Lately, we’ve been taking an expansive look at the world of investing – basic investment strategies, retirement accounts, risk tolerance, etc. In today’s article, we’re going to explore all sides of real estate investing, including when, where, and why to invest. So get comfy, grab a slice of pizza, and join me on this deep dive into real estate as an investment.
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Despite the fact that many financial advisors dislike the world of real estate investing, I am a big fan. I have a long history of investing in various types of real estate that includes everything from rental properties to timberlands. But why should we invest in real estate? What is the draw and what do we stand to gain?
There are several good reasons to invest in real estate but let’s keep it simple for the moment. The first reason to invest is that real estate typically increases in value. Average 20-year returns in the commercial real estate slightly outperform the S&P 500 Index, running at around 9.5%. Residential and diversified real estate investments do a bit better, averaging 10.6%. Real estate investment trusts (REITs) perform best, with an average annual return of 11.8%.
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However, timing matters even in data collection. It would be pretty easy to pick an investment that outperformed over a given period. For example, I could pick arbitrary dates when a particular stock outperformed everything else and make it seem like a greater investment than it actually is. According to the Case-Shiller Housing Index, the average annualized rate of return for housing increased by 3.7% between 1928 and 2013. Stocks returned 9.5% annualized during the same time.
Since 1940, the median home value in the United States has increased at an annualized rate of 5.5%. But this is misleading. Homes are significantly larger today, on average, than they were back then. The average home in 1940 was 1,246 square feet, roughly half of the 2,430 average of 2010. Adjusting for home size, the annualized increase on a per-square-foot basis drops to 4.6%. After accounting for inflation, the average home value has risen by just 1.5% per year.
So the point I am making is this. We have just seen three drastically different rates of increase, 1.5%, 3.7%, and 9.5%. Which one is correct? Technically, they all are and that just goes to show that typically, real estate increases in value.
Real estate investments can provide cashflow that you can use before you are 59.5 years old. Why is that number so important? Well, if you’re using a 401(k) and investing the maximum amount into it each year, you’re probably not going to touch that money before you are 59 and a half. With real estate, we can have an income-producing property (rental homes, mining properties, etc,…) where we aren’t limited by that pre-59.5 phase.
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This one should be a no-brainer with all of the home improvement shows on television these days. My wife loves to watch Chip and Joanna Gaines take these rundown houses and turn them into beautiful and functional homes. Real estate properties can be improved, thus increasing their value.
I was looking at investing in a rental property at one point and I went to look at the house with my wife, Emily. We walked up the drive to a beautifully picturesque exterior but when we went inside, oh my! This place could have been the set of a 1970’s sitcom. We kind of laughed about it but the place could have easily been improved with some modern renovations.
One thing to keep in mind, however, is that as the city grows, improvements may not always yield the top sales price. I have a client right now who purchased a property in the “country” area of Knoxville, but as the city has grown, that area is no longer in the country. As a result, the house is now sitting in a development zone and the price has waned. It’s value increased but with the changes to the city around it, the value has decreased drastically. So properties can be improved but it doesn’t always equate to top dollar.
Real estate can provide a variety of tax deductions if we invest in the right way. As long as you’re not investing in real estate through your IRA, you can use the deductions that real estate affords. If you’re paying a mortgage, the interest on the property can be deducted. Repairs, maintenance, even travel to and from the property can be used to lower your overall tax bill. This is one of my favorite things about investing in real estate. If I can legally give the government less of my hard-earned money, I am always for it.
What this means is there is an income tax deduction that enables us to recover some of the cost of the property over time. This is basically a non-cash deduction that states that the property is less valuable tomorrow than it is today. If you have purchased a residential property, you can amortize that property over 27.5 years. A commercial property allows you to do so over a 39-year period.
For example, if you have a $100,000 property, you can divide that by 27.5 or 39, if it’s a commercial property, and that will give you your annual deduction amount.
If I purchase a piece of real estate for $100,000 and I sell it 15 months later for $200,000, I’m going to pay long-term capital gains rates on that piece of real estate. However, if I buy the same property and sell it for the same price within 12 months, I will have to pay my regular income tax rate. In many cases, long-term capital gains rates may be lower than ordinary income tax rates.
