Real Estate 101: Financing (Free Money Finance)

The following is a guest post by FMF reader Apex. He has been investing in rental real estate for more than four years and is authoring a Real Estate 101 series, posting every Friday, based on his experiences.? (To read the series from the beginning, start here.) The series is designed to give prospective investors the basic tools they need to succeed.

The number one roadblock preventing most people from expanding in real estate is access to capital.? Real Estate is a capital intensive business.? Everything in the business revolves around access to capital.?
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It was one of the 6 reasons I listed in the first column in this series about why you should not invest in real estate.? It was also listed as one of the first steps along the path in the third column on where to start.? Many people want to get started in real estate but do not have enough capital to even get started.? Others can pull together one or two deals but then they hit the capital roadblock as well.? They want to expand into more properties but they are stuck perhaps for years trying to get the capital for their next deal.? Regardless of where you are on the real estate journey, most everyone hits the capital roadblock sooner or later.
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There are two different sources of money that you will use when investing in real estate, your money, and other people?s money (a.k.a. OPM).? The percentage of each of these sources of money that you use will determine your leverage ratio also know as a debt to equity ratio.? This ratio is determined by dividing the total amount of borrowed funds you have by the total value of all the properties you own.? For example, if you owned 4 properties worth $125,000 each and had $300,000 of borrowed money your debt to equity ratio would be $300,000 / $500,000 or 60%.?
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Your Money
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While it is possible to use only your money, it is almost always impossible to use only other people?s money.? In order to get access to other people?s money, you have to have some of your own money to start with.? There are many ways to get your own money.? It usually starts with a decent paying job from which you save a good portion of your money.? It could also involve getting a second job or second source of income.? If you have owned your own house for a number of years you could extract equity from it by doing a cash-out refinance.? It can come from selling things you can live without.? It can include downsizing your car, your house, and your lifestyle.? It can come from virtually anywhere.? You simply have to decide how badly you want it.? If you are driving a new model Lexus but can?t find the cash for a down payment, then you have made lifestyle choices that have prevented you from getting where you want to get.?
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In my first column I finished the section on capital with this sentence: Unless you are already cash rich, expect to feel somewhat poorer for a while.? If you are unwilling to feel somewhat poorer for a while, then you are the reason you are unable to find the capital to get started in real estate.
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Other People?s Money
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Your own capital will only get you so far and for most people that isn?t very far at all. Your money is limited. Other people?s money is vast.? When your money is gone, there is no way to replace it quickly, thus most expanding real estate businesses depend on access to a considerable amount of other people?s money or OPM.?
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You get OPM by simply borrowing money from whatever sources are available to you.? Getting some OPM might not be too difficult but the more debt you take on, the harder it is to get more.? Those who will be borrowing the money to you will be scrutinizing your debt carrying capacity.? They will be examining your income streams, business model, taxes, and credit ratings in detail.? Eventually many will simply refuse to give you any more money until you can improve your financial standing in their eyes.
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Because of this there are two primary rules that I consider essential when acquiring financing.

• Rule #1: Get the money for as long as possible.? You know you are going to need more money to purchase future properties so why would you want to be required to pay this money back any sooner than absolutely necessary?? That would just require you to get even more money later.? That may be difficult or impossible to do, and of course borrowing new money always has a cost.? As such you should prefer terms on your loans that are as long as possible.? If you need access to more money in the future, the last thing you want to do is take out a 15 year mortgage on a property you are buying today.? This will require larger payments resulting in significantly reduced cash flow.? If your business is generating less cash that will extend the amount of time it takes to generate enough cash to purchase your next property.? This is why I always prefer 30 year mortgages even if the interest rate is slightly higher.


• Rule #2:? Get as much money as you can get.? Maybe you have enough cash to put 50% down on a property.? Maybe you just feel more comfortable only being leveraged 60% instead of 75%.? There can be any number of reasons why you might choose to borrow less than the maximum.? Don?t do it.? If you are borrowing on a given property, borrow the maximum you can get on it.? If you are more comfortable with lower leverage then buy every third or fourth property with cash, but do not take out 50% or 60% loans on a property.? Always take the maximum they will give you.? It is always more difficult and more expensive to get more money out of a property once you have a mortgage on it.? If you purchase a property with all cash you can go back and borrow against it later.? When you do, you should once again borrow the maximum amount that they will give you.? You can manage your own leverage ratios across all your properties to ensure you do not over leverage yourself but do not put smaller leverage ratios on each property.

Where to Get Financing
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When seeking financing, the best place to start is with traditional banks using conventional financing and government backed loans.? These are known as agency loans and nearly every person who has ever taken out a house loan on their personal residence has this kind of a loan.? They are backed by agencies such as Fannie Mae, Freddie Mac, or FHA.? These loans typically have better rates than those not backed by a government agency and they also have longer terms.? Many agency loans are amortized over 30 years and not required to be paid in full for 30 years.? It?s almost impossible to find a private non-agency loan with those terms.?
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Luckily investors are able to qualify for these loans if the property has 4 units or less.? For the first 4 properties these loans can be acquired as easily as they can on your primary residence.? You can get up to 10 agency loans but anything beyond 4 gets considerably more difficult and there are currently very few lending institutions who are willing to offer agency backed loans if you have more than 4.? If you have hit your limit of 4 agency loans you will want to contact as many lending institutions and brokers as you can find until you find one that will continue to do agency loans beyond 4 properties.
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Other financing options include lines of credit on your personal residence or on any investment properties you may have that have appreciated in value.? Lines of credit offer the advantage of allowing you to take out money when you need it and pay it back when you don?t.? They are a great cash flow management tool.? The next financing option is a private or commercial loan that is not government backed.? The terms and rates on these will be less favorable so you need to make sure it does not put your cash flow in jeopardy.? You can also take out loans using other assets as collateral such as stocks, bonds, jewelry, cars, any assets you have that have value in them that you want to extract for the purposes of securing more financing capacity.? You could also consider borrowing from friends or family if you are in a relationship that supports that and understand the relationship risks that can come from that type of arrangement.?
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It is worth noting that OPM can be as addictive and seductive as the drug those initials sound like, so it?s important to remain disciplined when borrowing money.? Certainly one can put themselves in a highly over-leveraged state doing things like this.? I am not suggesting you should leverage everything you have to purchase real estate.? I am merely pointing out that there are multiple ways to get access to financing and capital.? As long as you keep your debt to equity ratio at a reasonable level and keep your cash flow margin well within the safety range I would not have much concern about any of the steps I have outlined here.? I would feel comfortable with a debt to equity ratio that did not exceed 80% and a cash flow margin that stays above 10%.? If that debt to equity ratio is higher than some people would feel comfortable with, they should choose a lower number that they feel meets their margin for safety.
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Lack of access to capital is probably the number one frustration of most beginning real estate investors.? Everyone runs up against the money roadblock.? Sometimes the only path is to wait until you can save enough money to go around the roadblock that is right in front of you.? Of course there is always another roadblock after that one.? However, the more cash flowing properties you can acquire the more cash they will throw off.? Eventually they will be the source of removing the capital roadblocks.? But until that time arrives which can be quite a long time for many real estate investors, you need to consider every option for getting access to capital and always be on the look out for new sources of funds if you want to keep your real estate business growing and expanding.

Source: http://www.freemoneyfinance.com/2012/12/real-estate-101-financing.html

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