Why Your Lending Source Matters in Real Estate Investing
Ever wondered why (or how) there is so much variance in offers on properties?
Look no further…Today we will discuss how leveraging options dictate investment decisions.
Are you aware of all the financing options that are out there?
Financial leverage ratio positioning and the source of money, plays a significant role in acquisition decisions.
Many investors think all investors are doing the same thing.
Not true. Ideally, an investor would have the possibility to use many leveraging techniques that we will cover today.
So what determines where each individual investor chooses to make their offer?
While everyone wants to position themselves to achieve high gains, there is clear reasoning why and where investors may align their ideal purchase price.
Let’s remove all expense and experience related factors for this topic so we don’t have too many variables introduced into the topic. (We will use a standard 35% operating expense and will remove the property management expense in the later examples that will involve self-management.)
- Of course experience, dictates better borrowing margins. Tenure with experienced technicians to complete your repairs will also grant you better cost margins.
- Volume definitely plays a role in acquisition decisions as well. Volume could grant you better price points on materials and labor due to consistency.
- One could also benefit from tax deferments with high enough volumes allowing you more time to complete exit strategies – securing profits.
So, omitting these factors, let’s focus on 1) the source of financing and 2) the base requirements of the lender and investor.
The funding source plays a huge role. Let’s create a list so we can easily display the options.
Hard Money –
In hard money alone, there is a wide range of variance. Interest rates could be from 7% to 13% with 1 to 3 points paid at closing.
Also consider the variance in funds needed by the borrower. Some are borrowing with 70% up to 90% of the loan to close with 100% of the rehab funds. While others may be borrowing at 100% of the loan to close including rehab funds if under 65-75% of ARV (after-repair-value).
Private Money –
Private Money is very similar to hard money, but usually is more lenient in the borrower’s favor. Interest rates could be from 5% to 13% with 1 to 3 points paid at closing.
Again, there’s variance in funds needed by the borrower. Some are borrowing with 70% to 90% of the loan to close with 100% of the rehab funds. While others may be borrowing at 100% of the loan to close with rehab funds if under 65-75% ARV. Sometimes, borrowers are not required to make loan payments throughout the course of the rehab and are only required to pay interest and points at closing. This option could be slightly better than hard money.
(Non-Entity Based) Institutional Funding –
These are funds are from a regional bank, national bank or credit union where the person borrowing is evaluated. These funds have better finance rates, but require more funds comparatively toward the down payment. Most borrowers are getting 75% to 85% of the loan to close with a down payment requirement of 15% to 25%.
Rates for borrowing from institutions will always follow the federal reserve and will vary based upon the borrower’s credit score. Currently, rates are likely to be anywhere from 3% to 4.5%
Entity Based Institutional Funding –
These are commercial funds from a regional bank, national bank or credit union where the asset being borrowed against is evaluated. Otherwise known as collateral-based loans. Most lenders will still use your credit score to determine your finance rate.
These funds usually have better finance rates then private money, but not as good as borrowing personally as shown in the Non-Entity Based Institutional Funding section above. There still is a requirement for more money toward the down payment compared to hard and private money. Most borrowers are getting 75% to 85% loan to close with a down payment requirement of 15% to 25%.
Rates for borrowing from institutions will always follow the federal reserve and will vary based upon the borrowers credit score. Currently, rates are likely to be anywhere from 4% to 9%.
401k Borrowing –
Real estate is an eligible purchase using your 401k. Some people partner, putting their 401k funds together for the purpose of investing. The rates for borrowing are usually between the two variable ways of borrowing from an institution shown above. However, many options are available here.
Although you will initiate a monthly payment to your 401k loan custodian once borrowed, you could use these funds to buy a property outright or use the funds for your down payment requirement in an acquisition.
These rates of borrowing are much better than hard or private money and usually remain competitive with institutional rates.
Home Equity Line of Credit (HELOCs) –
If you already have equity in real estate, this could be an eligible option for you. HELOCs are usually in alignment with institutional rates and will vary from bank to bank. While you may find a HELOC rate that is better than a mortgage rate, you have the liberty to write a check when you desire to use these funds. Once used, your monthly payment schedule (with interest) will begin.
Having the access and ability to write a check gives you the flexibility needed by investors to take action. Allowing you the potential for a quick close which is highly desired by many home owners from time to time.
Business Line of Credit –
Whether your business is a start up or is a tenured business, you may have business credit at your disposal. Usually these lines of credit have higher interest rates ranging from 6% to 30%, but be careful, some go a lot higher.
Access to this type of funding could also grant you the ability to write a check and take action when needed. However, your exit strategy must be well calculated due to the rates of borrowing here.
No investor wants to use their cash versus using leverage, but depending on their liquidity level, and the planned use of the property, this could be an eligible purchase strategy. Of course, this will grant you the best terms on the front end. However, it could cost you the loss of several other investments, if the liquidity used, caused a lack of funds available that could have been used to leverage against other investments.
