Funding Options for Your Rental Properties

When I think about real estate investing, I try to make it as simple as possible. To me, you need two things, the property, and the money to buy the property, doesn’t get more simple than that, right? In this post, I will assume you are content with being a fellow lousy investor and just buying some solid long term rentals that you believe will perform pretty well over time. Since most new real estate investors get stuck on the money part, lets dig into that today.

As with anything in life, there are trade offs to consider when thinking about where the money will come from to purchase your rental properties. Rarely in life are you going to get the financial equivalent of a dime show spouse, that is brilliant, an amazing parent (if you are lucky enough/decide to go that direction), that is frugal, and also thinks that you are an amazing person. Although I have to admit, my wife has all of those characteristics……but the last one.

With each of these financing strategies, I will give a safety score to indicate how dangerous the source of funds are to use, as well as a growth score, for how quickly you can build your portfolio using that source of capital. The higher the number, the better.

Cash- (Safety Score- 9, Growth Score- 3)

The most obvious way to purchase an investment property is to pay cash. The only reason that the safety score is a 9, instead of a 10 is because you are tying up your cash in an asset that can become very illiquid when the real estate market is down. I have met investors that pay cash for a property, and then have to scramble to find capital to pay the property taxes. Don’t do that! Only pay cash when you have built up significant reserves to handle all expenses that you will incur when owning a rental property. Let’s say you identify a single family house that you can purchase for $110k and it will need roughly $15k in repairs to make it rent ready. You need have at least $140k in cash (stay with me) to do the deal. Why $140k? First, I have only met a handful of people that have absolutely nailed it when it came to estimating the repairs. If you are new to the game, trust me when I say, it will most likely be more than you think (and typically even more than a contractor quoted you). Second, there will be closing costs. In North Carolina it will run you a few thousand dollars to get the deal closed. Finally, you need reserves! I have had AC units, water heaters, and dishwashers die almost immediately after purchasing the property. There will be something that happens. Cash is going to be the most difficult strategy to accumulate a lot of rentals quickly, unless you are absolutely LOADED. Frankly, if you have a few millions bucks to start your investing career, you don’t need to worry about scaling quickly unless your lifestyle resembles a 90’s rap video or a Dan Bilzerian instagram post.

Conventional Loan- (Safety Score 7, Growth Score- 6)

Conventional mortgages are the loans that many of us acquire when buying a personal residence. They are typically fully amortizing, meaning that with a 20 or 30 year mortgage, you have that entire period of time to pay it off. A conventional mortgage can also be a great tool to purchase rental properties as well. Cash flow is very important when buying rental properties and with a conventional mortgage, you will be getting about the lowest interest payment possible in the current economic environment. Keep in mind that the interest rate will be just slightly higher for buying a rental property in comparison to a primary mortgage. Some investors are not in favor of conventional mortgages as it shows up on their personal credit reports due to getting the loan in their personal name. My wife and I have deemed that to be a reasonable trade-off for a few reasons. First, one of the scariest elements of owning rental properties is not knowing what the lending environment will be in the future. If you lock in a 30 year fixed loan, that means that you will never have to refinance the loan, if you do not want to. There is nothing worse than being forced to refinance when the financial world is in turmoil (see the 2008 financial collapse). The properties showing up on our personal credit report is not a deal-breaker for us because our philosophy is that our credit is there to serve our financial life and thus we use our credit to buy income producing assets such as rental properties, the one caveat being our personal residence. We do not use our credit to buy vehicles or crap that we don’t need and do not have the money in the bank to pay for. Personally, I find that Conventional Loans can give you plenty of room for growth as you are able to get up to 10 personally mortgaged loans, including your primary. Since you can use a conventional loan to finance a 1-4 unit building, you could actually purchase 9 quad’s (4 unit buildings) for a total of 36 rentals. The largest challenge to growth with this strategy may be your ability to come up with the down payments, usually in the (20-30% range), depending on factors such as your credit, the number of units of the property (higher down payment for a triplex vs. a single family house) and how many financed properties you own (the more mortgages, the higher the down payment requirement).