A 25 percent rate applies to part of the gain from selling real estate you depreciated. Basically, this keeps you from getting a double tax break. The IRS first wants to recapture some of the tax breaks you’ve been getting via depreciation throughout the years on assets known as Section 1250 property.
I had a friend who made around $30,000 per year in annual income and he purchased a piece of property and made $30,000 in long-term capital gains. Because he was under the $79,400 mark for total income, he paid no taxes on the gains.
What do we do if we’ve purchased a property and all of a sudden the city comes through with a beltway or, over time, the city grows in size causing the property to double, triple, or even quadruple in value? Well, we can take those gains and defer them through what’s called a 1031 exchange.
Basically, a 1031 exchange is where we take the profits and use an intermediary — typically an attorney — and we buy another property allowing us to move the gains to our new property. There are a lot of rules surrounding this but it is a strategy that’s available to us.
We can also utilize the strategy of O-zone (opportunity zone) investing under the new tax cut. Under this strategy, we can defer our gains over a longer period of time, and if done right, we never have to pay taxes on the gains we’ve received.
Assuming that our property will appreciate — which we’ve already seen is often the case in real estate — then the value will increase while we are paying down that debt. That means that we are building up equity through the appreciation of the market and the dissolution of debt, as well. This is a pretty simple concept but equity growth is a valuable byproduct of real estate investing.
Now, I’m a big believer in preparing for retirement and anyone who has followed me on either the blog or the podcast for a while can attest to that. If done properly, real estate purchases can align with our retirement. What do I mean by that? Well, over time, rent prices should increase on the property. Meanwhile, the mortgage — if it’s purchased or financed in the right way — should remain constant or decrease over time. Therefore, it can act as a hedge against inflation as we enter retirement.
To be certain, this is a timing issue. I was speaking with a friend the other day and he has a building that’s worth $550,000 right now. The same building was valued at around $330,000 just two years ago. That’s a huge gain in such a short amount of time. Per his realtor’s advice, he decided he was going to sell it before the market bubble bursts. We can make the sale, take care of the taxes, and then use that money to reinvest in a new property or even several properties. In this case, his real estate investment can be coupled with a retirement plan to hedge against inflation or it can be used to supplement his retirement income. So don’t forget that the property we invest in today, can be a valuable asset to our retirement planning.
When we are young, it’s okay to have 100 percent of our market money in equity. However, as we get older, we want to diversify our assets in order to prevent a major pull-down. If we look back through time, real estate often acts as a dampening tool during equity drawdowns, interest rate moves, and international turmoil. Real estate can actually be a diversification tool that helps us as business owners and retirees, better handle our investment income in the long-term.
A lot of times we see these late-night television commercials or internet ads proclaiming that “Now is the time to invest in real estate!” But is it? Basically, what these ads boil down to are just get rich quick schemes in which nobody gets rich other than the person at the top of the scheme. Unfortunately, too many people believe they can accurately predict the right time to invest even though the evidence very clearly says otherwise.
I’ve done entire articles about timing the market and why it just doesn’t work. Because of this, I can’t say that now is the time to invest in real estate. Nor could I say that the correct time is a week from Tuesday. The point is this, there is a time when investing makes sense but we can’t rely on predicting how the market will behave to determine when it does make sense.
Now, some of you are probably saying, “But Justin, you can simply look at the time of year and know if it’s a good time to buy a real estate property.” To some extent, that is correct. In the wintertime, there are fewer houses on the market and we might be able to get a good deal from a motivated seller. Likewise, the housing market is typically pretty hot during the spring. However, rather than looking at the time of year, I am more interested in looking at the cycle.
Housing market trends are encumbered to various pressures. If interest rates rise or fall, that affects mortgage rates which affect purchase pricing. The federal regulation of credit practices, likewise, can impact the ease of access to credit. The more access a buyer has to credit, the more houses they can buy. Legislation, location, weather, and seasonal activity can all impact the housing market. This is why I believe watching the cycle is a much better way of determining whether or not it makes sense to invest.
