With apologies to Sesame Street, today's column on real estate investing is brought to you by the letters O, P, and M.
Other People’s Money. OPM.
Why do millionaires take out mortgages rather than pay cash for investment properties? Because they like the lower risk of OPM. Why do billionaire real estate developers borrow money from giant commercial banks? They prefer OPM.
You can start your real estate empire the same way. Leverage OPM to fund your investing and lower your exposure. Real estate investing is inherently risky but potentially lucrative, so play your cards right.
Here are three ways to get OPM for your investment properties so you can buy up Sesame Street and hire The Count as your bookkeeper. These approaches can work whether you're flipping a property or renting it out.
Use a home equity loan or HELOC to fund your investment
If you're a homeowner, you can tap your home equity and take out a loan against it. That comes with the risk of not being able to pay it back, but it's also your easiest and least expensive source of capital.
Leveraging one property to pay for another is the bread-and-butter of real estate investing, and if you don’t have another real estate property with equity to tap, your home is a good first place to start.
This type of loan is secured, backed up by your property, a tangible asset unlikely to depreciate. And since you live in the home and the lien is attached to your home, the bank knows you’re likely to pay it back since you risk foreclosure and eviction if you don’t.
Your options include a home equity line of credit (HELOC), which you can draw from and pay back like a revolving credit card account. A second option is a home equity loan. Once it’s paid back over time, or paid off at once when the property is sold, it extinguishes.
A cashout loan refinances your existing mortgage and advances you cash to use as you wish. But mortgage rates have risen to 7 percent this fall, making this option less attractive for most homeowners with lower rates.
With all three of these options, one big advantage is that the mortgage interest is tax-deductible if you itemize your deductions vs. taking the standard deduction for your federal income taxes.
Also, you won’t likely have to explain to your bank what you plan to do with your money. Of course, all the regular lending standards will apply, such as a bank examining your debt-to-income ratio, pulling your credit scores, and verifying your income, assets and debt.
Your available loan amount and terms depend on your equity, income, debt, credit score, and the specific loan program. Some banks may allow you to borrow up to 97% of your home’s value.
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Use the equity in your investment property to fix it or buy another
If you already own an investment property, you can leverage its equity like you would use your personal home's equity.
Now you've really got something going. Let's say you bought an investment property with cash from a loan or HELOC against your personal home. Even though you borrowed the money, you still have 100% equity in the investment property. You can leverage that equity for renovations, transaction costs or even buying another property.
Again, you could get up to 97 percent loan-to-value on your investment property, depending on your creditworthiness. One restriction is that the house in its present condition must be fit for occupancy.
Most lenders consider that to mean:
- The house must have electricity, plumbing, heat and water.
- The house must be habitable, with no structural, safety or environmental problems.
- The roof can’t leak.
- The property has no liens against it. (That’s because the bank has to be able to sell the property should you default on the loan.)
Even though this is a secured loan, you’re going to be evaluated as an investor, not a homeowner, this time around.
As a result, you’re likely to have tighter credit requirements. You'll need a higher credit score. And your loan will require a higher origination fee, down payment (sometimes 25 percent or more), and mortgage rate. The bank carries more risk with an unfinished or unleased investment property that you potentially could walk away from with no threat to your primary residence.
You can use two different banks, but the first lender will see that you’ve run up your line of credit, so you better have enough income to pay both loans and your own first mortgage if you have one.
If the property is a rental property and occupied, so much the better. But don’t count on the bank lending money on the rental. Most banks require a signed lease (or leases) and a rent history of several years to show that the rent income will cover more than 100% of the mortgage, plus monthly expenses and insurance.
Usually a bank won’t lend either if the vacancy rate is 20% or more in a building, or the leases are set to expire and haven't been renewed. Some banks will also require that the rents for the property be a certain ratio above existing comps, such as 1.2 to 1 before they lend on a rental.
Work with an experienced realtor or property management company before investing in rentals.
Consider using 'hard money' bankers for an unsecured loan
Hard-money banking may sound sketchy, but it really just means a higher-interest loan without collateral. You might consider it, under the right terms, if the two first options above aren't available to you.
You might use a hard-money loan if:
- You don't have other options available.
- You want to buy an uninhabitable home to renovate or tear down.
- You want to buy land and build on it.
Be aware that the loan will be more expensive. You'll likely have:
- Higher interest rates, sometimes in the double digits.
- Higher down payment of 25% or more.
- Higher original fees of 2 to 3 points or more.
- A shorter loan term, sometimes as little as one year.
- More scrutiny of your assets, income and credit score.
Essentially, hard money is a construction loan. You can use it to buy property, raze an existing structure, and pay for architectural plans, permitting, and construction. The loan pays out in "tranches," typically one-third before construction begins, one-third in the middle of the project, and one-third at the end.
Upon completion, you can sell the home or building and pay back the loan. Or you can rent it out, take out a traditional mortgage and pay off the hard-money loan. Either way, you have leveraged OPM to carry out your project.
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Don't risk your own money unless you can absorb a loss
How do you make a small fortune in real estate? Start off with a big one, as the old joke goes.
Real estate investing is high-risk. You might face problems such as:
- Cost overruns, such as with materials or labor
- Worsening of the sales or rental markets
- Contractors delaying, walking off the job, or running off with your money
- Inspection troubles
As a realtor working with investors, I've seen this all and more. I once had a city designate a new property as part of a historic district, effectively doubling the cost of exterior materials to conform to the new historical rules. At that same property, a city inspector made my client tear down the siding he had just installed and start over. My investor client had to eat the $7,000 cost.
So, don't risk your own money unless you can afford the risks. Instead, take on partners, try crowdfunding, or wait until you have more equity.
For some people, religious beliefs may prohibit borrowing money. For example, Muslims consider the charging of interest as haram, or exploitative. However, there is Sharia-compliant financing in which the Islamic bank pools investors' money and takes on part of the project in return for a piece of the profits.
As a real estate investor, you always need to deal with the unique aspects of the project at hand – and maybe the next one around the corner.