- Example – Joey uses $100,000 of his own cash to buy a house. Compare this to Joey using $100,000 to by 6 houses where Joey will need $15,000 toward each acquisition. His requirements will be a 10% down payment and he’ll need $5,000 for closing costs for each house. If Joey uses the $100,000 to make one purchase versus 6, and doesn’t have more cash to continue investing, Joey just caused a major halt in his investment potential.
So now that we’ve outlined some funding sources, let’s take a look at a specific example to apply the variance in possible offers.
- We will create the buy box for each investor based upon their source of financing and their base requirements.
SELLER EXAMPLE –
Mary has a (4) unit multi-family apartment building she’s rented out for 25 years. Mary purchased the property for $85,000. The property has been well kept and requires minimal renovations (if any). Mary budgeted well over the years and accounted for capital expenses including cosmetic upgrades as needed.
The property is up to date and in great condition. Dependent on the buyers choices, they could upgrade some cosmetic items in the units, but there are no large expenses necessary. Upgrades could vary from $2,000 to $5,000 per unit.
The fair market value of the home is $200,000 and could have an ARV of $250,000 with the correct upgrades (not exceeding $20,000). The gross income of the property is $30,000 per year.
- John is using hard money at 12% with 2 points and wants to get this property to renovate and resell, but he is unsure if Mary is motivated enough to consider his offer. Since John only qualifies for 70% of his ARV, but does get the renovations covered at 100%, John submits his offer at $155,000. John’s close will only require an appraisal contingency.
- Beth is using private money where her interest rate is 8% with 2 points at closing, and gets 75% of ARV of her loan covered and 100% of the repairs. Beth also wants to renovate and resell. Beth submits her offer of $167,500. Beth’s close will only require an appraisal contingency.
- David is a buy and hold investor, investing remotely and is looking for a multi-unit that he will purchase in his own name. David is required to put down 25%, but must confirm the debt service coverage ratio with his funding institution. David is pre-approved at a 3% APR and will not renovate the property. However, David will do as Mary did, and account for upgrades and capital expenses throughout his ownership. David offers $200,000. David’s cash flow is at $900/month. David’s close will require appraisal, inspection as well as other normal title and financing contingencies.
- Jeffrey is also a buy and hold investor, looking for investments, but he lives nearby and will self manage. Jeffrey is using institutional funding as well but he is purchasing in the name of his entity. Jeffrey must put down 15% but must confirm the debt service coverage ratio with his funding institution. Jeffrey is pre-approved at a 4.25% APR and will not renovate the property. Jeffrey offers $194,000. Jeffrey’s cash flow is at $900/month. Jeffreys’s close will require appraisal, inspection as well as other normal title and financing contingencies.
- Loop Investments is a partnership putting their 401k funds together and is looking for sound investments. They have the cash and want to purchase the property outright for it’s return on investment, cash flow and possible appreciation. They will not self manage and will not make any upgrades. Also, they will not renovate the property. Loop Investments will also do as Mary did, and account for upgrades and capital expenses throughout their ownership. The APR for their borrow will be 3.75%. Loop Investments offers $144,000. Loop Investments cash flow is $913/month and has return on investment of 5%. They refuse to invest if the ROI is less than 5%. The incentive is the equity potential of the property being worth $308,200 in 10 years. If appreciation stays consistent, the ROI is 10.4%. Loop Investments will have no contingencies upon closing.
- Samantha has several properties and is adding to her portfolio. Samantha wants to use a HELOC to cover the down payment and will get a fixed mortgage to cover the rest. Samantha is using institutional funding as well but she is purchasing in the name of her entity. Samantha must put down 20%, but must confirm the debt service coverage ratio with her funding institution. Samantha is pre-approved at a 4.35% APR and 4.99% for the HELOC. She will not renovate the property. However, she will do as Mary did and account for upgrades and capital expenses throughout her ownership. Samantha offers $170,000. Samantha’s cash flow is at $700/month, a cash on cash return of 24.7%, a return on investment of 4.9% and equity potential of $308,200 in 10 years. If appreciation stays consistent, the ROI is 10.3%. Samantha’s close will require appraisal, inspection as well as other normal title and financing contingencies.
- Bill is a cash buyer (liquid) and intends to purchase the 4 unit for his daughter Kelly to house hack. Kelly will live in one of the units and once she has enough saved from the cash flow, she will reinvest as she chooses. Bill will self manage, doesn’t plan to renovate and will close with no contingencies. Bill offers $175,000. Kelly will cash flow at $1,135/month.
This completes all the offers.
Mary would prefer to close quickly so she likes Bill’s and Beth’s offers. However, she has reservations about removing the tenant for Kelly, and Mary really has no need to rush. Therefore, she is also interested in David’s and Jeffrey’s offer. Even though David and Jeffrey may take longer to close, Mary is confident in her property passing all inspections and she see’s the sale going smooth.
Mary decides to sell to David at the market value price of $200,000.
Although there, are more possibilities in offer prices, today’s lesson covered a good amount of possibilities. Possibilities go beyond what we reviewed today, but the point of how leverage determines decisions has been displayed.
Thanks for joining us today faithful readers-future leaders!
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Love ya and keep striving for growth!
Please comment your current or targeted acquisition strategy based upon the leverage you’ve established…
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