There are roughly six stages to the real estate cycle. These six stages are the early downturn, full downturn, bottom, early recovery, early stability, and late stability. When I picture the six stages. I like to think of a roller coaster. We start on the top peak of the track and then speed quickly downward before climbing back up again. It can be exhilarating and terrifying but that’s the way that the real estate market goes.
Real Estate Cycles chart courtesy of RCLCO.
If we’re looking to buy real estate then the best time to invest is at the bottom of the market cycle. We saw this occur back in 2008-2009 when the housing market collapsed and people began to buy real estate again between 2011 and 2012. That’s when we began to see that the early recovery phase taking place. Conversely, the absolute worst time to buy real estate is during the peak of the cycle. When the cycle is peaking, the prices are soaring above their average over the long term.
Case-Shiller U.S. National Home Price Index chart courtesy of Federal Reserve Bank of St. Lewis.
So what do we do during the downturn? We hold onto the property until the market begins to recover. If we have a potential buyer, we may liquidate but we’ve got to be careful because of the taxation that comes with doing so. However, during a downturn, the typical strategy is to hold. This is about as simple as I can explain the real estate cycle. Just remember the roller coaster when looking at whether or not it makes sense to invest in real estate at this moment.
Since about 2012, we have been in a steady recovery period. In fact, the second quarter of 2019 has shown property values at an all-time high. The biggest caution that I could give is about taking on massive debt to buy property at record highs. I implore you, friends, not to put yourselves in that position. As you can see in the chart below, we hit an all-time high in real estate transactions in June of 2019. Over 700 transactions took place and at the worst possible time for investors. So please, be smart about when to buy.
I don’t know what the future holds. Although I wish I could hop into Doc Brown’s DeLorean and see exactly what’s ahead in the real estate market, I can’t do that. What I can say is that my long-term real estate clients that buy various types of real estate have been systematically liquidating for some time now.
We have a sign hanging up in our office that features a quote from Warren Buffet. It says “When others are greedy, be fearful and when others are fearful, be greedy.” What that means is, be smart about our investments. If the market is at an all-time high, — and others are greedy — we may consider liquidating. Conversely, when others are fearful because the market has bottomed out, we should be taking advantage of the low-cost of investments.
Now that we understand when and why we should invest in real estate, let’s explore how we should invest. Basically, we as investors must focus on cash-on-cash returns. What is a cash-on-cash return and why should we care about them? Essentially, cash-on-cash is a rate of return whenever we’re doing a real estate calculation that calculates the cash income earned on the cash we invested in the property.
In simpler terms, cash-on-cash returns measure the annual return the investor has made with the actual money they have invested into the property. To calculate our cash-on-cash returns, simply divide our annual pre-tax cash flow by our total cash invested. Simple, right? Well here’s where it gets a little more complicated. Our annual pre-tax cash flow is calculated like so: subtract the sum of our gross scheduled rent + other income, from the sum of our vacancy + operating expenses + annual mortgage payments.
This isn’t difficult math, but trying to explain it can become complicated. That’s why I have included the formula below.
GSR = Gross Scheduled Rent
OI = Other Income
V = Vacancy
OE = Operating Expenses
AMP = Annual Mortgage Payments
In order to better understand the technical nature of cash-on-cash return calculations, let’s take the following example. If I were to buy a property that is worth $100K and I put down 10% of the purchase price, I would need to borrow $90,000 from the bank. During the first year of payments, I have some closing costs, insurance, and some maintenance costs. For the sake of simple math, we’ll say that those expenses add up to $1,000.
After one year, I have now paid $2,000 in loan payments which equates to about $500 of the principle. At this point, I have spent around $13,000 out of pocket. and I decided that I want to sell the property for $110,000. With the payments that have been made, the outstanding debt is $89,500, meaning once the sale is final, I will walk away with $20,500. Now, I still have to pay taxes but I have made a profit.
So the cash-on-cash return for this scenario looks like this: $20,500 (the money I walk away with) minus $13,000 ( the money I put into the property) divided by $13,000, which gives me a cash-on-cash return of 57.7%.
