Real estate is an outstanding way to build wealth. But, many would-be investors believe that because they don’t have a ton of money, they can’t buy real estate. While a ton of money always helps, it’s absolutely not necessary to become an investor. As such, I’ll use this article to explain how to use other people’s money to buy real estate.
Using other people’s money means not putting your own cash into a real estate deal. You can do this by borrowing money (debt) or selling a stake in a property (equity). Most investors buy real estate with hard money loans. But, a variety of other techniques exist to use other people’s money.
I’ll cover some effective techniques for using other people’s money in the rest of the article. Specifically, I’ll dive into these topics:
Before discussing how to use other people’s money (OPM) to buy real estate, I need to first explain what I mean when I say to use other people’s money. In broad terms, when you buy real estate, you can take one of two paths. Option 1: you use your own cash. Option 2: you use other people’s money, paying them for the privilege of using that money.
With the latter option, you add the expense of these payments to your budget. That is, if you have to pay people interest or a portion of your profits to use their money, you inherently collect less money in absolute dollars. But, you also have the ability to significantly increase your return on investment, or ROI.
For example, assume you can buy a rental property for $250,000, and it generates $15,000 in net operating income every year. If you paid all-cash for this property, that would translate to a 6% return on investment, or ROI ($15,000 / $250,000). But, what if you instead used a mortgage with a 20% down payment to purchase the property? That would mean you invested $50,000 in cash and a $200,000 loan to buy this property.
Now, your loan payments would cut into your cash flow. But, you’d also increase your ROI. Assuming a 3.5% interest rate and 30-year term on that $200,000 mortgage, you’d have annual debt payments of ~$10,900. As such, your annual cash flow would now be $4,100 ($15,000 NOI – $10,900 in debt service). This translates into an 8.2% ROI, 2.2% higher than an all-cash deal! ($4,100 / $50,000 down payment).
And, using other people’s money has the additional benefit of expanding your purchasing power. For instance, assume you have $20,000 you’d like to invest. With a standard 80% loan-to-value mortgage, you could use these funds to purchase a $100,000 property. But, what if you could access another $30,000? Now, you’d have $50,000 – enough to purchase a $250,000 rental property.
Yes, this is a basic example. But, the important takeaway here is that using other people’s money can increase your purchasing power. From a deal analysis perspective, as long as you can generate larger returns on that $30,000 in other people’s money than you pay to use it, you benefit financially.
I hinted at it above, but when you use other people’s money, you can structure the deals in one of two broad ways:
In the rest of the article, I’ll outline a variety of options for using other people’s money to buy real estate – both with debt and equity. And, with each of these options, I’ll outline the strategy-specific advantages.
Hard money exists as an alternative to traditional financing (i.e. securing a 30-year mortgage from a bank) – and an outstanding way to use other people’s money. Furthermore, hard doesn’t mean challenging. Rather, it means that these lenders solely concern themselves with the “hard” asset, that is, the property itself.
As stated, traditional lenders require minimum standards with the borrower’s “soft” assets. Hard money lenders don’t concern themselves with this. These lenders look at a property and ask, what will this property become? They base their decision to lend on the projected after-repair value (ARV) of a property.
This system provides real estate investors two key advantages. First, you can secure a hard money loan even if you don’t have a great credit score (but, lenders likely won’t work with you if you have bankruptcies or judgements in your credit history). Second, you can use hard money loans for distressed properties, making them ideal for fix & flip investors.
Traditional lenders want to confirm that, if foreclosed upon, a property will cover the loan balance now. Hard money lenders assume more risk. They lend based on what they believe the property will be worth in the future. While each hard money lender offers different terms, at The Investor's Edge we’ll lend up to 70% of a property’s ARV. As such, if a borrower fails to successfully rehab a property, hard money lenders need to recoup their outstanding loan balance with a distressed property sale. And, selling a property in the middle of a repair likely won’t pay off the outstanding loan balance, as the loan was based on what the property would become.
Due to this increased risk and the shorter term nature of hard money loans, they have higher rates than traditional mortgages. Depending on your investing history and the quality of the deal, you can expect an interest rate from 7.99% to over 15%. However, investors can also close these loans extremely quickly. Traditional mortgages typically require 45 days or more to close . You can close a hard money loan in less than a week or two.
Once again, hard money lenders base their loans on what a property will be worth. But, how do you value something that doesn’t exist yet? To do this, hard money lenders require an ARV appraisal prior to issuing a loan.
With a traditional appraisal, appraisers look for recent sales comps for the property in its current state. ARV appraisals also include “as-is” comps and determine an “as-is” value. But, they also account for the planned renovation and what the house will look like after they’re complete. More precisely, an appraiser will analyze your submitted contractor bids for work, find properties that have had similar levels of work, and determine an ARV based on those comps.
While more expensive than standard appraisals, these ARV appraisals provide hard money lenders the information they need to determine how much they’ll lend.
This option represents one of the primary sources of other people’s money. That is, you can seek business partners or outside investors to help fund a real estate deal. Plenty of people A) want to invest in real estate, but B) don’t have the time or experience to do so. If someone has money to invest, you can potentially bring them on as a limited – or “money” – partner. These individuals provide funds, have no role in the day-to-day operations, and receive a return on their investment. Yes, you’ll need to sacrifice a portion of your returns. But, if it makes the difference between funding a deal or not, bringing on a partner can be a great option.
