Category: Education

Financing Your Real Estate Purchase

When it comes to financing your real estate purchase, you have plenty of options. Many investors pay cash for their investments. This is an attractive option to sellers because the closing process is expedited and the risk of loan denial by a bank is eliminated. In return, cash buyers often receive a lower purchase price. If you don’t have a bundle of cash readily available to purchase real estate, have no fear! There are a multitude of financing options available today. We’ll cover fixed rate and adjustable rate mortgages and explain the different mortgage types, including conventional, FHA, and VA mortgages. Finally, we’ll differentiate between conforming and non-conforming loan types.

The main difference between fixed rate and adjustable rate mortgages is the interest rate. Interest is the price you pay for borrowing money, and the interest rate on your loan can significantly impact your return on investment. This should be intuitive; the more money you pay to the bank, the less money you get to keep as profit. With a fixed rate mortgage, you have the same interest rate for the entire life of the loan. This is beneficial for planning and budgeting because you can be assured that you’re “locked in” to pay the same amount of interest every month. There are no surprises with a fixed rate mortgage. Fixed rate mortgages are typically offered on a 15-year or 30-year basis.

On the flip side, interest rates change periodically with an adjustable rate mortgage, or ARM. For instance, a 5/1 ARM has a stable interest rate for the first five years, after which it adjusts every one year. This can make financial planning for the real estate investor difficult. Let’s take, for example, an investor who pays $300 in mortgage interest each month and earns a healthy $400 monthly profit on a rental property. After five years of a stable interest rate (and stable interest payment of $300 per month), the investor’s adjustable rate mortgage has an interest rate adjustment. Now the mortgage interest payment jumps up to $375 per month, and the monthly profit subsequently drops to $325 per month. It’s common for adjustable rate mortgages to have a very low introductory interest rate which can be attractive to short-term investors. Once the adjustments kick in, however, they are commonly tied to a national mortgage index. Investors may prefer to use an adjustable rate mortgage to take advantage of low interest rate periods and take a chance that they won’t experience high interest rate periods. It’s a gamble, but it depends on the investor’s individual attitude towards risk.

Once you decide between a fixed rate or adjustable rate mortgage, you’ll choose the mortgage type, including conventional, FHA, or VA. The differences between these mortgage types have to do with whether the loan is insured. Conventional mortgages are not insured or guaranteed by the government. The minimum down payment requirement for a conventional mortgage is 5% for a primary residence and 20% for an investment mortgage. VA loans are part of a program offered by the U.S. Department of Veterans Affairs to military service members and their families. One huge benefit of VA loans is that there is no minimum down payment requirement! However, real estate investors cannot use VA loans to purchase investment properties, as the program requires the borrower to use the property as a primary residence.

FHA mortgages are insured by the Federal Housing Administration. The minimum down payment requirement for an FHA loan is 3.5% which makes it an attractive alternative for many personal home buyers. FHA loans have two main disadvantages for the real estate investor to consider. The first is that FHA loans are primarily restricted to buyers who intend to occupy the property they are purchasing. The second is that FHA loans require the borrower to pay for private mortgage insurance, or PMI. The price of the PMI is determined based on the borrower’s credit score, and it adds another monthly cost for the real estate investor to account for. One workaround to the FHA loan residency requirement is for the real estate investor to live in the property for some time and rent it out later. This is ideal for people who are just getting started in real estate investment and still need a place to live for the time being. As you can tell, these are all valuable considerations for the prudent real estate investor.

Another concept related to mortgages is based on the size of the loan in question. As a real estate investor, you will often make purchases of varying size. For example, one year you may purchase a single-family home as a rental property, and the next you may purchase an apartment building with 12 units. These two investments will carry two very different price tags. Depending on the size of the mortgage loan you need, you’ll fall into either the conforming loan or the jumbo or commercial loan category. Conforming loans meet the underwriting guidelines that have been established by the government. Non-conforming loans may also be granted, but they are typically accompanied by adverse factors like prohibitively high interest rates. Jumbo loans exceed the size limits established by the government, and for this reason the lender considers the borrower to be high-risk. To compensate for the higher risk that the lender takes on, it may require higher down payments, higher credit scores, and higher interest rates.

There is no shortage of factors that will impact a real estate investor’s investment – and mortgages are just one area of contemplation. If you’re not able to purchase an investment using all cash, then a mortgage is a necessary evil. Mortgage payments are a huge factor that impacts the overall profitability of a real estate investment, so make sure you choose the mortgage type that suits your investment goals. Be sure to work with a reputable mortgage broker that can help you understand the intricacies of choosing which mortgage is right for you.

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Charles Carillo is the founder and managing partner of Harborside Partners. He has extensive knowledge in renovating and repositioning multifamily and mixed-use commercial real estate. Prior to launching Harborside Partners, Charles founded an online payment processing company with partners and clients in 4 continents across the globe. Charles holds a BS from the Connecticut State University.

Investing Through the Buy and Hold Strategy

Real estate has long been considered a viable and reliable area for investment. Unlike the stock market, which can fluctuate based on the whims of the market, real estate is relatively cyclical in terms of time and is extremely local in nature. This means that a slow market in Los Angeles, California does not necessarily mean a slow market in Miami, Florida. In addition to this, the asset in a stock market is just a number on a computer screen – it’s not tangible, or something you can touch and feel. Let’s compare this to real estate, where you can actually see (and live in!) the asset you buy. You can add paint to improve it cosmetically, do more extended maintenance to improve it structurally, and generally control what you do with the asset.

