The Investor's Guide to Financing Options for Rental Property

Hey there, BP! Today we are going to talk about ways to finance those passive income assets – buy and hold rentals. Not all strategies work for everyone. It all depends on your resources, the time you have available, credit, and long term goals. All these things come into play! It’s much more than interest rates and loan terms, my friends. So let’s get to it! Hopefully one of the strategies outlined below will be right for you and your deal.

The Investor’s Guide to Financing Options for Buy & Hold Rental Property

1. All Cash

As they say cash is king, right? Well, if you have enough cash to do the deal you are looking to do, then buying all cash is by far the lowest risk option. Buying all cash means fronting all the purchase price and closing costs with cash out of your own pocket.

Pros: Your risk to over leverage is of course zero. If your property has any sort of revenue that exceeds the expenses, it’s all yours so your chance to lose on a monthly basis is about zilch. You also have a built in bank account in that you can get a line of credit or loan on the property in the future easily and pull your cash out.

Cons: Unless you are swimming in cash, your buying power will be diminished at some point. You are also missing one of the key advantages of real estate – leverage. You are not leveraging your purchase with any debt so your return on investment, cash on cash return, etc. are all greatly diminished.

Works if you: are not bankable at the time, have high income and are only looking to make a small amount of purchases per year, or are looking to park a bunch of cash somewhere and are not overly concerned about the return.

In My Humble Opinion (IMHO): This can work on a very short term basis, but doesn’t make much sense to me for holds over one year.

2. Owner Financing

If you come across an owner who has held the property for a very long time, you may find that they own the property free and clear. That gives a great opportunity for them to make some cash flow long term by being the bank for you on the purchase. Everything is negotiable – interest rate, loan to purchase price, loan term, etc. It’s all on the table. Even if the owner does not hold it free and clear, they can be a second mortgage to you if the bank you use for your primary loan is willing to allow it.

Pros: You can negotiate a very creative deal in these scenarios and can limit your out of pocket expenses. If the seller sees the value in the monthly checks from you and additional profit in interest they charge, they may be willing to cut you a better deal on the sell price.

Cons: Not every owner is willing to do this, as it takes a lot of trust in you to move forward. Also most owners are not willing to cut a long term financing deal with you – most deals I have seen max out at 5 years so you will still need to refinance down the road.

Works if you: can get an owner willing to give it to you at the right terms!

IMHO: I ask for this on most deals and get it sometimes. It doesn’t hurt to ask, and it’s a great deal if you can get it at the right terms; just don’t count on getting owner financing on every deal. Have another strategy in your back pocket!

3. Bank Financing

This financing is obtained through a mortgage broker or via Fannie or Freddie backed mortgages. These are the types of mortgages that most investors start with. They are typically obtained through a mortgage broker, not a local bank. The house may have previously been your primary residence and then converted into a rental (a.k.a. “house hacking“). When you bought it, you got a homeowner grade mortgage at a low rate locked for 30 years. Then you moved out and can then enjoy those low fixed payments with tenants paying the property off for you. You can also get these types of mortgages as an investor, but only so many ,and typically they show up on your personal credit report.

Pros: Very low rates, fixed for 30 years. The bank will typically pay your taxes and insurance for you out of an escrow account, which you pay into monthly as a part of your payment. If you start as an occupant in the house, you can get in for low money down. It’s a great for investors getting started. These loans can also be used on multi families up to 4 units.

Cons: Shows up on your personal credit, and from what I understand (feel free to correct me in the comment section), you can’t hold these types of mortgages in an LLC. Since you can only get so many of these, you could hit the wall quickly and have to look for other options.

Works if you: are looking for only a few rentals to hold long term as a side investment for wealth building while you work your day job or are just getting started and need a low money down option (consider a house hack on a multi family).

IMHO: Go for the house hack on a multi with this plan if want, but don’t buy long term hold rentals that you aren’t going to live in with this option.

4. Bank Financing – Small Community Bank

So this is a different kind of bank loan. It’s based on relationships and sometimes based on a track record (but not all the time). There are different kind of banks. There are enormous banks that work in all 50 states and some in many other countries. Banks like this have full mortgage divisions that will gladly give you a mortgage, but it will be set up like I mentioned above. In line with Fannie Mae guidelines, there are lots of restrictions, etc.