According to the Securities and Exchange Commission, or SEC, crowdfunding is a method of: raising money via the Internet to fund a variety of projects. And, these investments can only be made through an online platform operated by an intermediary (a registered broker-dealer or funding portal). These intermediaries link potential investors to companies seeking crowdfunding investments.
In simple terms, rather than pitch single investors, crowdfunding allows you to list a real estate deal in an online portal to solicit numerous, smaller investments. In this fashion, crowdfunding somewhat democratizes finding investors, as anyone with a well-developed deal can post a deal on a crowdfunding platform.
Major Benefits
Credit card companies want your money. As such, if you’re a responsible borrower, they’ll provide you pretty good personal loan options. Say you have a $25,000 limit on your credit card, but you only use $2,000 of it every month, always paying it off on time. There’s a good chance the card company will offer you a relatively low interest personal loan for the difference between the credit you regularly tap and your limit. This can be an outstanding strategy for using other people’s – the credit card company’s – money.
Overview
With a home equity loan (a.k.a. a second mortgage), you borrow against your home’s equity. More precisely, with a home equity loan, you receive a single lump sum, and you pay off that loan balance over time (similar to your initial mortgage). In this respect, home equity loans provide a level of predictability. You’ll lock in an interest rate for the duration, so you’ll make the same payments every month.
Home equity lines of credit, or HELOCs, are another great financing strategy for using other people’s money. Typically, investors tap the equity in their primary residences. So, assume you have $50,000 in equity in your property. A lender may not extend a HELOC for that entire amount, but even if you secure a $25,000 HELOC, this gives you a tremendous amount of gap financing flexibility. And, with HELOCs, you only pay interest on the money you draw. Once you repay the outstanding balance, you don’t need to pay interest.
Functionally, a business line of credit (LOC) acts the same as a HELOC. However, rather than secure the credit against your primary residence, banks use your business’s operations to secure a business LOC. Obviously, this option only exists for investors with a business. But, if you have a successful business, a LOC secured by its operations can be an outstanding financing option.
It seems like there’s a “hack” for everything these days, and housing is no different. With house hacking, you use part of your primary residence as an income-producing property. In a single-family home, especially if the homeowner is either single or a couple without kids, there’s likely an extra bedroom. While you can use this extra bedroom as storage or a guest room, you can also turn it into rental income.
With house hacking, this extra bedroom can be rented out to a tenant – either a friend or a screened applicant – to generate income. The ultimate goal is for this tenant’s monthly rent to cover your monthly mortgage. Once someone else starts covering your monthly mortgage payment on your primary residence, all the money that you would have paid to the bank can now be used to save or invest in other properties.
So how does this relate to using other people’s money?
With a conventional mortgage on an investment property, you generally need to make an at least 20% down payment. However, with government-backed mortgages for primary residences (e.g. VA or FHA loans), you can secure a home loan for 0% to 3.5% down. And, with the house hacking approach of turning this home into a partial investment property, this means you can access from 16.5% to 20% extra financing.
While completely using other people’s money to buy real estate can dramatically increase your return on investment, it also poses some risks. As with all investments, the greater the reward in real estate, the greater the potential risk. And, while using other people’s money to buy a home increases your potential returns, it exposes you to market risk.
For people who remember the Great Recession, you likely have heard the phrase “underwater mortgage” before. Simply put, a borrower is underwater on a mortgage when he or she owes more than the home is worth. And, when this happens, you lose the ability to A) refinance the property, and B) recoup all of your outstanding loan balance when you sell.
In “normal” times, home values won’t completely collapse in the six months or so that it takes you to buy, rehab, and sell a flip. But, it’s worth understanding the potential risk if something like this does happen (as it did in 2008-09).
As discussed, hard money lenders issue loans based on a property’s ARV. So, assume that you secure one of these loans in January, when the ARV is $300,000. Due to some economic factors outside of your control, say that in July, when you’re ready to sell the property, it is now only worth $200,000 – unlikely, but possible.
At an exit price of $300,000 – the ARV – you could sell your property, pay off the hard money loan ($210,000 plus accrued interest) interest, and still net a nice little profit. But, at $200,000, you cannot A) sell the property and pay off the hard money loan, or B) refinance it into a permanent mortgage to convert the property into a rental. As a result, you’d now be stuck with a high-interest hard money loan without the ability to completely pay it off, either via other financing or a sale.
In this situation, you have two options, both of which are bad. Option 1: you default on the loan and enter the foreclosure process, crushing your credit score in the process and losing any cash you have in the deal. Option 2: you sell the property at a loss and pay off the remaining hard money loan balance with cash.
While this level of market volatility generally doesn’t exist in real estate (as it does in stocks), it’s still worth understanding the potential risks of entirely financing a deal with other people’s money.
If you don’t have a lot of money, you can still become a successful real estate investor. Actually, I would argue that the most successful investors don’t use their own money. Rather, experienced real estate investors understand the value of using other people’s money to buy real estate. Not only does it increase your potential returns, it allows you to preserve your own cash for other investment opportunities. And, while hard money loans represent the most effective ways to leverage other people’s money, as the above article illustrates, plenty of other options exist.
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