Real estate investing is the most powerful tool for building passive income and long-term wealth. You may have heard a speaker talk about this at a local investor club, heard some guru on the radio, or read a book or article on the topic of real estate investing. Or, you may know someone who is an investor and have witnessed their success. While there are multiple ways to invest in real estate, we will focus this article on rental property.
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Rental Property
What other investment vehicle pays you five different ways like rental properties do? The answer? There isn’t one. What are those five ways? They are cash flow, appreciation, depreciation, principal pay down, and equity. Let’s briefly cover these to get a better understanding.
Cash Flow – This is the positive amount you get by taking the difference between the rental amount and the monthly payment. For example, if you have a property that rents for $1,000 per month and your monthly mortgage payment (including taxes and insurance) is $650 per month, your positive cash flow would be $350 per month.
Appreciation – Although you should never buy with the expectation that the value will improve over time, it most likely will depend on your market. There’s an old saying in real estate investing, ‘you make your money when you buy.’ This means buy it at the right price and you will be in good shape going forward. Any upward movement in real estate values will only benefit you and your dealer.
Depreciation – This is a non-cash deduction that you get to take that will lower your taxable income. Talk to your CPA about how this will work for you, as it varies depending on your situation.
Principal Pay Down – As your tenant pays rent every month, those funds are being used to make mortgage payments, which pay both interest and principal down in your notes.
Equity – This is the value of the property minus what is owed on it. For example, if you have a property that is worth $200,000 and you owe $120,000 on it, you have $80,000 in equity. The amount of equity in the property will increase incrementally as the principal is paid down and if/when the property appreciates in value.
Financing Availability
None of what was just mentioned above would be possible without the high availability of financing options, and the ability to leverage (using more of someone else’s money and less of your own). This means if you were to buy a deal at the right price, and you are creditworthy, you might only bring a very small amount of money to the purchase closing. The point here is building a portfolio over time doesn’t require you to have all of the money.
Most investors are concerned about finding the money, and this prevents many from taking the next steps to start investing. For most investment real estate, using cash, hard money, or a small bank line of credit, is the best way to finance an acquisition. Cash is self-explanatory, so let’s address the other two ways.
Hard Money
Hard money is a type of real estate loan that is an alternative form of financing. Hard money loans are based on property value, and also on the borrower’s creditworthiness. They are designed to provide funds for the acquisition and also for the repairs.
Most hard money loans have a higher LTV (loan-to-value ratio) than most forms of traditional financing, allowing a borrower to leverage, using more of someone else’s money, and bring less to closing. These types of loans are short-term, and allow you to close very quickly, which is normally a seller requirement. A quick Google search using the phrase ‘hard money lenders Houston’ will likely show a number of potential lenders in that area that can be used.
Before you commit to sourcing funds this way, be sure to use a hard money calculator. This will give you a better understanding of all the costs involved when financing a real estate project with a hard money lender.
Line of Credit
A line of credit at a small bank is most likely your best option, as the large, money center banks are not focused on these types of transactions. There are some big differences between using a small bank and using hard money. Small banks will generally require you to have some experience, they will take a longer time for you to close a transaction, you will generally have to put more money down out of pocket, but the costs will be much lower.
So why would anyone use a small bank for real estate deals? Once you get the experience you need (usually two years) this may be a good option for you depending on the deals you are doing.
Conclusion
Whether you use cash, hard money or a small bank line for the purchase, you will need to get the property rehabbed and have a tenant in place, to take advantage of the long term-financing options that will be available to you on your refinance. Some of the best loans available are still through Fannie Mae or Freddie Mac. They offer the lowest rates and longest terms on the market. To find the right deal, get your short-term and long-term financing in place, and take advantage of the benefits of owning rental property.
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