If you’re hoping to get your foot in the door and begin your career as a real estate investor, there are several phases that can be intimidating. One of the most daunting aspects of investing in real estate is financing. Buying a personal residence can be a headache all on its own, but when you add the many other factors involved in buying an investment property, the pressure is on.
You’re likely more concerned about whether or not you’ll receive ample returns than whether or not your financing strategy is suitable. Truth be told, the path you take in financing your investments can play a major role in your success as an investor.
Here are some of the more notable financing strategies investors employ, why and why not, and some tips and tricks you’ll want to remember as you seek a new property acquisition.
An Investor’s Quick-Guide to Property Financing
The “Traditional” Route
In a traditional financing strategy, investors turn to a banking institution to establish a mortgage. While this initially may seem like a negative as it creates debt, it also creates leverage: one of the biggest advantages for the real estate investor.
Leverage allows investors to effectively use others' money (in this case, a bank's) to increase the potential return on investment.
This is because you are in actuality only using a fraction of your own money to acquire and benefit from an investment property. While your ROI percentage does not change, the ratio of your own money contributing does—thus allowing you to acquire more properties faster through leverage.
At the same time, there are limitations in borrowing from banks. Fannie Mae sets down guidelines for investors that prevent them from taking on more than ten loans at any given time. Even before that point, some banks may consider investors too risky to finance.
So what can an investor do to help secure their financing?
- Target smaller banks.
- Make sizeable payments.
- Seek investor-friendly and investment-savvy institutions.
- Maintain excellent credit.
Some investors would rather opt for the all-cash option. This is a riskier choice as it eliminates your leverage. However, it reduces the lead time involved with acquiring a mortgage: a process that can not only be lengthy but comes saddled with numerous fees.
While many new investors are not in a position to make all-cash offers, the opportunity opens up as your income streams grow. One could argue that by the time you have your cash saved, you could have acquired a mortgage. And this may be true. Paying all-cash for every investment opportunity will likely result in a slower scaling of your portfolio. Ultimately, it's a lot of money to set on one investment, and even more to put in multiple investments.
However, if we are to look at the pros of making an all-cash offer on an investment property, we must consider:
Investment properties are often more affordable.
Because ideal investment properties are usually not at a high price-point, it is easier to save to make an all-cash offer for an investment rather than for a personal residence. At the same time, one must consider both the cost of the property and making renovations. When making all-cash offers, the process is no doubt simplified but certainly more costly as well.
All-cash is attractive to sellers.
Sellers are attracted to all-cash offers. This is something we see often in markets where there are bidding wars. In these situations, cash is most certainly king. The seller isn't dealing with the underwriting falling through or mortgage contingencies. They just have your offer, in all cash. That is a lot more attractive than putting up with the frustrations of a lender.
Your monthly cash flow improves.
One advantage of paying for a property in all-cash is a lack of a monthly mortgage payment. While you may have to deal with the higher up-front price tag, all of the cash flow you are generating is true cash flow. None of it is pouring back to pay off a mortgage. While you will likely have other expenses to manage, paying back your lender will not be one of them.
Private Lending & Hard Money Loans
Private lending and hard money loans are of increasing popularity in investment circles. This alternative strategy benefits investors in a "best of both worlds" sense. You are not going to a bank for traditional financing, you go to private lenders. These lenders may be more flexible in their negotiations. However, keep in mind that while some details may work in your favor, the interest rates and payback period tend to be higher and shorter, respectively.
However, private lending and hard money loans allow you to leverage and stretch your dollar with the appearance and benefit of an all-cash offer. It may be worth looking into, particularly for skilled investors who have met their limit for bank loans.
Lastly, you can invest via your SDIRA. If you are unfamiliar with the SDIRA, it is a self-directed IRA. The SDIRA is a traditional or Roth IRA in which the custodian allows a wider array of investment options to the IRA holder. One of these options is, in fact, real estate. Traditional IRAs are limited to investments like stocks, bonds, mutual funds, and ETFs.
However, through an SDIRA, nontraditional options open up.
A real estate investor would first acquire an SDIRA account (usually through the help of a company that specializes in setting up and managing these accounts) and a custodian to help navigate the tax code. Selecting a custodian or LLC to work with in this regard takes the utmost due diligence: SDIRAs can be complicated, and some custodians work in complicated fees.
As with many cases in real estate, it is wise to create an LLC to hold your SDIRA account and other investments. This limits your liability. When complex legalities are concerned, this is key.
Once you have an account and a custodian, how do you invest? And what's the benefit of going through the legal and tax hassle?
As with any IRA, an SDIRA benefits from its tax-deferred status. As an investor, that means you can benefit from the tax-deferred income that goes back into you SDIRA until you withdraw at 59.5 years old or after.
This isn't to say that investing via an SDIRA is always easy or without its pitfalls. For example, you must ensure positive cash flow, must beware of creating a taxable event, and may find the restrictions of the SDIRA make diversifying your portfolio more challenging. However, for many, investing in real estate through an SDIRA is a highly attractive option.
While the many ways to finance your real estate investments can be intimidating, they don't have to be. With the help of your turnkey partner at Memphis Invest, you can rely on a personal advisor who will help you navigate your financing options and make the right decision when building your portfolio.
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