How to Get the Money
This is Part 8 of a series on how to get started in real estate. Each article is a bite-sized tutorial gleaned from 30 years of investing experience. The goal is to remove as much doubt and fear as possible, so you’ll begin, or continue, the process of creating enough passive income to change your life.
Though this step comes after the contract is signed, it’s information you should know before you make your offer.
You need money to buy real estate.
This comes in two main forms – debt and equity.
We’ll discuss both – and how to get them.
Debt
Debt is not required, but most of the time it’s necessary. It’s also a tool that will help you get you to your financial destination faster than if you used cash only. It’s very difficult to have a large real estate portfolio without the leverage that debt provides.
I my book Why Doctors Don’t Get Rich, I discussed good debt and bad debt. Good debt is typically paid by someone else for a cash flowing asset. Bad debt is paid by you for depreciating assets.
You’ll want to use good debt in your real estate journey, and it is readily available. This is one component of using “Other People’s Money” or OPM.
The first step to obtaining good debt is to look good to the lender. You can do that by being prepared.
Be Prepared to Borrow
In Part 4 of the Real Estate Series, we talked about your finances. The information in that module will give you the best chance of securing the loans that you require to build your portfolio.
If you have a strong balance sheet and adequate liquidity, you’ll be deemed a good risk, and lenders will flock to your door. So, review module 4, and get your finances in order before you try to buy your next property. It’s easier when there’s no time pressure.
Some suggestions to be prepared:
- Have two years of taxes in electronic form, including any K1s you might have received.
- Have access to two years of tax returns for any business for which you own 25% or more.
- Have copies of your W2 statements or 1099’s for the past two years.
- Be able to access three months of pay stubs if you have a W2 or 1099 job.
- Have a spreadsheet of all your cash, with bank statements for every account. Keep it up to date so you’ll know how much cash you’re holding.
- Create a living Personal Financial Statement (PFS) that is readily updated and can quickly be sent to a lender.
- Know all your personally guaranteed debts and have that in a spreadsheet. Be prepared to explain each debt.
- Keep a spreadsheet of all your revenue sources, both passive and active
It’s simple. Lenders want to know that you’re a good risk, and you can pay them back if the property falters. You want them to be confident that you have the strength to buy.
No Cash?
If you don’t have the required net worth or cash available, you can rent it or find a partner that will make you collectively a more attractive buyer.
You can sometimes get individuals with a strong balance sheet to co-sign on the debt with you. It’s not easy to get because that person is signing on for the long run and will be at risk until they’re off the note. That doesn’t occur until sale or refinance.
So, those that are willing to lend their balance sheets will typically want to partner and get a piece of the deal. That’s common. You do all the work, and they help you get the necessary loan to purchase the property. Both of you profit. They take increased financial risk but get “free” equity. You give up some profit, but you purchase a property that you otherwise couldn’t have obtained.
The more experienced you become, the less you’ll need this type of help. Besides, each purchase is increasing your net worth and hopefully increasing your cash position.
The more experience you have and the stronger your balance sheet gets, the easier is becomes to secure loans to buy more investment property.
Types of Debt
There are many forms of debt, but for our purposes, we’ll discuss the two main divisions – recourse and non-recourse.
Recourse debt is a loan that you personally guarantee. It’s what most of us are familiar with. If you’ve bought a personal home, or financed a car purchase, you have used recourse debt. If something goes wrong, the lender can seek relief through any of your personal assets.
Most single-family home purchases are recourse. Many industrial, retail, manufactured home and storage properties will also be secured with recourse debt, though some will be non-recourse.
Non-recourse debt is a loan that is secured by the property itself. Though the lender underwrites you as the buyer, once the deal is closed, your assets and balance sheet are no longer on the hook. There are still penalties if you default, but the property will secure the loan, rather than your personal assets.
Non-recourse debt is common with commercial properties, especially multifamily. You can also get non-recourse debt on certain office, industrial, retail, storage, and hospitality assets, to name a few.
Though you can’t get non-recourse debt for every deal, when you do, it helps you sleep better at night!
Terms vary for real estate loans, and they’re often different than terms you would get for your personal residence. So, be prepared and don’t be surprised.
Some loans will amortize for 30 years, and the rate is fixed for the full term, like your personal home. Others will amortize for 20 or 25 years. These loans can be fixed for the full term, or only for 5, 7, 10 or 12 years. It depends on the market, the economy, the property, and the prospective lender.
Get some idea of your terms before you analyze the property and before you make your offer. You need to know what your debt payment will be so you can accurately estimate your operating expenses.
One thing to keep in mind is that your lender will ask you for a lot of information. Remember, they’re protecting their risk by making sure you’re a good borrower. Give them everything they need and don’t get frustrated when they ask for even more!
After all, they’re helping you buy an asset that will increase your wealth and hopefully improve your lifestyle!
Where to Get Your Debt
Most of the time, you’ll seek out a local or regional bank for your property acquisition loan. They will guide you through the process. This will be recourse debt.
For some properties, you can use “Agency Debt.” HUD, Fannie Mae and Freddie Mac are referred to as agency lenders. They will lend on small properties and are also a typical source for large multifamily and commercial loans. Often this is non-recourse debt. Your broker can help you initiate a loan with these entities.
Insurance companies lend on large projects with a combination of recourse and non-recourse options.
Lending funds offer recourse and non-recourse options. These carry rates that are typically higher than agency or bank debt, but the loans can be executed quickly.
Small and large “hard money” lenders also offer debt options. These are not criminals who break legs if you don’t pay. They’re often people or groups with large sums of money who will lend at higher rates, but don’t require as much paperwork as a bank, insurance, or agency loan.
Equity
Almost all lenders want you to have skin in the game. This comes in the form of the down payment, or equity.
You can use your own money, or you can use other peoples’ money (OPM). I’ve done both but prefer the latter!
If you’re buying smaller properties, you’ll typically use your own hard-earned cash to make the down payment. Your down payment is called the “Equity,” and your loan is the “Debt.”
If you are buying larger properties or have used most of your own cash on previous acquisitions, you might want to partner with someone and split the profits accordingly. You can have one or many partners. In the case of many partners, this is called a syndication, and has its own set of rules. That’s discussed in detail in a separate series.
When buying your personal residence, there are programs that will allow you to put down as little as 0% up to as much as you prefer. Typically, owner-occupied home purchase requires 5-20%. That equates to a loan-to-value (LTV) of 80%-95%.
Investment properties generally have higher equity requirements. Lenders will want a lower LTV than your typical owner-occupied single-family home. Equity requirements for investment property runs from 15% to 40%, or LTV of 60%-85%.
If you’ve spoken to a lender, you’ll have an idea of the equity required. Then you can determine if the property makes sense. If it does, you must make sure you have that money ready to go at closing.
Summary
Debt and equity are critical components required to purchase investment real estate. The easier it is to obtain each piece, the faster your wealth will grow.
Speaking from experience, the more prepared you are, the more willing the bank is to give you money!
When I bought my first property, I knew none of this. However, I learned with each subsequent transaction. You too will be an expert in short order.
Just follow the steps, be prepared for surprises, and get that next deal under your belt!
To your success!
Tom