Putting the math aside, the key thing to take away from cash-on-cash return is that, more often than not, the less money we put down on a real estate investment, the greater our cash return will be. Conversely, the more cash that we put down, the lower our return is. The real estate is most likely going to appreciate in value even if there is a debt to be paid on it.
I have personally utilized this strategy many times over. In fact, if I am able to purchase a property with zero money down, I do it. The property is still going to increase in value whether I owe $100K or $10, so why would I pay more than I have to on my investment? A popular trend in real estate is to pay for the property in cash. Most of the time, we’re still going to see a return but our cash-on-cash return will be a fraction of what it would be if we took on debt to purchase the property and paid it off with the proceeds of our own sale.
There are three very good reasons why cash-on-cash return is so important. First, by calculating our cash-on-cash return, we’re able to keep a close watch on what the expenses of the property could be — if we’re doing so on the front end of the investment — or what they have been, if looking back on the history of our investment.
The next reason is that it allows us to select only the best properties for us to purchase. If we’re trying to decide between two or three really good properties, the cash-on-cash return can help us to make that decision a little more simple. Finally, cash-on-cash return is important when we settle on financing.
Far too often, investors choose a mortgage by looking at its interest rate. In my opinion, the terms are more important than the interest rate. For example, if the interest rate were a little higher but the loan had no closing costs, it might be better than a mortgage with a lower interest rate that had closing costs. Similarly, we might find a mortgage with higher interest but allows us to float the rate and value down. These things matter when choosing the right mortgage.
There are many different opinions on this topic, but that’s just the thing, they’re opinions. I know some investors who won’t touch a property if it doesn’t yield them at least a 12% return on their cash investment. There are mobile home investors that demand a 70 or 80 percent return before they will consider purchasing a property. However, what it really comes down to is the amount we choose to finance.
If we’re limited in our financing options, we may receive a lower cash-on-cash return but that’s the best we could do. It doesn’t mean it wasn’t worth it. It just means that it was the best option available to us at that moment. A good cash-on-cash return is nothing more than a comparable status to that of other real estate investors.
There are other factors that determine whether a cash-on-cash return is good or bad, as well. What investment strategy are we using for the property? Is it a rental property? Are we going to “flip” the home? Is this a long-term purchase? All of these must be considered when assessing our cash-on-cash return and whether or not it is a good return.
I am of the opinion that we should be calculating our cash-on-cash returns a couple of times throughout the investment process. One of the most important times to make this calculation is BEFORE we purchase. We might do it three or four times if we need to, but we must be absolutely certain of our strategy and our return before we sign on the dotted line and go into massive debt. This is an investment and it’s intended to earn an income so knowing its potential before the purchase is a must.
After our initial calculation, should we decide to go through with the investment, I recommend looking at the cash-on-cash return on an annual basis. Doing so can help to decide if we should refinance or, perhaps, pull some equity out of our property. As equity builds, our cash-on-cash return will decrease. We may find ourselves in a position, as the real estate market rises, where we were at a 30% cash-on-cash return and now we’re only at 6%. If that’s the case, it may be time to refinance or even sell our property. So an annual cash return calculation is something I strongly suggest.
Finally, we want to calculate our return after we’ve sold the property. If you’re saying, “Why does it matter? I’ve already sold the property,” the reason is we’re dealing with a longer timeframe. What I mean by that is when we begin to calculate our cash-on-cash return over a longer period of time, we find that the return is not as good as we think. This is important to know because we can see where we did really well or very poorly during that investment. Then we can recreate the successes while hopefully avoiding a repeat of our mistakes.
When we look at real estate, we have five main categories: residential, commercial, industrial, land, and special purpose. Now, most of the people I know, choose to invest in residential real estate which, as the name implies, is a property that people make their homes in. But many investors say, “Justin, I just don’t care to have to deal with a tenant and all of the headaches involved in that.” That’s fair. Being a landlord isn’t always a pleasure. So what do we do when we want to buy real estate but we don’t want to deal with the hassle of tenants, taxes, and upkeep?
