Real Estate Investing for Business Owners – An In-depth Guide

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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Podcast Time Index for “Why Should A Business Owner Consider Investing In Real Estate?”:

• 01:56 – Why Real Estate
• 04:06 – Real Estate Typically Increases in Value
• 07:16 – It Can Provide Cashflow Pre-59.5
• 08:08 – It Can Be Improved
• 09:27 – Real Estate Can Provide a Tax Deduction
• 09:59 – Real Estate is Depreciable
• 11:05 – Real Estate Can Have Lower Tax Rates
• 13:03 – You Can Defer Real Estate Gains
• 14:15 – It Provides For Equity Build Up
• 14:48 – If Purchased Right, It Can Align With Retirement
• 15:59 – It Can Be Leveraged
• 16:48 – It Acts as a Diversification Tool
• 17:38 – Summary

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Why Invest in Real Estate?

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 timberland. But why should we invest in real estate? What is the draw and what do we stand to gain? Of course, after reading this article, you should discuss specifics with your financial advisor. Investing in real estate might be a great option, it might not be… is not a one-size-fits-all option for everyone especially a small business owner.

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 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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RELATED READING: Investing for Business Owners –  A Basic Overview

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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.

Provides Cashflow

Real estate investments can provide cash flow 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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RELATED READING: Ways to Avoid the 10% Early Retirement Penalty

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Properties Can Be Improved

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.

Tax Deductions

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.

Real Estate Is Depreciable

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.

Lower Your Tax Rate

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.

Gains Can Be Deferred

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.

Equity Build-Up

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.

Preparing For Retirement

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.

Real Estate Equals Real Diversification

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.

When Investing in Real Estate Makes Sense

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.

The Real Estate 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.

Six Stages of the Cycle

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.

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The Best Time To Buy Or Sell Real Estate

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.

Looking Ahead

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.

How To Invest In Real Estate

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.

RELATED CONTENT: Investment Basics Part I – Asset Types And How They Apply To You

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Crowdfunding Provides New Options

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.

Top 4 Crowdfunding Companies for Real Estate

1. Fundrise

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.”

2. Prodigy Network

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.

3. Realty Mogul

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.

4. RealtyShares

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.

Wholly Accessible

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.

Should You Buy Property Using Your IRA?

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.

Rules and Regulations for Investing Using Retirement Money

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:

1. You Cannot Buy Your Own Home

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.

• Podcast: Pros and Cons of Buying Investment Property Using Your IRA

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.

2. There Can Be No “Indirect Benefits”

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.”

3. You Cannot Use Your Personal Name

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.

4. Financing Available

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.

5. Unrelated Business Income Tax

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.

6. Expenses Must Be Paid From Your IRA

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.

7. IRA Real Estate Income Must Return To Your IRA

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.

 So, Should I Invest In Real Estate Using My IRA?

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.

Pros and Cons of Ways of Paying for Real Estate Investments

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.

• Podcast: How You Can Pay for Real Estate as an investment 

Conventional Loans

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.

Pros

• They are easy to understand.
• The most widely available type of financing, so you can easily shop around for the best rates and terms.
• Typically, conventional loans have the lowest interest rates of any loan options.
• In most cases, the required PMI (private mortgage insurance) payment automatically burns off as you gain equity in the property.
• They have fewer burdensome provisions than FHA, VA, or other loans.
• If you make a down payment of at least 20% of the purchase price, there is no PMI required.
• You can qualify for even lower interest rates than FHA and VA loans offer if you’re credit score is 720 or above.

Cons

• You can only have a certain number of conventional loans.
• In order to qualify for most conventional loans, you must have a credit score of 640 or above.
• If you’re purchasing properties through an LLC, rather than your own name, securing a conventional loan can be difficult, if not impossible.
• Conventional mortgages typically take three to four weeks to get through the underwriting process. This is a downside because investment properties often go to “cash buyers” who don’t need to delay the closing by attaching a mortgage loan approval contingency to their offer.
• You may also have to pay a loan origination fee.

Federal Housing Authority Loans

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.

Pros

• The 3.5% down payment is about as low as you’re going to find. You still need to pay closing costs, but many of those costs can often be financed into the loan itself.
• Unlike conventional loans, an FHA loan is easier to qualify for.  Many banks require a credit score of only 550 or 600 to qualify.

Cons

• You must live in the property for a minimum of one year.
• The FHA’s version of private mortgage insurance is MIP (mortgage insurance premium), and you have to pay it for the life of the loan. It’s the price you pay for getting a mortgage with such a low down payment. A 10% down payment can get you out of the MIP obligation but at that point, you may as well go with a conventional loan.
• There is more paperwork at closing, and it typically takes a little longer than a conventional loan.
• FHA loans cannot be taken out under an LLC. They must be in your name and you may only have one FHA loan out at a time.
• In addition to the strict appraisal needed for loan approval — to determine the market value of the home — the house has to pass inspection by the U.S. Department of Housing and Urban Development (HUD). These additional “health and safety” inspection guidelines can be pretty strict. And if the house requires repairs to pass inspection, these repairs must be done before the sale can go through. You either need to make the repairs before you actually own the property (not recommended) or ask the seller to make the repairs at their cost prior to the sale.
• Stricter appraisal and inspection requirements make it nearly impossible to buy a fixer-upper with an FHA loan. You will likely pay market value because the home essentially has to be move-in ready to pass the HUD inspection

Using A 203(k) Loan

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.