Passive real estate investing through the “buy-and-hold” strategy entails buying a property for the long haul. This is opposed to wholesalers and flippers, who buy properties in the hopes of making a quick return. Buy-and-hold investors purchase a property, typically using bank financing, and rent it out for long-term passive income. The term “passive” means that you are not actively working for the money you earn. After the initial investment into a turnkey residential property or an income-producing commercial property, investors typically hand the property over to a property manager who takes care of the tasks related to hosting a tenant. These investors then receive a check from the property manager each month with a portion of the earnings.

The buy-and-hold strategy is ideal for retirees who don’t want to actively manage an investment and just want to receive a steady flow of money throughout their retirement. It’s also quite ideal for young investors who have a longer investment horizon, or time consideration, for their investments. They can purchase income-producing properties whenever they are financially viable, even at the start of their careers! Now they can collect a paycheck from their employer and a check from their rental property. Most employed adults have a 401-k plan through their employers, and typically have a pension plan as well. Real estate investing is a steady and relatively safe way to build a retirement portfolio and diversify your investments even further.

One important concept related to passive real estate investing using the buy-and-hold strategy is the benefit of using bank financing instead of buying a property with cash. It’s true that you can often negotiate a much lower purchase price when you have cash to pay with – it’s enough of an incentive for the seller to forego the pains of dealing with a buyer who must get approved for a mortgage and ultimately fund the loan at the closing table. The seller gets cash in their bank account, and the buyer walks away with a new property – everybody wins, right? Not exactly, and that’s due to a concept called return on investment, or ROI.

Return on investment is a metric that many investors use to determine how successful their investments are. It’s expressed as a percentage and is calculated with a simple math problem: (total money earned) divided by (total money spent). It is typically calculated on an annual basis, so the ROI for your first year owning the property will be calculated as follows: (total rent money earned in year one) divided by (total amount of money spent purchasing the property, including the purchase price, closing costs, and any money spent on initial repairs and improvements). This calculation gives the investor a general idea of how much “bang for the buck” the property has.

When an investor buys an investment property using all cash, the portion of the equation related to the total amount of money spent is extremely high. This, in turn, drives the ROI metric down and essentially tells the investor that he or she is getting a low return on the property for year one. On the other hand, when an investor buys a property with bank financing, the bank typically requires a 20-25% down payment. Though this may sound high, it’s a lot less money than paying 100% in cash. This lower initial investment will drive the ROI up when compared to a cash transaction. Keep in mind that ROI should increase as the years go on, because the total money spent is generally the highest at the time when the property is initially purchased. ROI is just one of many metrics that investors use to gauge their success, but it can be a quick and helpful signal.

Once you’ve decided whether to purchase using cash or financing, it’s important to have a general sense of what your profit will be. A licensed real estate agent will be able to help you get the relevant figures for the properties you are interested in. Profit is essentially the money you earn after all expenses are paid, and for a residential rental property it’s calculated as follows: (total rental income) minus (total property expenses). Pretty simple, right? Let’s expand a bit on what property expenses consist of. These include your monthly mortgage payment if you’re using bank financing and monthly HOA dues if the property resides in an area with a homeowner’s association. It’s also important to include escrows in your calculation of property expenses. Escrows are funds put away for later, and these include property tax payments, property insurance payments, and a reserve for maintenance and repairs. You should determine what profit threshold you are comfortable with so that you can easily spot the properties that fall within your requirements.

Here’s a simplified example of how to calculate your profit. Let’s say you found a single-family home with 2 bedrooms and 2 bathrooms. You’re putting down a total of $50,000 plus $5,000 closing costs. The homeowner’s association charges $150 per month. The yearly taxes on the property for the prior year were $3,000, and property insurance runs about $1,500 per year. The property needs a little bit of work, so you figure you’ll need $500 for paint and electrical panel replacements. After speaking with your mortgage broker, you find out your monthly mortgage payment will be $800 per month. Then, after speaking with your real estate agent, you find out that the average rent in the neighborhood is $1,600 per month for a 2-bedroom, 2-bathroom house. What’s your profit? How about ROI?

Profit = Total Rental Income – Total Property Expenses
Total Rental Income = $1,600 per month

Total Property Expenses = $800 monthly mortgage payment + $150 monthly HOA payment + $250 monthly tax escrow + $125 monthly property insurance escrow

Profit = ($1,600) – ($800 + $150 + $250 + $125) = $275 per month

Return on Investment = Total Money Earned / Total Money Spent
Total Money Earned = $275 monthly profit * 12 months

Total Money Spent = $50,000 down payment + $5,000 closing costs + $500 initial repairs

ROI = ($3,300) / ($55,500) = 5.9% annual ROI

Once you have these figures, you can make a more informed decision on whether the rental property in question is right for you. If you’re ready to get started with passive real estate investing through the buy-and-hold strategy, consult with your licensed real estate agent and mortgage broker.

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Charles Carillo is the founder and managing partner of Harborside Partners. He has extensive knowledge in renovating and repositioning multifamily and mixed-use commercial real estate. Prior to launching Harborside Partners, Charles founded an online payment processing company with partners and clients in 4 continents across the globe. Charles holds a BS from the Connecticut State University.

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