The majority of investors do not have enough cash to pay for their investments (at least not - the whole enchilada- 100%). Most are paid using DEBT! Or as investors prefer to call it LEVERAGE. This is a technique known as OPM (Other People’s Money) to buy more investments faster and make bigger profits.
Deep Dive Into Investment Loans
Real estate investment loans can come from “countless” sources and
be structured in even more ways. We are going to dive a little
deeper into the most relevant loans, their terms and the way to
get them structured. If you just want a quick overview / list of ways to pay
for your investment, hop to: How To Jumpstart Your Own Cash Machine? (free financial kit download)
It’s very important to understand the sources and the terms to ensure that you meet your financial goals. Many successful investors, especially those with loads of cash make “big buys” with minimal cash on hand – sometimes even with zero, nada, null, zilch dollars down. Even better they use “debt” as a way to increase their investment yield/ returns by creatively structuring the loans.
Commercial vs. Residential Loans, What’s the Difference?
Residential Real Estate Loans, also known as home loans, are often backed by a Government Entity (like FHA loans). There are many options including mortgages, home equity lines of credit (HELOCs), grants, seller financing, microloans, and retirement funds. Most of the loans are granted based on the credit score of the lender. On the other hand, when investing in Commercial Real Estate, you will need to know how to properly value the property since the loans will be backed by the property’s NOI (Net Operating Income or ability to produce an income) not your credit score. The rates are usually higher than those for home loans. Also take additional charges into account that you must add to the lending price: survey fees, loan application fees and legal fees. Take note that these are due before the loan application process even begins.
The difference is that Residential loans are backed by you and Commercial Loans are backed by the property itself.
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The most common ways to get commercial real estate financing are banks and private lenders.
Banks assess real estate investors’ income statements, tax returns, personal and professional balance sheets for the past 3/5 years. Bank financing works best if you have excellent credits, a solid employment income, profitable businesses, and/or other investments. Commercial property lenders commonly ask for 30% down, depending on the type of lender, local real estate market and investor qualifications (credit and available assets). If you want to maximize your chances to get your loan approved on your investment check out How to get star loan approval?
Some banks will have investors sign agreements that require you to meet certain cash flow requirements, debt-to-cash ratios, and other conditions; failure to meet these conditions for whatever reason will trigger a higher interest rate or rejection all together. It is always smart to have a lawyer and/or financial advisor carefully check these conditions before signing any loan. You should get as much information about the terms and the required documentation for your commercial loan as possible before applying. Remember it can be a time-consuming process and the more detailed and prepared you are the higher your chances to get the loan approved.
Private lenders are not just professional lending institutions. Private lenders can be family, friends, neighbors, and co-workers. There are also other investors, who love to co-invest on a deal or lend the money when the deal is great. Private lenders may have fewer lending requirements than a traditional lender, but their interest rates are usually higher and their terms certainly heavier. Hard money loans, also known as predatory loans, are extremely expensive. You should carefully consult the terms of each loan with your financial advisor and preferably your lawyer.
Credit Line Agreements
Credit line agreements are popular financing strategies for those who already own properties. If some or all of your initial properties are paid in full or if you have built up significant equity in your property, a bank will typically extend you a line of credit secured by that property (depending on other credit checks and assessments.). These financing methods can be very lucrative. There are many types of credit lines loans:
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 estates you own. You can typically borrow up to 75% against the value of the property for a term of between 10 and 20 years.
Bank financing options for residential real estate investments are just like loans for primary home purchases. Banks normally assess an individual’s creditworthiness, assets, liabilities, income and expenses, and usually requires a 20% down payment. If your credit rating is below 740 you might face higher interest rate charges; banks also 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 meet certain financial qualifications: such as property improvements, and - no resale - restrictions. These types of programs or loans are called Small Business Administration Loans or Federal Housing Authority Loans.
Creative financing is any form of financing method beyond the traditional lenders and are used when you don’t have a favorable credit or enough assets to secure a loan. But it more often than not is used as a strategic way to leverage a lucrative financial advantage using them:
Seller financing: the seller assumes the note and you make mortgage payments directly to them (Lower Interests)
Peer-to-peer lending: loans made between individuals, usually through a third-party such as an online micro-lender (Better Terms or Interests).
Self-directed IRA purchases: purchases of real estate investments using the assets within an IRA (Tax advantages).
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.
Credit card down payments; A risky and expensive payment method but sometimes the only option or the fastest option to secure a property.
But Why Dive Deep Into Debt Anyway?
Leverage: Faster Closings, Flexibility & Scalability
The greatest advantages of using creative financing is leverage. Leverage allows an investor to pay less money out of pocket and leverage their capital into buying more properties. As a new rental property investor, it’s good to have a financing partner who can help you grow your rental property business through the power of leverage as opposed to traditional bank financing that requires more money out of pocket. Let’s put it this way: If you have $50.000 saved to start investing. You can either choose to use it as a 100% down payment on your first house free and clear cash flowing $850 a month or as a 20% down payment on a $250.000 duplex cash flowing $2000 a month with leverage. Bigger deals (Scalability) and faster growth.
With the traditional bank path, you will need to prepare for the typical mortgage process. Taking high rates, several costly fees and a long, long, tedious underwriting process. Creative financing often comes with higher but straightforward rates and terms and the ability to close faster, being able to obtain quick financing is crucial in the increasingly competitive real estate investing world where a gazillion real estate investors make bids on a single property. Leverage gives you options with how you want to finance and how fast you grow your portfolio. So "Debt" becomes a strategy, a vehicle to go (move) & grow faster! Who's ready to dive?
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