanding which real estate financing option will compliment your business strategy. By taking the time to research the various real estate financing options out there, new investors are sure to realize how accessible investing can be. Broadening one’s toolkit of real estate investment financing options is simply a matter of being knowledgeable about what strategies exist, as well as proper ways to leverage them. Keep in mind that all investors have faced the financing hurdle at some point in their career; when in doubt, there is nothing wrong with tapping into your investor network and ask for advice.
Real Estate Financing Options
Investors with a deal lined up have already accomplished one of the most important steps in home flipping. However, finding a viable deal is only one piece of the puzzle. Once you find a good property to invest in, you need to then be able to finance the impending transaction.
Financing a real estate deal tends to send new investors into a fit of anxiety or is even enough to compel them to pack up their dreams and retreat to their nine-to-five job. However, if an investor commits to doing his or her due diligence, the fear of a lack of funds is irrational.
If you have a great deal on the table, there is no limit when it comes to ways to fund it. A great example would be leveraging a self-directed IRA, which would require some careful consideration beforehand; however, it goes to show that there are many available options for real estate investment financing. For investors wondering how to finance an investment property, I’ll explain some of your real estate financing options:
Cash Financing: Great for investors who have access to a significant amount of capital, either personally or through their network, and wish to purchase properties free and clear.
Hard Money Lenders: Accessible to investors who have less-than-perfect credit or financial history and need a short-term loan.
Private Money Lenders: Investors who are well-connected can often tap into capital from personal connections, borrowing money at a specified interest rate and payback period.
Self-Directed IRA Accounts: Individuals who have elected to create savings through a self-directed IRA may make the decision to tap into their account as a way to access capital.
Seller Financing: Buyers and sellers can sometimes strike up a mutually beneficial agreement, allowing the investor and seller to avoid having to go through a private lender altogether.
As an investor, cash is a monumental tool to getting what you want. Along with getting more offers accepted, cash financing enables investors to save on interest, increase their cash flow, and receive instant equity in their investment. It also could save investors on the purchase amount.
In the first quarter of 2016, all-cash homebuyers for single-family homes and condos paid, on average, 23 percent less per square foot than all homebuyers nationwide, according to RealtyTrac.
In addition, it is important to remember there will be times when paying cash for a property makes sense and other times when other financing options should be considered. If you have your own capital, however, you should always consider using it in the best possible scenarios.
Hard Money Lenders
Funded by private businesses and individuals, hard money lenders provide short-term, high-rate loans for real estate investors. This financing option, which doesn’t conform to bank standards of creditworthiness, is typically used by rehabbers looking to renovate a property.
Hard money financing is generally determined by the value of the investment property itself, with lenders analyzing the “After Repair Value” (ARV) to determine the size of the loan. Hard money lenders generally will not fund an entire deal, but rather fund a percentage of the purchase price or the after-repair value, which will range from 50 to 70 percent.
Hard money lenders also charge fees apart from the interest on the loan. These fees are generally delineated in points (three to five), which represent additional percentage fees based on the loan amount. In general, hard money lenders charge much higher interest rates – sometimes double the amount of a traditional mortgage, plus fees. In the end, all hard money lenders will have different requirements and real estate investors need to be fully aware of what they are getting themselves into.
Private Money Lenders
Private money lenders are integral to the growth of every new investor. They have the means and intent to invest capital into your business, and they are just as interested in working with you, as you are with them.
Generally speaking, private money lenders will provide investors with cash to purchase real estate properties in exchange for a specific interest rate. These terms will generally be established up front and with a specified payback period – anywhere from six months to a year. These loans are most common when investors believe they can raise the value of a particular property over a short period of time, typically through renovations. It is also important to understand that, like hard money, private money should only be used when you have a clearly defined exit strategy.
Self-Directed IRA Accounts
A self-directed IRA (Individual Retirement Account) is, at its most basic level, a savings account that allows for compounded, tax-free growth, over time. Self-directed IRAs are unique from other types of savings accounts, such as a 401K, as the owner can control a wide array of investment options, including real estate.
Owners of self-directed IRA account enjoy a unique benefit of being able to purchase, rehab and sell properties while still being able to defer taxes. However, it is important to note that owners under the age of 60 are typically subject to a penalty for withdrawing funds early.
There are some scenarios when both an investor and a seller can strike up a mutually beneficial seller financing deal. In seller financing, the buyer of the property will make payments directly to the seller of the property, rather than going through a bank. This can help a motivated seller sell the property more quickly, and the investor can avoid having to jump over traditional mortgage lending hurdles, such as financial and credit score minimums.
Together, the buyer and seller can often enjoy a faster transaction process, as well as avoid many costs and fees associated with the closing process. Furthermore, the owner has the option to sell the promissory note if they no longer want to manage their own owner financing.
Peer-to-peer lending allows investors to borrow money from other investors, or groups of investors (hence the name). The basic process can be thought of similarly to hard or private money lending, though the specifics are quite different. Like these methods, investors can bypass the strict requirements of traditional funding and allow their portfolios to do the talking.
This form of real estate financing does typically involve a lower loan-to-value ratio when compared other types of funding. This often prevents investors from borrowing the entire loan amount needed to purchase a property; however, do not be afraid to seek out the financing you need. Peer-to-peer financing offers a high degree of flexibility overall.