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For several years now, crowdfunding has given entrepreneurs a way to raise money without having to seek out venture capital. The crowdfunding movement has since expanded to real estate. It is estimated that crowdfunding investors will be putting $2.5 billion into the U.S. real estate market this year. As an investor, crowdfunding opens up investment opportunities that may have previously only been available to the extremely wealthy.
With the rise of this new branch of the investment industry, several crowdfunding companies have taken the lead in providing investors with real estate investment options. Let’s take a look at few.
Fundrise launched in 2012 and was founded by Ben and Dan Miller with the hopes that the average Joe would have the opportunity to invest in the same real estate projects as corporate institutions. The Fundrise online marketplace allows investors to pick different real estate projects to invest in, for as little as $5,000. Each week, Fundrise receives over 250 new deal proposals, but only 5% of those actually meet its rigorous approval standards. Fundrise offers a diverse selection of potential investments: investors can invest in a single-family home project, a multi-family condominium building or even a mixed-use manufacturing building. The platform pre-funds all deals upfront so investors start accruing interest as soon as their investment settles.
Fundrise CEO, Ben Miller says they “are able to find the needles in the haystack that others can’t because of the sheer volume of opportunities [they] see.”
Rodrigo Niño founded Prodigy Network in 2003 as a way to connect accredited investors with commercial real estate in Manhattan through a secure online platform. Prodigy offers investment options in most major cities for multi-family, office, retail and hospitality properties. The platform gives investors the opportunity to invest as little as $10,000 in a project; however; the total portfolio must consist of $20,000 in assets.
The company only partners with experienced developers that have a track record of success. In order to get the most bang for their investors’ buck, Prodigy invests in properties in locations with high growth potential. They offer investments in major markets with solid fundamentals to avoid potential bubbles and invest in projects that will improve neighborhoods, eventually boosting the properties’ overall value. In addition, each investment is run through a bank account controlled by a third party and investors have access to the company’s equity partners and favorable lender terms.
This company was founded in 2013 with the vision of making it easier for individuals to invest in real estate. Since then, Realty Mogul has raised over $10 million in funding. The company has over 15,000 active users with a total of $70 million dollars spread across more than 240 properties. One of the platform’s most well-known crowdfunding campaigns is a $1.5 million stake, or 15% share, in the Hard Rock Hotel Palm Springs.
Investment periods can last six to twelve months, and investors start earning a return within a few weeks of the period. Realty Mogul gives its investors a wide variety of investment options ranging from multi-family apartments to medical facilities.
In April, this company announced a $10 million Series A round of funding, which will help it to increase its number of underwriters and build out the number of available properties available to investors. RealtyShares aims to provide quality real estate investments to accredited investors. The platform is hoping to bridge the gap between project sponsors and the developers behind each project.
Once an investment is 100% funded, it usually takes two to three weeks for the property to close and the investors to start accruing a return on their investment. Returns for different investments can vary, but RealtyShares CEO, Nav Athwal, says that it can be anywhere from 8% all the way up to 20%. Investors can choose to invest in several different types of properties, including residential, commercial, retail, and mixed-use.
With crowdfunding, real estate investing has become wholly accessible to the average Joe. These are excellent options for business owners that want to get into real estate investing but just don’t have the time or energy to manage an individual property. These positions allow for tax deferrals, dividends, and portfolio diversification. So talk to your financial advisor to see which one is right for you and your needs.
It seems like everywhere we look, these days, there’s some real estate investment opportunity staring us in the face. This isn’t necessarily a bad thing, but some of the strategies aren’t as beneficial as others. I was recently asked about using your IRA to purchase real estate and whether or not you can do so. The answer is, yes. You can purchase real estate through your individual retirement account, but I think the better question to ask is, should you buy real estate property through your IRA?
The first thing to look at is the fine print. IRA’s have rules that could cause some serious issues when using the funds to invest in real estate. In fact, I have a client who used his solo(k) to purchase an eligible piece of property but, in doing so, has totally messed up the tax savings of the solo(k). Even worse, he could potentially be facing a fortune in back taxes and penalties, as a result. They were advised to do so by a popular, low-cost custodian who now wants to settle a formal complaint lodged by the client. So there are some risks involved in investing in this way.