Commercial Loan- (Safety Score 2, Growth Score 7)

Commercial Loans are used by “companies” to purchase rental properties. Typically the company is simply an LLC that will own the property. Many like the idea of commercial loans because the loan is in the name of their LLC, not their personal name. It is important to note that you are almost always personally guaranteeing this type of loan meaning that even though the property is owned by your LLC, if everything goes south, the lender can still come after you personally in many states. It is common for landlords to use commercial loans once they have maxed out their ability to get conventional financing. Commercial loans have different requirements and flavors due to the fact that most of the time the lender will not be selling these loans, so in theory the terms are negotiable but it will never be as good of terms as a conventional loan. Typically a commercial loan has a 10-20 year payment amortization with a 3-7 year balloon. The balloon part is key because that means that as the balloon approaches you will need to find a solution for how you will continue to finance the property. Again, if the world, or your finances are in turmoil, you may not be able to refinance the property with your current lender or any other! That may seem a little dire so let’s take it down a notch. A more common issue may be refinancing into a much higher interest rate which isn’t awesome for your cash flow. What if you started with a 4% rate and had to refinance 7 years later into a 7.5% rate? Will that happen? I have absolutely no idea, but it could. In the 80’s people were getting mortgages at 18%!!!!! If you are looking to build your portfolio with this type of loan, you will have the same general issues in terms of down payment requirements that you have with conventional, the difference being that there is not a hard cap on the amount of commercial loans that you can accumulate.

Seller Financing- (Safety Score- 8, Growth Score 9)

Real estate offers many way to use creative tools to finance the purchase. One of my favorite tools is seller financing. When you are working on a real estate deal that is not listed with an agent, also known as an “off-market deal” there are endless ways that you can structure the purchase with the owner. My favorite is a owner carry-back, or seller financed note. The seller decides to let you make them payments instead of getting all of their money at the time of sale. You might be saying, “what kind of a knucklehead would want to wait for their money?” A sophisticated seller. In a nutshell, if a seller receives all of their money at closing, they have to pay a much larger tax bill than if they receive their money over the years. You pay your taxes on the money you receive, when you receive it. If you deal with a savvy, and sometimes grumpy old landlord, you will find that they like the income stream but they don’t want to “fool with the house anymore”. They know that if they cash out at the point of sale, they have a huge tax bill and then they will most likely put whatever is left in the bank to earn a small rate of return on their investment dollar. It can actually be a legitimate win-win! Some states, North Carolina being one of them, also have this great law about seller financed notes being non-recourse meaning that if you end up making a complete mess of the real estate deal, which we are going to try avoid at all cost, the only thing the lender (original seller) can do is take the property back through the appropriate foreclosure proceedings. They cannot sue you to take any of your other assets. Also note that my seller financed deals have never shown up on my credit report. All things being equal, seller financing is a great tool to finance a property. If you can negotiate great terms, especially low/no down payment, you can scale your portfolio very quickly.

Private Money (Safety Score 8, Growth Score 10)

Private money is the process of borrowing money from an individual/LLC. The benefit to private money is that you can negotiate a debt structure that works for the borrower and lender. Many times the lender is providing the capital based upon a relationship with the borrower (you), and does not usually have a rigid idea around a specific interest rate or term of the loan. If you identify a rental with significant equity, it is very common to have your private lender fund the entire purchase and rehab thus giving you maximum scalability. I find it much more palatable to work with a friend or family member instead of an employee of a company that has 6 bosses and shareholders that they must report to.

Hard Money (Safety Score 2, Growth Score 2)

When it comes to building a rental portfolio, I’m not a fan of Hard Money Loans. Hard money is seen as an individual or private company lending money on a real estate project with points and a high interest rate. Many times they will have a defined idea for what terms are acceptable such as 2 points and 12% interest (usually interest only). This means that if you borrow $100k, you are paying $2k in points, usually taken out of the amount to be funded at closing, and $1k a month in interest payments. Unfortunately, it is rare that a rental property can support a double digit interest rate in this market. This means that you will have to quickly find a more permanent funding sources in order to keep the property going, which means that you are typically going to eventually land on one of the above strategies that we have discussed. The argument that I have heard is that if you get a great deal, you can buy it with no money down. Sounds great, if hard money is your only available source of capital to purchase the property, do it, and then refinance into a commercial, or ideally conventional loan once you have owned the property for 6 or 12 months depending upon your lenders requirements.

There are additional acquisition strategies that we will explore in future posts that are more complicated in nature. The goal for this article was simply to give an introduction to the fundamental tools necessary for the enterprising new landlord to consider.

What is your favorite strategy for financing rental properties?

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