No matter how you acquire a property, it is a fundamental law of the universe that you will need to spend money. Recording the deed, property taxes, utilities, and the list of expenses goes on. You should think of money as the fuel needed to keep our speculation engine running. We'll try and slip some money out of the project, but it is better to be safe than sorry. Real estate speculation is for people who have the means to support themselves and the project's expenses. So don't run off to quit your job just yet. It could take anywhere from four to twelve months (or more) to complete a project. You will not know if you will make any profits until after you sell the property. This is a long time to go without any income, and even worse if your project losses money.
So, how much can you really afford to wager? You will quickly learn that cash is king. The cash available to put into the project will determine the price of properties you can afford. Take an honest look at your personal financial situation and see how much capital you are able to put at risk. Review your income and expenses and see if between your savings and income you could support the project if things go sideways. Your monetary reserves are your ejection seat that gives you options. Those who can carry the project (pay the bills) in times of adversity increase their odds significantly for positive outcomes. Folks who jump in without any cash reserves are like fighter pilots without ejection seats. They either survive or go down in flames - foreclosure in our case.
Is there a minimum amount of cash that I need? It is hard to say since every location and property is different. For the most part, you can probably get started with $5,000 but should be able to access around $10,000." What happened to no money down?" It is possible to get into a property with little or nothing down, but as you will soon discover there are other expenses which will need to be accounted for. Again, cash is king and you will need it.
Now that you determined how much money you could wager, it is time to see how much financing is available.
You are in for a rude awakening. You are financing an investment property, not a primary residence (never use the term speculation in front of a lender). Financial institutions see you differently. They know that home investors/flippers are at a higher risk for default, especially new ones. If you make a huge mistake and cannot cover your expenses, they are certain you'll have no problem handing them the keys to clean up your mess. Don't expect a red carpet. Oh, and one more thing - you had better have a reasonably good credit score. If not, you'll need a partner who has good credit.
Your goal is to check around your local banks to find the best terms, and hopefully set up a long-term relationship. Be honest; let them know what you're up to so they can provide you the most accurate information. Just let them know you are shopping around and looking for terms to put in your feasibility study. After going to a couple of financial institutions, you are going to have a good idea of what financing is available and the typical terms. If you told them how much equity (cash) you are able to put into the project, they can give you an idea of what they are willing to lend - better yet, what types of property they will lend on. Gather information on their loan to value (LTV), interest rates, amortization period, and closing fees. You will need this information for the feasibility study.
What are the typical terms you should expect? That will depend on the location and economy, but here are some rough approximations for what to expect. Interest rates change based on macro-economic issues. With real estate investment, the financial institution will typically add a point or two of interest on top of the standard rate to compensate them for the additional risk. Again, they see you as a higher risk client and they want compensation for the additional risk. The amortization period will be shorter around 20 to 25 years. The shorter the amortization period is the higher the mortgage payment. Finally, you would like to know the fees the bank charges to process and close the loan. Typically, it is around 2% of the total loan amount; and yes, they deduct it from the funds you are borrowing.
"I like to shop my loans online". It is tempting to go online and select a site that shops your loan for you. You will save a lot of legwork. However, if something goes wrong with your project (as it always will) you will be calling into a call center to plead your case. Tears and begging work better in person. Nothing like being face to face to solve financing problems.
If you are developing a property or conducting a major renovation, you will be seeking construction and development financing. This is a bit of a different animal, and the financing is somewhat customized. The risks here are much higher, and the bank is going to be looking at you to carry more of the risk. Construction loans are typically interest only payments for a period of time to cover the construction. Once construction is complete, a permanent loan will take its place with similar terms covered earlier. Development and heavy renovations are really a different animal from flipping houses, and require some prior experience in some aspect of the project. Unless you have experience in these type projects, it is probably best to pass for now.
If you are unfamiliar with mortgages and financing it is strongly recommended you go out and read up on the subject. At a minimum, you should understand how mortgages payments are calculated along with the variables that go into the computations. First impressions last the longest, so walking into the bank and understanding the lingo puts you in a much better light. So, feel free to do some research if needed then continue on.
No doubt in your internet searches you have run across these financing programs. These loans are called hard money. With hard money loans, you can typically get financing on projects that lending institutions are unwilling to accept. To compensate the hard moneylender for the additional risk they charge very high interest rates - up to and over 16%. In addition, they will require fees up front to see if you qualify. Some serious red flags should be popping up in your head right now.
At such high interest rates, who would use hard money? Hard money is just another tool in your financial toolbox. Every tool has a purpose, and if used properly can be helpful. The best use of hard money is as additional equity for the project. If you have a large project , the hard money loan can be equity in lieu of finding an additional investor. Why? An investor will want to share in the projects income, ownership, and profits that will cost far greater than the hard money loan. You just need to be certain that you can make the additional payments and pay the loan off when it becomes due. Hard money loans generally have short terms of one to three years. Developers usually anticipate the project will stabilize with cash flow by the end of the loan, and they will pay off the hard moneylender with new financing.
On smaller projects, you will need to have a very compelling reason to use hard money. Like a double-edged knife, it cuts both ways and leaves you with very little room for error. As this guide is really for fundamentals, it may be best to leave this lethal tool alone for now. You should focus on simpler projects initially.
If you must use creative financing, use a local mortgage broker that is reputable. You will find that some of the community banks can give you a few good names. A reputable mortgage broker should be able to help you with complex forms of financing. They get money for a living and know whom the other reputable players in the business are - you will not be a sucker who paid upfront fees for nothing.
Alas, it is your responsibility to determine if the project is feasible. Use great care when considering creative financing.
Leverage in real estate is the ability to use a small amount of cash to do a larger project. You put in 10 to 20 percent of the funds required, and the lender puts in the rest. The bank lets you know how much leverage they are giving with the loan to value (LTV) percentage. An LTV of 80% means you will need to provide 20% equity (cash). So utilizing leverage, you can buy a property many times worth your initial cash investment. "This is good, but what is the effect on my bottom line?" Why superior returns of course.
To illustrate, suppose you had a property that you purchased for $100,000 with a LTV of 80%. This means that in order to buy the property the bank required you to put up 20 percent of the funds, $20,000. The remaining $80,000 is provided in a mortgage by the lender. Suppose that after we sold the property we made $5,000 in profits. Had we invested 100 percent cash in the deal we would only realized a 5 percent return - not very good. However, using leverage our returns are actually the profits divided by our equity contribution of $20,000: a very impressive 25 percent.
You have seen the positive benefits of leverage; however, there is a dark side too. Negative leverage. Primarily an issue for income properties, negative leverage occurs when the real estate income cannot cover the cost (payments) of the financing and expenses. There are an unlimited number of reasons why this could happen, and this is precisely why the banks only lend a certain loan to value (LTV).
"How does this affect me? I'm flipping - not holding the property for income". For the most part, you should not have to get overly concerned. In your feasibility studies, you'll remove much of the risk. Where negative leverage could rear its ugly head is if you cannot sell your property and decide to rent it to avert further financial hemorrhaging. If you did not consider renting as a plan B you may find local rents are much lower than anticipated. With rental levels inadequate to cover the mortgage and property expenses, your project is negatively leveraged. The project has become a financial black hole sucking money out of you each month. Let's hope your cash reserves can carry you until a buyer comes along to save you.
If used responsibly, leverage can be your best friend. Abuse it at your own peril.