So what are some of the rules and regulations tied to investing in real estate through your retirement account? Let’s take a closer look:
If you or another “disqualified” individual owns a home, you cannot purchase that home with funds from your IRA. IRS regulations don’t allow transactions that are considered “self-dealing,” and they don’t allow your self-directed IRA to buy property from or sell the property to any disqualified person, including yourself.
I’ve provided a link that gives greater detail into what defines a disqualified individual, above. Basically, you can look at your own relationships and draw a cross between you and the people that are deemed ineligible. The line going up and down connects you to your grandparents and to your children or grandchildren. The horizontal line connects with fiduciaries, self-directed companies, and custodians. So you can’t buy or sell properties through your IRA when any disqualified individual is involved in the transaction.
What is an indirect benefit? In basic terms, it means you can’t purchase a vacation home that you will sometimes use. Likewise, you cannot rent an office space for your business that is in a building that your self-directed IRA owns. The purpose of the IRA is to provide for your retirement at some future date. It’s not intended to benefit you (or any other disqualified person) today. If your IRA engages in a transaction that, in some way, benefits you or a disqualified person, this is considered an “indirect benefit.”
You and your IRA are two unique entities and any properties purchased through your IRA must reflect that. Your investment must be titled under the name of your IRA, along with any other documentation related to the investment. The correct title for most real estate IRA investments is, “Equity Trust Company Custodian FBO (for benefit of) [Your Name] IRA.” Failure to appropriately title your investment can result in some serious delays.
It is possible to purchase real estate without funding the entire purchase through your IRA. So you don’t have to use your retirement account to cover the full price of the investment. You typically have a few options where financing is concerned. These other options include using undivided interest and partnering with others. You can also finance the investment with your IRA, but it must be structured properly.
Unrelated business income is any income that is derived from trade or business. Business activity is not always related to exempt status. Your self-directed IRA can purchase real estate using financing as long as the loan is non-recourse. If you do use financing, unrelated business income tax (UBIT)applies.
We all know that real estate ownership comes with some expenses beyond the initial purchase price, but how do we handle those expenses when investing in real estate through our IRAs? In short, All expenses related to property owned by your self-directed IRA, including maintenance, improvements, property taxes, condo association fees, and general bills must be paid from your IRA. Paying the expenses out of pocket is considered a contribution and causes a myriad of tax issues.
If you’re thinking that you might invest in real estate through your IRA and use the income to subsidize your retirement, think again. All income from the property must be returned to your IRA. As you can see, there are a lot of rules and regulations involved in purchasing real estate through your IRA, and there’s even more than what I’ve listed here.
From a philosophical standpoint, I would say no. You see, one of the greatest advantages of real estate is its ability to create tax deductions. More than that, it’s the ability to build cash-on-cash returns and to build wealth through leverage. So, when you lose those potential tax deductions and you give up the cash-on-cash returns because you’re paying cash for the property, then where is the value? Why would we give up the very things that make real estate investment so lucrative in the first place, only to also add on a huge tax bill to our revenue?
So, again, should we invest in real estate using our IRAs? I still think the answer is no. No, because we lose the tax advantages and the cash-on-cash return. I say no because it is contrary to what we are often trying to do when we invest in real estate. Perhaps, most importantly, I say no because we are business owners. I just don’t know why any of us would want to try to manage IRA funds into self-directing real estate investments when that isn’t our main business. If it is your primary business, then you know what you’re doing and you know that you can’t self-deal.
I know we’ve covered a lot of ground up to this point but it is all really useful information to have before you begin investing in real estate. Just as important, is knowing how to pay for your real estate investments. We have several ways that we can pay for our investments, each with their own unique nuances that make them better or worse for different situations. With that said, let’s explore some of these options.
The first and most obvious way to pay for our property investments is through conventional loans. It really is as simple and straightforward as it can be. We come up with a down payment and the bank puts up the rest of the cash in exchange for a lien on the property secured by a mortgage. Often times, the bank allows borrowers that plan on making the property their full-time residence to put down just 5%. However, most investors will put 20% down in order to avoid being subject to private mortgage insurance.
