A guide to borrowing money to buy property: Commenter OwnMyHood here. Since the Playboys gave a few of us real estate guys the open invite to drop some knowledge, I figured I’d stop back in for another post… Having read this blog for a couple years now, I see the primary takeaways as: 1) Grind it out while you’re young and stack your chips, 2) Don’t follow the herd, 3) Regardless of how much you work, live an interesting life, 4) Don’t get hitched (legally due to penalties), 5) Avoid living in a city you hate… and the Holy Grail: Start that business and *earn money while you sleep*
If you found this blog, the first 5 items should be pretty straight forward (and if it isn’t, the WSPs were nice enough to provide instructions for you). But I’ll admit it, starting that business can be a bit of a challenge.
We’re lead to believe that every successful business is built around some totally novel concept. All you need is a bright idea and some garage space and before long you’ll be the next Jobs or Wozniak. VC firms will be throwing money at you and growing your business and marketing your product will be a piece of cake… Well, in the real world, it doesn’t quite work that way.
Let’s face it, most of us don’t have that novel business idea. We may have thought of something that stands a decent chance of making some money, but who is going to back us? Even if you’ve saved up a few hundred large, you’ll likely need some outside help to to get things off the ground.
Think you’re a good salesman? Walk in to a bank with no prior biz experience and ask for a loan to start that great restaurant, bar, car wash, gym, online store, propeller beanie factory, (fill in the blank) that you’ve always dreamed of owning. If you can convince them to give you a loan, congrats you have no need for this site.
Now for the other 99.9% who got the raised eyebrow and the “sorry, I wish I could be more help” spiel, there is another way. There is one business where you need no experience, relatively little start up capital and have the ability to leverage it by borrowing large amounts right from the get go (sometimes with government backing). What biz is this you ask? Real Estate.
So You Want to Buy Your First Property, Where Do You Start? Well pal, since you asked I’ll lay out four of the most common loan options topped off with some tips from the trenches meant to help you maximize the amount of money you can borrow for your investment. Let’s start with what is likely the most common option, good ol’ residential mortgages:
The bread and butter of the beginning real estate investor. These are the loans individuals and families have been using for decades to buy single family homes and condominiums. What you may not know is that they can also be used for multi-unit residential properties with up to 4 apartments as well, so if you’re looking for income property but have no prior experience, residential loans are usually a good place to start.
You can get these types of loans from a bank or mortgage broker and your lack of RE experience isn’t going to have any bearing on your chances of securing the loan. In the residential space, your personal financial situation is paramount, the key things lenders look at are: 1) You have good enough credit and 2) You have enough income
Residential mortgage lenders use the Debt to Income Ratio (DTI) as their primary metric when determining whether or not you can afford to borrow money. This is all of your monthly debt payments (mortgage, car, student loan etc) added up and divided by your income. If you are at 35% or less you are usually good to go.
To sum it up here are some Pros and Cons of this type of loan:
Pros: 1) Ease: Relatively easy to get for beginners and you can put less than 20% down with private mortgage insurance or government backed programs: FHA 3.5% down, VA 0% down, USDA 0% down etc. 2) Rates: Lower rate with long amortization schedule (30 years) with ability to lock the rate for it’s entirety, 3) Low Hurdle: No RE experience needed, 4) Regulation: Highly regulated, so your chances of being “taken advantage of” by the lender are low
Cons: 1) Scale: You can only use these loans to buy smaller properties (1-4 residential units), 2) Four Loan Maximum: You can only have 4 loans per person if they are the type that are sold to Fannie Mae or Freddie Mac, 3) Underwriting: Underwriting is standardized, so your relationship with whoever originates the loan likely isn’t going to make much of a difference, 4) Red Tape: There is a fair amount of red tape that isn’t present with other loan types (multiple reviews of bank balances, employment verification, appraisals always required etc). For someone with a relatively simple financial situation, these aren’t bad. For biz owners or others who’s situation is more complex, these can be a headache; 5) Occupancy: May need to occupy the property to be eligible for certain programs
Once you max out your residential mortgages, want to buy apartment buildings with 5 or more units or commercial properties, if you’re borrowing from a bank, you’ll have to get a commercial mortgage. Though on the surface, this is still a loan used to purchase real estate there are quite a few differences with the residential loans described above.
