Unlike securities investments, which can be purchased in increments of as little as $20.00, real estate property investments are significant purchases, ranging from a few thousand dollars for a parcel of land to tens of millions of dollars or more for Class A office space in a central business district. The vast majority of investors do not have the cash on hand to cover 100% of their real estate investments outright; most are purchased with leverage.
Real estate investment loans can come from a variety of sources, and be structured in at least as many ways. It’s important to understand these sources and terms if you are considering investing in multiple properties to ensure that you meet your financial goals.
Further, there are ways to increase your investment yield through creatively structuring your loan terms. Some successful investors, even those with the cash to cover their real estate investment cost completely, have made sizable purchases with minimal cash outlays – sometime even with zero dollars down. This is a technique known as OPM, and refers to using Other People’s Money to make your investments and profits.
In this article, we will cover 1) commercial real estate financing, 2) residential real estate financing, 3) options for commercial real estate financing, 4) options for residential real estate financing, 5) successful real estate financing strategies from real estate entrepreneurs, 6) key terms for commercial real estate financing, and 7) key terms for residential real estate financing.
- 1 COMMERCIAL REAL ESTATE FINANCING
- 2 RESIDENTIAL REAL ESTATE FINANCING
- 3 OPTIONS FOR COMMERCIAL REAL ESTATE FINANCING
- 4 OPTIONS FOR RESIDENTIAL REAL ESTATE FINANCING
- 5 SUCCESSFUL REAL ESTATE FINANCING STRATEGIES FROM REAL ESTATE ENTREPRENEURS
- 6 KEY TERMS FOR COMMERCIAL REAL ESTATE FINANCING
- 7 KEY TERMS FOR RESIDENTIAL REAL ESTATE FINANCING
COMMERCIAL REAL ESTATE FINANCING
In general, when investing in commercial real estate, you will need to know how to properly value the property, as the amount of financing you can obtain should at least match this value. Commercial loans, unlike home loans, are not backed by a government entity, so the rates are traditionally higher than those for home loans. Balloon loans are common among traditional (bank) lenders, so you must determine whether your projected income will be enough to pay the mortgage off when the balloon payment is due. If you cannot, you may be forced to refinance and pay a higher interest rate.
There are also ancillary charges that you must add to the lending price, such as survey fees, loan application fees, and legal fees. Often, these must be pre-paid before the loan application process begins.
RESIDENTIAL REAL ESTATE FINANCING
There are many options available to the real estate investor looking to purchase a residential real estate property as an investment, including, but not limited to mortgages, home equity lines of credit (HELOCs), grants, seller financing, micro loans, and retirement funds.
OPTIONS FOR COMMERCIAL REAL ESTATE FINANCING
The most common vehicles for obtaining commercial real estate financing are banks and private lenders.
Typically, bank lenders assess real estate investors’ income statements and tax returns, as well as personal and professional balance sheets for the past three to five years. Bank financing is best for those with excellent credit history and a history of solid income from employment, businesses, and/or other investments. Commercial property lenders typically ask for 30% of the purchase price as a down payment for loans, though this can vary by type of lender, local real estate market, and by investor qualifications (i.e. credit-worthiness and available assets). You should also make sure that you have an up-to-date business plan and realistic financial projections to accompany your historical information, though lenders may pay more attention to your past financial history.
Some banks require investors to sign covenants that require you to meet certain cash flow requirements, debt-to-cash ratios, and other conditions; failure to mean these conditions for whatever reason will trigger a higher interest rate. You should employ a lawyer and/or financial advisor to carefully scrutinize these covenants and conditions before signing the loan. You should also ask a bank lender for as much information about the typical terms and required documentation for a commercial loan before applying as it can be a time-consuming process.
Private lenders are not just professional lending institutions. Private lenders can include family, friends, neighbors, and co-workers. There are then of course professional investors, who you can find through online searches, and private professional lending institutions. The latter may have fewer lending requirements than a traditional lender, but their interest rates may be higher and/or terms more onerous. Hard money loans, also known as predatory loans, are the most restrictive and are extremely expensive. You should carefully consult the terms of each loan with your financial advisor.