Conventional loans are a good solution for buy-and-hold investors building a portfolio of income-producing rental properties. They’re not typically used to flip houses because these mortgages are underwritten for a term of 15, 20, or 30 years. Conventional loan lenders aren’t interested in providing short-term financing. Now that we understand the basics of the conventional loan, let’s review the pros and cons.
FHA loans are sponsored by the government in order to convince people to buy homes. Because the FHA sponsors the loan, they are guaranteeing the loan for the lender, giving lenders the confidence to approve buyers they might not ordinarily approve and allowing them to offer a competitive interest rate. They offer an option for the buyer to put down just 3.5% of the purchase price.
Like the FHA loan, a 203(k) loan is designed with the homeowner in mind, rather than the investor. You might consider a 203(k) loan if you wanted to purchase a distressed property for $100,000 that needs $35,000 worth of rehab work. Because 203(k) loans allow you to lump the rehab costs into your mortgage, your loan amount would be $135,000 to include the cost of rehab.
Qualifying for VA loans is one of the best perks of military service. Basically, this loan offers no-down-payment loans to veterans, service members, and select military spouses. With a loan through Veteran’s Affairs, you can buy as many houses as you’d like, provided you don’t exceed the amount of money you are qualified for. Like the FHA loans, VA loans require that you live in the residence for at least one year.
Adjustable-rate mortgages (ARMs) are great when you need short-term financing because the interest rates won’t fluctuate as much in a short timeframe. Where we typically run into problems with ARMs, is when the interest rates begin to creep up. With most ARMs, your interest rate is adjustable for the full term of the loan, but there are “hybrid” ARMs with which your rate is fixed for a certain number of years before transitioning to the adjustable rate. I personally stay away from ARM financing because of the risk of increasing expenses on my investment properties.
Seeking financing from family, friends, co-workers or people you’ve met at your local real estate investing meetups can be tricky. Typically, private money will be more expensive than a conventional mortgage, but terms are much more flexible. Also, the qualifications to obtain this type of financing are much more relaxed. On the other hand, taking money from, friends, colleagues, and family can go south in a hurry if you or the person lending the money isn’t above reproach when it comes to keeping within the terms of the agreement.
Hard money is similar to private money, but instead of coming from an individual, the funding comes from a hard money lender. The term “hard money” is fitting because the lenders use the hard asset (the property) to secure the loan. Hard money loans are short-term loans, most often used by borrowers who buy to fix up and flip. Typically, you’ll get hard money to cover 70–80% of the property’s purchase price before rehab. Therefore, the lenders must be confident that the property is worth more than the loan and their cost to liquidate the property if you default. Hard money lenders usually charge higher interest rates and include other fees such as loan origination fees into the terms of the loan.
If you’ve already purchased a home and have built equity in it, a home equity line of credit might be a good option for you. Let’s say you’ve lived in your current residence for ten years. During this time, you have faithfully paid down your mortgage while your property has appreciated in value. Assuming your home has recently been valued at $500,000 and you still owe $250,000, your available equity is the difference between the value and what you still owe. In this case, you have $250,000 worth of equity to purchase a new property with.
I have a lot of personal experience in real estate investing and I’ve used many of these methods to finance my investments depending on my cash flow situation and the unique circumstances of each particular deal. Starting out, I invested in real estate by transferring my 401(k) funds to a self-directed individual retirement account (SDIRA). Once I’d deployed those funds and wanted to keep investing in real estate, I took out a HELOC on our primary residence to purchase and rehab a property. The HELOC is probably my preferred strategy because it’s so flexible and inexpensive.
So which one is right for you? There is no clear cut answer to this question. Each individual situation is unique and must be treated as such. Discuss your strategy and options with an experienced loan officer who has worked with investors and come up with the best financing arrangement for your particular circumstances, understanding that those circumstances change over time.
I know this has been a lot of information to take in, but I hope that you take away a better knowledge and understanding of why, when, and how to invest in real estate. There are so many benefits to real estate investing if you make well-informed decisions. Friends, life is hard, life is good, and life can be difficult but, with the basic information I’ve just shared with you, we can at least make real estate investing financially simple.