Throughout my real estate investing career, I’ve spent Owner Business many dozens of hours speaking with lenders and potential financiers of my deals. With all the different types of loans and equity financing products available to investors these days, it’s important to understand the benefits and drawbacks so that you can choose the most appropriate financing option for your particular need(s).
Of course, given today’s credit situation, options are more limited than they were a couple of years ago, but the definition of a “good deal” from a lender has also changed. When I first started looking at financing for single-family houses, I passed on a couple of potential options that, in hindsight, were pretty good given today’s tight credit market, so it’s important to not only understand the types of financing that are out there, but also which types are most prevalent and most easy to come by.
The point of this article is to define the four most common types of financing available to real estate investors; At the same time, there are, of course, more than four ways of financing real estate investments; most are a derivative — or combination — of the four we will discuss here.
1. Traditional Financing
This type of loan is generally done through a mortgage broker or bank, and the lender may be a large banking institution or a quasi-government institution (Freddie Mac, Fannie Mae, etc). The requirements to qualify for a loan are based strictly on the borrower’s current financial situation — credit score, income, assets, and debt. Suppose you don’t have good credit, reasonable income, and a low debt-to-income ratio (i.e., you earn a lot compared to your monthly obligations). In that case, you likely won’t qualify for traditional financing.
Benefits: The benefits of traditional financing are low-interest rates (generally), low loan costs (or points), and long loan durations (generally at least 30 years). If you can qualify for traditional financing, it’s a great choice.
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Drawbacks: There are a few drawbacks to traditional financing for investors; some major ones:
- The biggest drawback to traditional financing is what I stated above — it’s difficult to qualify these days. A year or two ago, you could have trained under a “sub-prime” variation of traditional lending, where income and credit were less of an issue. Still, given the sub-prime meltdown (many of these borrowers defaulting on their loans), these sub-prime options have disappeared. So, unless you have good credit, income, and small debt, you’re better off not even getting traditional financing.
- Traditional lenders generally require that at least 20% be down as a down payment. While this isn’t always true, investor loans with less than 20% down can be tough to find via traditional lending.
- As an investor, dealing with traditional lenders who don’t necessarily understand your business can be difficult. For example, a house I closed last week with conventional financing almost fell through because the lender wouldn’t provide the funds until the water heater in the investment property was working. As an investor, it’s common that I’ll buy houses with broken water heaters (among other things), and I can’t generally expect the seller to fix this for me, especially when my sellers are usually banks. In this case, I had to fix the water heater before owning the house, which I do not want to do regularly.
- Traditional lenders take their time in appraisals and pushing loans through their process. It’s best to allow at least 21 days between contract acceptance and closing. As an investor, you often want to incent the seller to accept your offer by offering to close quickly; with traditional lending, that can often be impossible.
- If the lender is financing through Freddie Mac or Fannie Mae (and most will), there will be a limit to the number of loans you can have at one time. Currently, that limit is either 4 or 10 loans (depending on whether it’s Freddie or Fannie), so if you plan to be an active investor going after more than 5 or 10 properties simultaneously, you’ll run into this problem with traditional lending at some point.
- No traditional loans will cover the cost of rehab in the loan. If you plan to buy a $100K property and spend $30K in rehab costs, that $30K will have to come out of your pocket; the lender won’t put that money into the loan.
2. Portfolio/Investor Lending
Some smaller banks will lend their own money (as opposed to getting the money from Freddie, Fannie, or some other large institution). These banks generally can make their lending criteria and don’t necessarily have to go just on the borrower’s financial situation. For example, a couple of the portfolio lenders I’ve spoken with will use a combination of the borrower’s economic crisis and the actual investment being pursued.
Because some portfolio lenders (also called “investment lenders”) have the expertise to evaluate investment deals, if they are confident that the investment is solid, they will be a bit less concerned about the borrower defaulting on the loan because they have already verified that the property value will cover the balance of the loan. That said, portfolio lenders aren’t in the business of investing in real estate, so they aren’t hoping for the borrower to default; given that, they do care that the borrower has at least decent credit, good income, and cash reserves. While I haven’t been able to qualify for traditional financing due to my lack of income, portfolio lenders tend to be very excited about working with me because of my good credit and cash reserves.