Credit line agreements
Credit line agreements are a popular financing strategy for those who already own at least one property. If the initial property is paid in full or if you have built up significant equity in said property, pending credit and other assessments, a bank will typically extend you a line of credit secured by that initial property. Using this as a financing method can be lucrative, but risky. If, for example, your net income on the second property is negative, you will be stuck paying off the cost of the credit line used to obtain financing and the mortgage payments out of pocket; missing payments could then cost you both properties.
There are many types of credit lines in addition to balloon loans, including, but not limited to:
- Short Term Loans: These are usually secured loans for a term of a year or less.
- Asset Based Loans: These are secured by your professional, or in some cases, your personal assets.
- Contract Financing: This involves your work as a business owner being compensated through the contractor making direct payments to your lender.
- Term Loans: These are loans, typically made by traditional lenders, and typically secured, for a fixed term, at least partially determined by your income statements and projections.
- Equipment Loans: These are real estate loans that are secured by business equipment and against which you can typically borrow 60 to 80% of the value of the equipment for the projected life of the equipment.
- Real Estate Loans: These loans are secured by other real estate you own. You can typically borrow up to 75% against the value of the property for a term of between 10 and 20 years
- Balloon Loans: These loans are typically for 3 to 15 years and are indexed against a Treasury index.
Financing Options for Commercial Real Estate
OPTIONS FOR RESIDENTIAL REAL ESTATE FINANCING
The most popular options for residential real estate property investments are traditional lenders (banks), private lenders, and government grants.
Bank financing options for residential real estate investments are not dissimilar from those for primary home purchases. Banks typically assess an individual’s credit worthiness, assets, liabilities, income and expenses, and usually require at least a 20% down payment. Increases in interest rate charges start if your credit rating is below 740; banks also often like to see at least six months’ worth of cash reserves for each property to ensure that you can make mortgage payments if a tenant fails to pay the rent. If your credit and/or down payment is not sufficient, avoid big banks and look at neighborhood banks, and/or private lenders.
Federal agencies often offer potential investors grants to facilitate their purchase of distressed properties. These grants come with stipulations, including that the investor must mean certain financial qualifications, that the investor will improve the property, and that the investor will not attempt to resell it before the improvements are made. More information on these types of programs is available on the websites of the Small Business Administration and the Federal Housing Authority, as well as the websites of many state and local housing authorities.
Creative financing refers to financing methods beyond those used by traditional lenders, and are used when both your credit and assets cannot secure you favorable traditional loan terms, or when you can spot and leverage a lucrative financial advantage using them. They include, but are not limited to:
- Seller financing: wherein the seller assumes the note, and you make mortgage payments directly to them
- Peer-to-peer lending: loans made between individuals, usually through a third-party such as an online microlender
- Self-directed IRA purchases: purchases of real estate investments using the assets within an IRA
- Interest-only loans: a type of loan agreement in which your monthly payments are applied to the interest only for a set period
- Subject to transactions: a transaction in which you purchase the home and assume the existing mortgage on the property without telling the lender
- Loan assumptions: a transaction in which you formally assume the terms of the loan through the bank or lender
- Seller carryback: a type of financing where the seller carries a lien on the property, assuming the role of lender for the buyer/investor
- Friends and family: when you finance your property using funds borrowed from your friends and relatives.
Make money in real estate using residential investment financing
SUCCESSFUL REAL ESTATE FINANCING STRATEGIES FROM REAL ESTATE ENTREPRENEURS
There is a lot to learn from real estate tycoons about financing real estate investments, and while some require massive amounts of capital to emulate, they provide insight into how you might approach your own investments, and finance them using OPM.
Commercial real estate financing strategies
One such strategy that is difficult to emulate unless you are a multi-millionaire is one of buying massive amounts of stock in real estate rich firms. Steven Roth, Chairman of Vornado Realty Trust, spent $600 million on J.C. Penney stock in order to buy into the retailer’s rich real estate portfolio directly. Vornado, which owns skyscrapers in Chicago and New York can benefit from an appreciation in the firm’s stock price, and as the new owner of 26% of the firm, can influence the direction and management of the firm’s real estate portfolio, helping to harness its income generating capacity. In an interview with the Wall Street Journal, Roth stated:
“If you look at the math (1,106 stores and 41 million square feet of leased or owned space) and you look at the investment, I think you’ll agree it’s a pretty terrific investment.”
