One of the most important things in investing in income property is cash. More specifically, your cash (or rich relative's if you are lucky). To finance the property you will need to put down a percentage of the purchase price known as equity. On top of your equity you will need to pay for inspections, fees, and anything else that may pop up. Even if you pull off a lease-option or option for the property, you will need cash to cover unforeseen expenses and most likely a fee to the property owner. In some form or another, you need access to cold hard cash.
As with most things in life, the amount of cash (a.k.a. equity) you have will determine what you can do. Specifically in income properties, you will need enough equity to obtain financing, pay expenses until the property is leased, and have some reserves for maintenance. Knowing your honest ability to cover the project equity and costs will determine the maximum project size you can pursue. By pursuing projects you can support financially, you will drastically reduce your risk of losing the property when the market is in decline. If you gave yourself some "padding", you will be able to lower your rents and still pay your expenses. Rents tend to gradually increase over time on average, but can have sudden sharp moves up and down. Like the scout's motto, "Be prepared".
"What is the minimum amount of money I need to invest in income property?" That depends on what you are looking to do and your specific location. General commercial property would require at least $100,000 to get into a small property. Into four star hotels, better have a cool $15 to $20 million laying around. For our site example we are going to stick with a single family residence, where you may be able to invest with as little as $10,000. " What happened to no money down?" It is possible to get into a property with little or nothing down, but as mentioned earlier there are expenses that will need to covered so you will need something set aside. Consider cash as your ammunition going into battle - you can never have too much ammo.
Now to all you would be flippers who are skimming the income property material, if you really want to reduce your risk you should model your flips as income property. By doing so you will know that if you cannot sell the property you could rent it and wait for a better market in the future. Think of is as Plan B - your reserve parachute.
Time to see if anyone is lending….
Most real estate investors require financing to purchase their property. In fact, you need to utilize financing if you wish to leverage your returns - this will be covered later. When you approach a lender as an investor, you will be considered a higher risk than a primary home owner. "Why?" Because you can walk away from the deal leaving them with the bulk of the problems. "How so?" The lender typically lends the majority of the funds needed to purchase the property. You on the other hand will only put in around 20-percent towards the purchase. "Twenty percent? What happened to my ten percent down financing?" Again, low down payments and interest rates go to people buying a primary residence. Lender's feel you will try much harder to keep your house than hold onto a bad investment property. They do not like "Jingle mail" - slang for when owners drop the keys off to the lender. So, this leads nicely to the next topic - typical requirements from lenders.
One of your primary jobs as a real estate investor is finding funding. With a small residential house as a rental, you probably can hit up a few local lenders. Once the project gets large, you require financial engineering. Let's keep it simple to learn the fundamentals. When you start looking for financing you will notice there are many different lending programs. Some will have a higher equity requirement, but better terms as far as interest and amortization period (if these terms are new to you, please research them prior to going too much further). You will undoubtedly find lending programs with little or no equity required, but the terms are less favorable with higher interest and shorter amortization. "Which is better?" As always, it depends. If the project produces enough income to support the higher interest, there may be a valid reason to utilize the financing. For now, figure you are only seeking financing from a banking institution. Typically, as mentioned earlier, banks may require a twenty percent equity contribution from the investor toward the property purchase price. Furthermore, to compensate them for the higher risk, they will require a higher interest rate. The interest rate could be as high as a percent or more over what is quoted to primary home buyers. Your credit history could also affect your interest rate and whether the lender will consider you for a loan. Remember, you are a different animal now. Another shocker is that the amortization term may be shorter, 20 to 25 years for many banks. All of these slight changes make large impacts on the finance payments - they get more expensive.
" Won't the higher expenses make it more challenging to find a property that works?". You bet. To make it even more challenging, they also have another hurdle for your project to meet. Know as the debt service coverage ratio or DSCR for short, it is the ratio of the income to the debt payments. To calculate it, you simply take the projects income minus expenses (excluding debt) then divide it by the debt payments. Generally this is done on a yearly basis. The DSCR requirement is usually around 1.15 for smaller rental properties. "What does the 1.15 mean?" It means your income is 15-percent higher than needed to make the lenders payments. You can think of the DSCR as a built in safety cushion for the bank. It's good for you too if you think about it - a kind of tough love.
As each financial institution is different, you need to shop around for the best deal. Initially though, you are trying to do a bit of research for the current loan terms. Your first question to the lending officer needs to always be "Are you lending for my type of project?" It may seem silly at first, but sometimes they are not interested in what you are doing. So instead of wasting everyone's time, just ask upfront and get to the point. They will appreciate the directness and probably don't care or need to hear any chit-chat. By calling around to a few lenders you can get a feel for the current lending market and who may have the best deal. The market forces them to make changes quite regularly so you need to verify what lending terms are being offered for each deal you are considering. Call at least three different lenders for terms. You'll then have a fairly strong indication of the lender's appetite for your project and the average terms that you can expect.
If you already read the Flipping material, you can skip to the next chapter. If not read on, this is important material. Better yet, flippers; read this again so it sticks.
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 (or if your credit is pretty bad). 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 for now.
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) and a debt service coverage ratio (DSCR).
For the most part, you should not have to be overly concerned with negative leverage. In your feasibility studies, you'll remove much of the risk since you will avoid projects where the income is insufficient. If used responsibly, leverage can be your best friend. Abuse it at your own peril.