Some of the big differences are: 1) Rates and terms can vary a decent amount from bank to bank, so it is best to shop around; 2) Relationships with the banker (how much they like & trust you) and bank (how much you have on deposit) matter quite a bit; 3) Commercial loans are not governed by the same regulations as residential mortgages, so there is more likely to be some harsh clauses built into the contract (learn how read the docs and utilize a lawyer); 4) The primary concern of the bank is “will this specific property make money.” Your personal financial situation matters, but only as part of the bigger picture. If you can convince the bank the property will make money and you aren’t a financial basket case, you likely will get the loan
The mortgage broker who originates your residential mortgage sees your investment as a transaction: you get a loan and he gets a commission. Meanwhile the mortgage gets sold to another bank 1000 miles away while he moves on to the next deal. If you default 5 years from now, it’s not money out of the broker’s pocket.
When it comes to commercial lenders, relationships do matter. Commercial banks keep the loans in house, so the banker you’re talking to has much more incentive to make sure you and the property you’re pitching him are a good investment. Also, the person you talk to when applying for a commercial loan is usually a decision maker, so getting them on your side can only help.
When it comes to determining the risk involved in lending you money, commercial banks primarily rely on the deal’s Debt Service Coverage Ratio (DSCR). This is the NOI of the property divided by the mortgage payment. Though there is quite a bit of variance across different geographic areas, property types and market cycles, usually you want a deal to have at least 1.2 DSCR when approaching a commercial bank.
Pros: 1) Range: You can purchase a wide range of properties with these loans; 2) Trust: If you do multiple deals with a particular bank and build a relationship with their staff, this can make future mortgages easier to get; 3) Terms: More flexibility regarding terms; 4) Limits: There is no limit to how many loans of this type you can have (though banks will have limits depending on their size and relationship with you)
Cons: 1) Interest: Rates and terms are usually worse than residential mortgages (shorter schedules with adjustable rates or balloon payments); 2) Complexity: Less regulated so you want to be more careful regarding terms, banks can put some nasty stuff in there; 3) Origination Costs: These can be quite expensive. Commercial appraisals aren’t cheap and banks can charge whatever the market can bear as far as fees go
Ahh now we’re talking, you want to put the pedal to the metal when it comes to leverage? This is one of the quickest ways to do it. Seller financing is when an owner has equity in their property and is willing to “be the bank:” take incremental payments over time instead of one big up front payment. How is this different than the above two options? Well, for one the rate and terms are whatever you and the seller can agree on. 0% down with a 50 year schedule and a balloon after 25 years? If you can get an owner to sign on the dotted line it’s all yours…………………. If only it were that easy.
Your average real estate deal involves a fair amount of haggling but in this case, in addition to the standard negotiations you’ve also got to convince the seller to invest in you via a mortgage. This is essentially like handing them a junk bond in exchange for what could be their most valuable asset. Needless to say it’s not always an easy sale (and I’d probably use a different analogy when pitching a seller…) and though some sellers are out of touch, it’s uncommon to have price and terms vary widely from the market in general. Regardless, if you can make it happen, it’s seller financing that often allows ambitious RE investors to build massive portfolios in a relatively short amount of time.