Roth has made other similar investments over the years. His first firm, Interstate Properties was started with OPM – $250,000 investment which Roth used to purchase strip malls. He was so successful that he was able to pay it back within a year. He formed Vornado, bought a controlling stake in the retail chain Alexander’s, and used income from this purchase to finance his purchase of multiple, lucrative commercial office properties in Midtown Manhattan.
Residential real estate financing strategies
Of course, not everyone has a spare $600 million dollars to spend. Barbara Corcoran, multi-millionaire real estate magnate, financed an initial $1,000 loan from a boyfriend and built a wildly successful real estate brokerage firm, which gave her the capital to invest in commercial and residential properties of her own. She counsels against using home equity loans as a financing strategy, citing the following personal experience in an interview with Bankrate:
“I’ve only used it once. In 1988, I remember I got 110 percent financing from a very friendly mortgage broker on a country home, a renovated school house in Pawling, N.Y., and I used that money to float my business because I was going to go down. It was either that or sell the house, and that would have broken my heart. The money did float the business for about seven or eight months, I drained it right down, and I also paid for the mortgage with it, but it saved my business. I only did it because Citibank, at the time, had a credit line for me that I never used, and then when I needed it and pulled it, they closed it down — the first $10,000, BOOM! I thought credit lines were there for the trouble times; that was an interesting business lesson. But then my good old house saved the day. I still have it. I was able to pay off the entire mortgage on it two years later because the business was doing so well, so the business returned the compliment, I guess.”
KEY TERMS FOR COMMERCIAL REAL ESTATE FINANCING
There are many key terms specific to commercial real estate financing that are critical for you to know. The most significant of these include:
- Net Operating Income (NOI): obtained by subtracting operating expenses from the gross operating income, and should, ideally be positive.
- Cap Rate: the value of properties that produce income, such as multi-family apartment buildings or Community Retail Centers.
- Cash on Cash: a formula used to assess operating performance that takes into account cases in which the selling investor has used leverage to purchase property and discounts operating expenses accordingly.
- Gross Scheduled Income: the total revenue derived from a property with a 0% vacancy rate.
- Gross Operating Income: gross income minus vacancy losses.
- Operating Expenses: all expenses associated with maintaining the property.
- Break Even Ratio: This is equivalent to the operating expenses plus the debt payments divided by the gross operating income and can be used to quickly assess whether the property is in danger of default.
- Loan-To-Value (LTV): The value of the property divided by the lesser of its appraised value or selling price.
KEY TERMS FOR RESIDENTIAL REAL ESTATE FINANCING
Among the terms critical to understanding residential real estate financing are:
- Cash equity: the amount of money you have invested in a property.
- 80-10-10 mortgage: A real estate transaction involving two mortgages originated at the same time, the first with an 80% LTV and the second with a 10% LTV. You would, in this situation, make a 10% down payment.
- Disclosure: When a seller reveals something about the property that had been previously undiscussed. Consumer protection laws stipulate that certain facts about the condition of the property must be disclosed to the seller before a transaction can be completed.
- Earnest money deposit: A partial down payment to show your commitment to make a property purchase. Usually, you will pay the balance of the down payment at closing.
- Escrow: This refers to an account maintained by a neutral third-party where your funds are stored during closing, and released at the conclusion of the transaction.
- Prepayment penalty: A special fee you pay if you pay off a loan before the loan term ends. This is often stipulated in loan documents.
- Private mortgage insurance: Insurance that covers the lender in case you default on the property. If you have a down payment that is less than 20% or your credit is less than 700, you will likely have to buy private mortgage insurance.
Image credit: Flickr | Emilio Labrador and Flickr | Mark Moz under Attribution 2.0 Generic.