Benefits: As mentioned, the major base of portfolio lending is that (sometimes) the financial requirements on the borrower can be relaxed a bit, allowing borrowers with less than stellar credit or low income to qualify for loans. Here are some other benefits:
- Some portfolio lenders will offer “rehab loans” that will roll the rehab costs into the loan, essentially allowing the investor to cover the entire cost of the rehab through the loan (with a down payment based on the full amount).
- Portfolio loans often require less than 20% down payment, and 90% LTV is not uncommon.
- Portfolio lenders will verify that the investment the borrower wants to make is a sound one. This provides an extra layer of checks and balances to the investor about whether the deal they are pursuing is. Good For new investors, this can be a very good thing!
- Portfolio lenders are often used to dealing with investors and can close loans in 7-10 days, especially with investors who are familiar with and trust.
Drawbacks: Of course, there are drawbacks to portfolio loans as well:
- Some portfolio loans are short-term — even as low as 6-12 months. If you get short-term financing, you need to either be confident that you can turn around and sell the property in that amount of time or be convinced that you can refinance to get out of the loan before its expiration.
- Portfolio loans generally have higher interest rates and “points” (loan costs). It’s not uncommon for portfolio loans to run from 9-14% interest and 2-5% of the total loan in up-front fees (2-5 points).
- Portfolio lenders may seriously scrutinize your deals, and if you are trying to make a deal where the value is obvious to you but not yto our lender, you may find yourself in a situation where they won’t give you the money.
- Because portfolio lenders often care about the deal as much as the borrower, they often want to see that the borrower has real estate experience. If you go to a lender with no experience, you might find yourself paying higher rates, more points, or having to provide additional personal guarantees. That said, things will get much easier once you prove yourself to the lender by selling a couple of houses and repaying a couple of loans.
3. Hard Money
Hard money is so-called because the loan is provided more against the hard asset (Real Estate) than against the borrower. Hard money lenders are often wealthy business people (either investors or professionals such as doctors and lawyers looking for a good return on their saved cash).
Hard money lenders often don’t care about the borrower’s financial situation as long as they are confident that the loan is being used to finance a great deal. If the value is great — and the borrower has the experience to execute — hard money lenders will often lend to those with poor credit, no income, and even high debt. That said, the worse the borrower’s financial situation, the better the deal needs to be.
Benefits: The obvious advantage of hard money is that you may get a loan even if you have a very poor financial situation. Again, the loan is more against the deal than it is against the deal-maker. And hard money lenders can often make quick lending decisions, providing turn-around times of just a couple dof days on loans when necessary. Also, hard money lenders – because they are lending their own money – can finance up to 100% of the deal if they think it makes sense.
Drawbacks: As you can imagine, hard money isn’t always the magic bullet for investors with bad finances. Because hard money is often the last resort for borrowers who can’t qualify for other types of loans, hard money lenders often impose very high costs on their loans. Interest rates upwards of 15% are not uncommon, and the upfront fees can often total 7-10% of the entire loan amount (7-10 points). This makes hard money very expensive, and unless the deal is fantastic, hard money can easily eat much of your profit before disagreements are made.
4. Equity Investments
Equity Investment is just a fancy name for “partner.” An equity investor will lend you money in return for some fixed percentage of the investment and profit. A common scenario is that an equity investor will front all the money for a deal but do none of the work. The borrower will do 100% of the work, and then at the end, the lender and the borrower will split the profit 50/50. Sometimes the equity investor will be involved in the actual deal, and often the split isn’t 50/50, but the gist of the equity investment is the same — a partner injects money to get a portion of the profits.
Benefits: The biggest bust of an equity partner is that there are no “requirements” that the borrower needs to fulfill to get the loan. IThey can do so ifthe partner chooses to invest and take (generally) equal or greater risk than the borrower, OOften the equity investor is a friend or family member, and the deal is more of a partnership in the eyes of both parties, as opposed to a lender/borrower relationship.
Drawbacks: There are two drawbacks to equity partnership:
- Equity partners are generally entitled to some profits, maybe 50% or more. While the investor doesn’t generally need to pay anything upfront (or even any interest on the money), they will have to fork over a large percentage of the profits to the partner. This could mean even smaller earnings than if the investor went with hard money or some other type of high-interest loan.
- Equity partners may want to play an active role in the investment. While this can be a good thing if the partner is experienced and has the same vision as the investor, when that’s not the case, this can be a recipe for disaster.