Five Ways to Finance Real Estate Investments
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- Amanda Farrell
- June 6, 2022
- 4:07 pm
- No Comments
One of the biggest hurdles to real estate investing is understanding the lending options and which best aligns with your goals and financial circumstances. While it’s possible to invest in real estate with little or no money, scaling a real estate portfolio and maximizing returns requires more advanced and creative lending. Here are five of the approaches investors take to mitigate the upfront costs of buying real estate.
1. Fix and Flip Loans
Fix-and-flip is a common strategy among real estate investors looking to capitalize on growing homebuyer demand. Often, these properties are found and bought at auctions and may require extensive work to become market-ready. When running low on the capital to purchase the property and cover the costs of renovations, investors may choose to take out a fix-and-flip loan. Because these loans bridge the gap between the acquisition and renovation to increase the value of the property and final sales price, these loans are also called bridge loans.
These are short-term loans that are usually paid off with the proceeds from the sale. Here are a few aspects of this type of loan to know about:
- 12- to 18- month loan terms
- Evaluation of the After Repair Value (ARV)
- Lenders may cover up to 90% of the purchase,
- 100% of renovation costs (as long as they don’t exceed a percentage of the ARV)
- Submission of a Scope of Work (SOW)
- Business plan detailing the renovation and anticipated costs
While most investors end up selling the property, there’s also often an option to modify the loan into a longer term loan with lower rates. This gives investors flexibility if market conditions change and make a buy-and-hold strategy more appealing than selling for a lower price than planned.
On the other hand, because this is a short-term loan with high interest rates, any hitch in the renovation process that delays the sale can result in mounting financial burdens on the borrower. Borrowers with less fix-and-flip experience may face even higher rates on the loan.
Before financing a project with a fix and flip loan, investors should make sure they are confident in their ability to see the project to the finish line.
2. FHA 203(k) Loan
First-time fix and flippers may want to consider another route using an FHA 203k loan. While the typical borrower of this loan is a homebuyer looking to purchase a personal primary residence to renovate, certain investors may qualify.
An FHA 203k loan is best suited for an investor who matches these characteristics:
- Purchasing a multi-family property (2-4 units)
- Plan to live in one of the units full time for at least 12 months
- A minimum credit score of 500 (certain lenders may have a higher minimum)
- A minimum down payment of 3.5% (or 10% if your credit score is below 580)
- A debt-to-income ratio of 43% or less
This is a great financing solution for real estate investors to get their foot in the door. It’s a great way to learn the ropes of being a landlord and property management. However, because it requires investors to share walls with their tenants, it may be considered a drawback.
Another disadvantage of this loan type is that, like with other FHA loans, the 203k comes with a monthly mortgage insurance payment that will remain for as long as you maintain the loan. With that in mind, investors should consider refinancing when the rates are favorable.
This approach shouldn’t be used as a long-term financing strategy because it’s unlikely that you’ll be approved for another FHA loan again. While it’s a good option to build initial cash flow and equity for future investments, it’s not appropriate for investors looking to build a large portfolio or fix and flip houses regularly.
For sophisticated and serial investors looking to scale, there are other financing options.
3. Conventional Mortgage
As mentioned above, FHA loans are only available for primary residences. If investors are looking to purchase a single-family home or don’t plan to live in a multi-family property, they’ll have to explore other options like a conventional loan.
Before an investor is approved, a few of the requirements of a conventional loan include:
- A minimum down payment of 15 – 20% as a general rule
- A down payment for a multi-unit may be a higher percentage
- If less than 20% is put down, the private mortgage insurance will be higher
- A good or excellent credit score
- A minimum debt-to-income ratio of 43% or less
- If you have a lower debt-to-income ratio, a lower credit score may be acceptable
Lenders will want to carefully review a borrower’s income and assets in addition to credit score and credit history before approving a conventional mortgage loan for an investment property. They’ll be looking for clear financial stability, but future rent income isn’t always factored into the debt-to-income calculations. Lenders often expect borrowers to have cash reserves to cover the mortgage and other debt obligations. It’s a high bar for a lot of cash-strapped investors to clear, so those who want to deal with fewer financing hurdles might turn to private money lenders.
4. Private Money Lenders
Private money loans come from wealthy individuals instead of lending institutions like a bank. Oftentimes, these are family members, friends, business partners, or other acquaintances. Most investors turn to networking to find a partner to back their investment projects. While the requirements to get approved for a private loan will vary, investors should have the following information ready for review:
- Business portfolio
- Financial statements
- Property details
- Projections of the property’s Return on Investment or ARV
Investors taking this route should be careful. The terms of the loans can vary from favorable to predatory. While the personal relationship with a private lender may give investors more flexibility in accessing cash, defaulting on the loan could damage those ties. Before signing a contract with a private money lender, carefully consider how it may affect the relationship.
5. Hard Money Loans
For those with mediocre credit scores and less than stellar financial records, hard money loans are easier to secure. These are short-term loans that use the property as collateral. While this is a compelling alternative for investors who have trouble getting a loan from a traditional lending institution, hard money loans are often risky.
Characteristics of a hard money loan include:
- Shorter-term for repayment (a few years instead of 15 or 30 years)
- Fewer underwriting requirements than a traditional loan
- Higher interest rate
- Higher down payment
- The property has an attractive ARV
Because hard money lenders don’t follow standard underwriting processes, they take on more risk, requiring more money up front and higher interest rates. It ends up being a more expensive way to borrow money, but it may be the only option under certain circumstances.
Finalizing the Transaction with Blueprint
Regardless of which financing route an investor takes, Blueprint provides a title and closing experience designed for the needs of modern professionals. Our platform provides transparency in every transaction, so you don’t have to sift through emails or call your title company for an update. Our processes are also developed to align with the more complex transactions executed by investors like assignment contracts, double closes, and more.