Pros: 1) Can Be Cheap: This type of financing is inexpensive, oftentimes the only significant origination costs are lawyer fees (which you have to pay anyway when you utilize a bank), 2) Flexibility: Rate, terms and down payment are whatever you and the seller can agree on; 3) Speed: These loans can be some of the quickest to close. When you work with institution, you do a lot of waiting: waiting on the underwriter, waiting on the appraiser, waiting on finding a date when all parties can get together. With seller financing it really just comes down to when you, the seller and an attorney can meet and sign documents
Cons: 1) Regulations: There are few regulations regarding these types of loans so sellers can build all kind of stuff into their mortgages. Make sure to read thoroughly before signing; 2) Availability: There is limited availability when it comes to seller financing: there are many sellers who can not afford it or have no interest in holding paper, it’s up to you to convince the one’s who are open to it that it makes sense
You could also refer to this as “friends and family” money. Private Money in this case just means borrowing from individuals who have money to lend. If you have a rich friend or Aunt who is looking to make some money and is willing to back an up and coming RE investor, this might be worth looking into. Notably, private money has the most in common with seller financing, in that the fees to originate the loan are low and the terms are whatever you and the lender can agree on. That said there are some very important differences:
1) Loan is unsecured: In many cases the lender has no right to any collateral if the borrower defaults, so if you don’t pay them back, they’re SOL. Even if they do require some kind of collateral, they are usually last in line were you to go bankrupt and would likely recover only a small fraction of what they lent you (if anything at all) and 2) Lenders are oftentimes not RE investors: With seller financing you are purchasing a building off another investor, this is someone who has at least some experience with market cycles, vacancy, the random nature of certain expenses etc. When you borrow from old Uncle Vlad who earned his money working 9-5 in the same factory for 50 years and tell him that you’re going to be late next month due to having to replace a collapsing roof, he might not be so understanding.
Private money can be easy to come by if you know the right people, but I’d caution any investor before using it. As stated above your relationship with the lender usually goes beyond pure business, and this can make things tricky. In order to avoid ruining personal relationships (which often are a whole lot more important than whatever deal you’re pursuing) I’ve put together some criteria for using private money:
Don’t borrow what someone can’t afford to lose: Let’s say Grandma is on a fixed income but has $50k in the bank, and it just so happens there is a beautiful duplex for sale that requires… you guessed it, a $50k down payment. She would love more than anything to help her grandson get started building his future and wouldn’t hesitate to write you a check. As tempting as it might be to borrow her entire net worth, tell Granny to keep her loot. Even if you make the payments on time, what if she has a large medical expense 6 months after you buy your duplex? Where’s the money going to come from to pay the good doctor? When the rest of the family finds out what Grandma did with her emergency fund things are going to get awkward for you real quick.
Avoid the “active investor:” You don’t want to borrow from a friend who thinks just because they loaned you some dough they suddenly get to be involved with the day to day operation of your business. Partnerships are generally unstable to begin with, now throw in the weird dynamic of having to work with someone who likely has no experience with real estate. Not a winning situation. As with many things in the RE game, this requires being a good judge of character prior to signing on the dotted line.
Don’t use private money for your first loan: Now, there are plenty of successful RE investors who got started with money from daddy (last I checked one was running the country). That said, I strongly suggest saving up for your first purchase on your own. Knowing what it took to earn your money will make you think long and hard before spending it, ideally leading to a more prudent investment decision. More importantly, if you have a few deals under your belt, you’ll actually know what you’re doing. This will lead to more confidence and a more realistic proposal when you go approaching your old college buddies hat in hand.
Pros: 1) Inexpensive: Can be very inexpensive, usually this is just a written or handshake agreement. If the lender is well known to you its common not to involve a lawyer; 2) Flexibility: Rate and terms are whatever you and lender agree on; 3) Speed: You can get the money quickly, as soon as the lender hands you a check it’s yours to spend; 4) Legal: If you default, often the lender can’t come after your assets. That said, if this is a major consideration when borrowing money you should see a shrink. Don’t be a scumbag. Pay your bills
Con, Potential to Ruin Relationships: A wise rapper once said “Money and blood don’t mix.” Given all the business names with “& Sons” tacked on the end, I’d have to disagree with him. That said, one should not underestimate the power money has over personal relationships. Not only does borrowing from someone close to you expose you to the potential pitfalls described above, it will generally change dynamics in any personal relationship. Even though they’re earning interest, the average person who lends to you will feel they did you a favor, and that you “owe them one.” I’ll let you use your imagination when it comes to how that could impact your friendship. Just make sure before you approach someone to ask them for a loan, you consider what type of personality they have and how it might change the dynamics between you, them and the rest of those around you
Looking for seller financing? Target the oddballs: If you want to avoid dealing with a bank you have to find a seller who’s motivated enough to invest in something extremely risky: your real estate career. Where do you find these types? While they can be found anywhere, I’ve noticed they’re more likely to own oddball or run down properties. Oddball properties could be a weird mix of residential and commercial units at one location, buildings in less than desirable areas, specialized commercial buildings that are currently vacant, multiple single family homes on one lot, and just about any other combination of traits that make them tough to market. Obviously if the seller thinks he’ll have difficulty selling, he’ll be more open to sweetening the deal by holding paper. Run down properties are a sign the owner is either uninterested in maintaining them, or has no idea how to manage property. Either way these people aren’t up to dealing with the challenges of property management which often makes them more motivated than your average seller.