There are also very small banks — ones that have a handful of branches and cover a small geographical area. These banks typically keep the loans in house, meaning they don’t sell them off to investors like Fannie Mae once they give you the loan, so they can to a degree write their own rules. They will want to get to know you a bit more and might require some more face time, but once they do one deal with you, they will be very easy to work with. They might require that you keep all your deposits with them, but that’s a small price to pay for the loan. The small community banks I have worked with also love it if the deals I am looking to do are in their area, close to their branches. If not, they may pass.

Small banks like this also understand equity partnerships because they see that in other businesses outside of real estate. If you are looking to raise investors to buy larger properties with you, these banks can help you structure the loans for those deals.

Pros: Once you build that relationship, it gets easier and easier to get loans.

Cons: They will most likely require that you use an LLC, so if you don’t have one, you will need to set that up. They will only lend around 75% Loan to Value, so you will need to figure out how to find the rest of the equity. If you don’t have that lined up, keep reading.

Works if you: are looking to do this full time.

IMHO: I love working with these types of banks. You can sit face to face with the decision maker and negotiate a deal. If you don’t have the equity lined up, get creative. To a certain extent, these banks will allow that. They do want to see some skin in the game but there are ways around that.

5. Private Loan / Bank Combo

So this gets a bit more complicated, and it takes a while to get your business set up for it. That being said, it’s the way I see most seasoned investors play the game.

Most banks, including your friendly lender at the small community bank mentioned above, want to lend on cash flowing real estate that is stabilized with solid tenants and no defects to the building. So there are many properties out there that don’t meet those criteria. They are either in disrepair or mismanaged or both. The play is to buy these properties with private lenders (finding private lenders is another conversation, but believe me, they are out there and they want to lend you money). Once you own the properties, you want to get the property stabilized, which in my book requires two things. Number one, they are filled with vetted-out tenants on at least year-long leases. Number two, all physical repairs are completed.

Once they are stabilized, you can go to a bank and get that private lender refinanced out, but I typically don’t stop there. I will get a few deals lined up and do a larger mortgage on all the addresses to knock out all the private money at once. The reason I do that is that the small community banks will take you more seriously. They will view you as a larger fish if you bring in a larger loan with more stabilized properties. Let’s face it, they have to spend the same amount of time on your single property refinance for $100,000 as they do on your multiple property deal for $400,000!

Now let’s talk about equity and money down. If you play your cards right, you will buy a dilapidated property at a nice discount. Once it’s stabilized, the property should be worth much more, right? Well, if you bought at the right price and were smart with your repairs, the new value will support a 70 to 75% LTV loan that will take out that private lender with no money out of your pocket!

Pros: Creates a nice cycle to create more deals because when you refinance out your private lenders, they will want to give that money right back to you, and off you go onto the next round of deals. And building a huge portfolio of properties with little to no money out of your pocket is a pretty nice perk also.

Cons: You need to have a lot lined up to do these deals. You have to have your private lenders and small community banks in place and ready to play ball. You also need to find the right deal that fits the model so you may have to be picky on what you get into.

Works if you: can coordinate a lot of moving part and parties. I have only seen this strategy work for investors that are doing this full time and looking to build a sizable portfolio.

IMHO: This strategy works really well for doing deals on properties at 4 units and below. Getting larger than that can expose you to high interest payments to private lenders on big deals.

6. Passive Investing

So all that being said, if you have the cash but don’t have the time to put the deals together, you may want to consider being a money partner for someone. There are plenty of investors out there with some experience who are willing to be the action taker for someone willing to front the money for the deal.

Pros: You get into the game without having to spend the time finding and managing deals.

Cons: You need to find an action taker that you can trust, and you will have to put in some time up front to structure the partnership.

Works if you: are looking for a completely passive investment in real estate.

IMHO: This play is all about building long term wealth while you focus on other things. If that’s your strategy, look into this further.

Conclusion

So those are the ways that I can think of for structuring and financing those buy and hold deals. The bottom line is that not any one of the strategies I wrote is the “right” one. Aligning the strategy you use with your long term goals, your assets, and your time available will ensure your success!

I know I left a few out like doing a deal “Subject To” the seller’s mortgage and lease options. I haven’t done either of these so if you have, feel free to comment below on how you’ve found them to work.

What else did I leave out? Have you used any of these strategies and how did it go?

I’m looking forward to hearing your feedback. Have a great week!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.