Financing real estate investments
Although the stock market has rebounded recently, many investors
still are looking for solid alternatives, and few things are more
solid than real estate.
That's why some are looking to buy single-family homes,
duplexes or condos, either to rent out or to renovate and resell.
"The stock market bubble a few years back led
to a lot of insecurity in stock investing," says Mark Hancock,
executive vice president and chief credit officer at Piedmont Bank
in Atlanta. "When it's insecure, people fly to quality, and
real estate has been quality in this decade."
But before you head out with a real estate agent to
pick out your nest egg, there are a few things you should know about
the financing. Buying real estate for investment is different from
getting a mortgage for your own home.
"They need to understand that the interest rates
they see all over the place don't apply to them," says David
Finkel, co-author of Making
Big Money Investing in Real Estate. "People ask, 'Why
wouldn't I get 6.5 percent?' It's because people who have nonowner
occupied properties have a higher default rate."
It's true, Hancock says. If times get tight and a
person has to choose between paying his own mortgage and making
the monthly payment on his investment property, he's going to keep
the roof over his own head every time. Hence, lenders consider investment
property a riskier loan and will charge a higher interest rate or
points than in a traditional mortgage.
Depending on how much you put down and your personal
credit rating, expect to pay from 1.5 percent to 2.5 percent more
than the going rate for owner-occupied mortgages, says Barbara Sama,
regional branch operations manager for New York-based American Mortgage
You should also be prepared to make a much larger
down payment than was required for your own home. As a rule, banks
will be looking for at least 20 percent.
That's why Finkel considers banks his third choice
Seller-financing tops the list
"My first source of financing always will be the seller. That
will always be cheaper," he says. "The seller won't charge
me points, PMI or loan origination fees. They'll be thrilled if
I give them 6 or 7 percent on a first mortgage. That's lower than
I get from the bank. They'll let me make interest-only payments,
and I can always prepay the principal."
Finkel often offers sellers a balloon note to get
their full payment within 60 months. At that point, he can refinance
through traditional channels.
His second choice for financing is private lenders,
people with cash who are losing money in the stock market or making
1 percent to 2 percent in certificates of deposit. An investment
that returns 7 percent to 8 percent with a house as collateral is
an attractive alternative.
Regardless of who's providing the financing, you'll
need to put together a loan package that outlines the viability
of the investment. An appraisal of the property will need to include
not only information on comparable sales in the neighborhood but
a rent survey of the area.
Finkel includes a photograph of the property, a rent
survey for a quarter-mile radius, projected income and expenses,
and a projected vacancy factor (how long the property could remain
unrented) based on the area's vacancy rate. All the estimates are
conservative, he says, because that's how bankers make their projections.
"That done, I'm going to show the banker it will
pay for itself, plus something else," he says.
That's especially important if you're going to the
traditional lending market because the requirements have tightened
for banks that sell their mortgages, says Robert Galbraith, an attorney
in Rochester, N.Y., with more than 15 years of experience in handling
residential and commercial mortgages.
The more experience you have in managing rental property,
the stronger your application for a traditional loan will be, Galbraith
says. Your level of experience may determine how much of the rental
income they include as your income for the loan.
They also want to see sufficient reserves to cover
the payments if it's not rented for an extended period, Sama says.
Or they may require rental-loss insurance.
"You need the skill and experience to manage
(rental property) and the financial wherewithal to pay for them,"
Galbraith says. "People come in, buy a duplex, run it into
the ground and wind up losing it in foreclosure."
While the application process for rental property is fairly similar
to that of an owner-occupied mortgage, the financing for renovating
and reselling houses is completely different, Hancock says. Loans
for rental property will be long-term notes, usually for 30 years.
Rehab projects are short-term loans, generally no longer than a
year, to cover the necessary time to complete the renovations and
sell the property.
"It's a whole different ballgame," he says.
The down payments will vary by the deal and will depend,
in large part, on how much work needs to be done on the house.
"If you're taking off a roof, I promise you your
banker will look for a bigger down payment," Hancock says.
"A lot of time on rehabs, when you start construction, the
value of property goes down. If you demolish the house, you have
a vacant lot. We have to cover the bank's position if you don't
The loans on rehabs will vary based on the prime rate,
with fees in the 1 percent to 1.5 percent range "depending
on the financial strength of the buyer," he notes.
The buyer's experience in residential renovations
also figures prominently in the deal, he says. He looks carefully
at the borrower's list of suppliers and subcontractors and flatly
refuses to lend money to weekend remodelers.
"They have to have experience in this particular
area," he says. "The collateral I have will be good collateral.
It sounds silly, but I've had pilots with major airlines walk in
and I've shown them the door. Just because they're rich doesn't
mean they're a home builder."
Sama recommends that buyers consider two other options.
You may qualify for a Fannie Mae long-term rehab program called
the HomeStyle Loan. It allows buyers to roll rehab costs into their
mortgage, putting the money into an escrow account that a contractor
can draw from to perform the work.
"I love this program," she says. "The
rates are a touch higher (than a regular mortgage), but not much."
The second option is for a buyer to use the equity
in his own home for a credit line. That gives him maximum flexibility
to use the funds as he sees fit.
"It's a great way to do it," she says.
"Of course, you have to be able to withstand the extra debt.
This is for the borrower with pretty good credit and income."