Want to do a deal with little or no down payment? It’s easier than you think: Though high leverage deals come in all shapes and sizes, the most common types usually just combine two or more of the lending options I described above. For instance, want to put only 10% down, on a 10 unit apartment building? Get a commercial mortgage for 75% and a seller second mortgage for 15%. I’ve done that exact deal and a few other very similar ones. Want to put nothing down on that duplex? Borrow 75% with a residential loan and get Aunt Wilma to put up the rest with private money.
When choosing a bank, go local: As I mentioned above in the commercial loans section, relationships with bankers do matter and generally speaking, the smaller the bank, the more likely you are to be treated as a valued customer instead of a number. If you do multiple deals with the same bank, are easy to work with, never miss a payment and have gotten buddy buddy with the lending officer there, it will greatly increase your odds of getting a loan going forward (and make it less time consuming as they will already be familiar with your situation). In addition to this, local banks are more comfortable with the surrounding area and will often be more likely to loan money for local properties that a big bank considers too risky. Many smaller banks even have mandates that a certain % of their lending must go toward borrowers in their city, county, etc. These factors can only increase your odds of getting the loan.
Don’t throw all your eggs in one basket, or dollars in one vault: Though I recommend dealing with smaller banks, there are a few downsides. They oftentimes will only be comfortable lending you a finite amount of dollars within a given year, so while it could have been a piece of cake to get your most recent purchase approved by Main Street Bank & Trust, if you approach them with another deal two weeks after closing, they may get nervous. Also, if you do it right, there is a chance you’ll outgrow the bank and your deals will be too big for them to underwrite, or you’ll already have so many loans on the books that they won’t be comfortable lending you any more. To get over this hurdle I suggest cultivating relationships at multiple banks so that if Maine Street Bank & Trust is cutting back on it’s Commercial RE loan exposure this year, you can talk to your guy at Community Credit Union in order to get a mortgage to buy that strip mall where your two pack-a-day aunt goes tanning. The same goes for maintaining deposit accounts, as in all situations, money talks and banks will be far more open to working with you if you toss some dead presidents their way.
When starting out, don’t be afraid to “live the dream:” Many RE investors get their start by occupying their first (or even first few) investment properties. The reasons being A) we all need a place to call home B) Owner occupants receive preferential treatment from lenders and can qualify for generous government backed programs. I’m not going to get into the different programs here as that would be an article in and of itself, but a simple online search will yield quite a few results.
Leverage can make you rich but only do the deal if you make money: No matter how sweet the deal is: nothing down, cash back on closing, whatever. Don’t let it blind you to the most important factor: it needs to make money. Prior to signing on the dotted line, always take the time to put together an accurate projection of what you stand to make and spend on a given property. If there’s red ink on that bottom line, walk away.
RealtyShares: If you’re interested in investing in real estate (passive or active) we can recommend RealtyShares, a crowdfunding platform for investments around the United States. By using a crowdfunding platform run by professionals, you can potentially benefit in the following ways: 1) ability to see how professionals look at real estate by viewing multiple approved projects, 2) access to a variety of asset types including single family homes, multifamily, retail and office, 3) access to offering types including debt, equity and preferred equity offerings and 4) a range of targeted returns and holding periods to meet your personal risk-return profile. Finally, we note that minimums are as low as $5,000 allowing you to get your feet wet in real estate investing for the first time or build a large portfolio of assets that provide passive income.
Thats that. Thanks again to the WSPs for allowing me to post and thanks to all of you for reading. – OwnMyHood