Pros

• You are able to finance the entire project through a single lender.
• The 203(k) allows you to include foreclosures and fixer-uppers along with turnkey properties.
• You can negotiate a better deal on a property in need of rehab, which means you can likely benefit from instant equity.
• Contracting the rehab on your own can cost less and help you to build equity faster.
• You don’t need to find additional cash for rehab costs, and when you’re finished, the home will likely be worth more than the loan amount.

Cons

• You are required to use the property as your primary residence.
• If you do any. of the work yourself, it will not be covered under the 203(k) loan. You will need licensed contractors to fill out the paperwork.
• All contractors are required to be vetted and approved by the lender.
• Usually, 203(k) loans have more paperwork involved before, during and after settlement.

Veteran’s Affairs Loans

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.

Pros

• Although there are closing costs and fees, you don’t need to make a down payment to qualify for the loan.
• VA loans offer the lowest interest rate available.
• There is no private mortgage insurance requirement.
• Lower closing costs. With VA loans, the seller pays some of the closing costs the buyer would normally pay. In Maryland, for example, the seller has to pay all of the 2% property transfer tax instead of the usual 50/50 split between buyer and seller.
• You can purchase multiple properties as long as you qualify.
• VA loans allow a higher debt-to-income ratio.
• You can effectively build a portfolio of rental properties with no money down by living in each one for a year. When You’re ready to move, simply find a tenant to rent your current home and move on to the next.

Cons

• Not everyone has access to this type of loan.
• The VA charges a funding fee to keep the program running which is lumped into your loan amount.
• You are required to live in the property for a minimum of one year.
• Upon settlement, there is a great deal of paperwork.

Adjustable-Rate Mortgages

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.

Pros

• ARMs usually have lower initial interest rates than fixed mortgages.
• Potentially, your interest rates could decrease over time.
• Historically, rates increase or decrease slowly over time. This makes ARMs ideal for short-term financing because the rates won’t likely fluctuate much.

Cons

• Interest rate — and therefore cash flow — is more difficult to predict with any reliability. So there’s an element of risk that must be considered with an ARM.
• ARMs tend to be complex and are challenging to analyze.
• Over the last few years, interest rates have been at a historic low but are steadily rising. There is a strong likelihood that your interest rate will increase over time, increasing your monthly payments.

Private Money

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.

• You don’t typically have to meet certain financial criteria to qualify. You just need someone who is willing to invest with you.
• Since the terms of the loan are determined by you and the investor, loan structures are usually pretty flexible.

Cons

• Just as it would be if you borrowed money from Tony Soprano, interest rates are usually much higher than with a traditional lender.
• You will most likely need the services of a lawyer to draft or review the final contract.
• Because of shorter terms — typically 3 to 5 years — and higher interest rates, your monthly payments will likely be higher.
• If things do not go right, it could create some bad blood between you and the lender.

Hard Money

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.

Pros

• Hard money offers a very flexible loan structure.
• Because the loan is secured by the property rather than your personal financial situation and your ability to pay back the loan over time, hard money loans are easier to qualify for. However, if you’re deemed a higher-risk borrower, you’ll pay more than a borrower who is considered less risky.
• Hard-money lenders understand the unique needs of real estate investors and offer quick loan approval and funding. Very quick turnaround from application to funding allows you to negotiate more favorably when putting in offers –it’s the next best thing to having cash in hand.
• Finding hard money loans is easy.

Cons

• Hard money carries higher interest rates than other loans, often falling in the range of 10–12%.
• If you are perceived as risky, hard money loans can be even more expensive. You are deemed high risk if you don’t have a good credit score and a lot of real estate experience.
• Hard money loans are usually for a year or less. This means higher monthly payments.
• If you decide to rent the house instead of flipping it once you’re rehabbed it, you’ll need to refinance out of the hard money loan. And it may be difficult to refinance your entire purchase — plus the cost of rehab — into a traditional mortgage due to market fluctuations.

Home Equity Line Of Credit

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.

Pros

• A HELOC is a cheap financing option in terms of interest rates and closing costs.
• Since you pay on the outstanding balance and not the entire HELOC, you can pay it off whenever you like.
• Closing costs are considerably lower than other means of finance.
• HELOCs are the most flexible type of financing. You pay interest on only the amount borrowed at the time. In the example above, you would have $250,000 available to use, but if you used only $100,000 of it, you would owe interest on only that outstanding amount.
• If used strategically and managed well, HELOCs are a great way to leverage and build wealth.

Cons

• Spending the equity in your original home increases the cost to retain it.
• Most HELOCs have adjustable rates, making them difficult to predict financing costs over time.

Which Is Right For You?

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.

In Conclusion

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.