The 4 Types of Investor Financing
Throughout my investing career, I’ve spent many dozens of hours talking to lenders and potential financiers of my deals. With all the different types of loans and equity financing available these days, it’s important to have a good understanding of the benefits and the drawbacks of each, so you can choose the most appropriate financing option for your particular need(s).
Of course, given today’s credit situation, options are not only more limited than they were a couple years ago, but the definition of a “good deal” from a lender has changed as well. When I first started looking at financing for single family houses, I passed on a couple potential options that in hindsight were pretty good given today’s tight credit market; so it’s important to not only understand the types of financing that’s out there, but also which types are most prevalent and most easy to come by.
The point of this article is to define the four most common types of financing available to real estate investors; while there are, of course, more than four ways of financing real estate investments, most are a derivative — or combination — of the four we will discuss here.
The four most common types of RE financing are:
Traditional Financing
This type of loan is generally done through a mortgage broker or bank, and the lender may be a large banking institution or a quasi-government institution (Freddie Mac, Fannie Mae, etc). The requirements to qualify for a loan are based strictly on the borrower’s current financial situation — credit score, income, assets, and debt. If you don’t have good credit, reasonable income, and a low debt-to-income ratio (i.e., you earn a lot compared to your monthly obligations), you likely won’t qualify for traditional financing.
Benefits: The benefits of traditional financing are low-interest rates (generally), low loan costs (or points), and long loan durations (generally at least 30 years). If you can qualify for traditional financing, it’s a great choice.
Drawbacks: There are a few drawbacks to traditional financing for investors, some major:
- The biggest drawback to tradition financing is what I stated above — it’s difficult to qualify these days. Just a year or two ago, you could have qualified under a “sub-prime” variation of traditional lending, where income and credit were less of an issue; but given the sub-prime meltdown (many of these borrowers defaulting on their loans), these sub-prime options have gone away. So, unless you have good credit, income, and small debt, you’re better off not even bothering with trying to get traditional financing these days.
- Traditional lenders generally require that at least 20% be put down as a down payment. While this isn’t always true, investor loans with less than 20% down can be tough to find via traditional lending these days.
- As an investor, it can be difficult to deal with traditional lenders who don’t necessarily understand your business. For example, a house I closed on last week with traditional financing almost fell-through because the lender wouldn’t provide the funds until the hot water heater in the investment property was working. As an investor, it’s common that I’ll buy houses with broken hot water heaters (among other things), and I can’t generally expect the seller to fix this for me, especially when my seller’s are usually banks. In this case, I had to fix the hot water heater before I even owned the house, which is not something I want to do on a regular basis.
- Traditional lenders take their time when it comes to appraisals and pushing loans through their process. It’s best to allow for at least 21 days between contract acceptance and close. As an investor, you often want to incent the seller to accept your offer by offering to close quickly; with traditional lending, that can often be impossible.
- If the lender will be financing through Freddie Mac or Fannie Mae (and most will), there will be a limit to the number of loans you can have at one time. Currently, that limit is either 4 or 10 loans (depending on whether it’s Freddie or Fannie), so if you plan to be an active investor going after more than 5 or 10 properties simultaneously, you’ll run into this problem with traditional lending at some point.
- There are no traditional loans that will cover the cost of rehab in the loan. If you plan to buy a $100K property and spend $30K in rehab costs, that $30K will have to come out of your pocket; the lender won’t put that money into the loan.
Portfolio/Investor Lending
Some smaller banks will lend their own money (as opposed to getting the money from Freddie, Fannie, or some other large institution). These banks generally have the ability to make their own lending criteria, and don’t necessarily have to go just on the borrower’s financial situation. For example, a couple of the portfolio lenders I’ve spoken with will use a combination of the borrower’s financial situation and the actual investment being pursued.
Because some portfolio lenders (also called “investment lenders”) have the expertise to actually evaluate investment deals, if they are confident that the investment is solid, they will be a bit less concerned about the borrower defaulting on the loan, because they have already verified that the property value will cover the balance of the loan. That said, portfolio lenders aren’t in the business of investing in real estate, so they aren’t hoping for the borrower to default; given that, they do care that the borrower has at least decent credit, good income and/or cash reserves. While I haven’t been able to qualify for traditional financing on my own due to my lack of income, portfolio lenders tend to be very excited about working with me because of my good credit and cash reserves.
Benefits: As mentioned, the major benefit of portfolio lending is that (sometimes) the financial requirements on the borrower can be relaxed a bit, allowing borrowers with less than stellar credit or low income to qualify for loans. Here are some other benefits:
- Some portfolio lenders will offer “rehab loans” that will roll the rehab costs into the loan, essentially allowing the investor to cover the entire cost of the rehab through the loan (with a down-payment based on the full amount).
- Portfolio loans often require less than 20% down payment, and 90% LTV is not uncommon.
- Portfolio lenders will verify that the investment the borrower wants to make is a sound one. This provides an extra layer of checks and balances to the investor about whether the deal they are pursuing is a good one. For new investors, this can be a very good thing!
- Portfolio lenders are often used to dealing with investors, and can many times close loans in 7-10 days, especially with investors who they are familiar with and trust.
Drawbacks: Of course, there are drawbacks to portfolio loans as well:
- Some portfolio loans are short-term — even as low as 6-12 months. If you get short-term financing, you need to either be confident that you can turn around and sell the property in that amount of time, or you need to be confident that you can refinance to get out of the loan prior to its expiration.
- Portfolio loans generally have higher interest rates and “points” (loan costs) associated with them. It’s not uncommon for portfolio loans to run from 9-14% interest and 2-5% of the total loan in up-front fees (2-5 points).
- Portfolio lenders may seriously scrutinize your deals, and if you are trying to make a deal where the value is obvious to you but not your lender, you may find yourself in a situation where they won’t give you the money.
- Because portfolio lenders often care about the deal as much as the borrower, they often want to see that the borrower has real estate experience. If you go to a lender with no experience, you might find yourself paying higher rates, more points, or having to provide additional personal guarantees. That said, once you prove yourself to the lender by selling a couple houses and repaying a couple loans, things will get a lot easier.
Hard Money
Hard money is so-called because the loan is provided more against the hard asset (in this case Real Estate) than it is against the borrower. Hard money lenders are often wealthy business people (either investors themselves, or professionals such as doctors and lawyers who are looking for a good return on their saved cash).
Hard money lenders often don’t care about the financial situation of the borrower, as long as they are confident that the loan is being used to finance a great deal. If the deal is great — and the borrower has the experience to execute — hard money lenders will often lend to those with poor credit, no income, and even high debt. That said, the worse the financial situation of the borrower, the better the deal needs to be.
Benefits: The obvious benefit of hard money is that even if you have a very poor financial situation, you may be able to a loan. Again, the loan is more against the deal than it is against the deal-maker. And, hard money lenders can often make quick lending decisions, providing turn-around times of just a couple days on loans when necessary. Also, hard money lenders — because they are lending their own money — have the option to finance up to 100% of the deal, if they think it makes sense.
Drawbacks: As you can imagine, hard money isn’t always the magic bullet for investors with bad finances. Because hard money is often a last resort for borrowers who can’t qualify for other types of loans, hard money lenders will often impose very high costs on their loans. Interest rates upwards of 15% are not uncommon, and the upfront fees can often total 7-10% of the entire loan amount (7-10 points). This makes hard money very expensive, and unless the deal is fantastic, hard money can easily eat much of your profit before the deal is even made.
Equity Investments
Equity Investment is just a fancy name for “partner.” An equity investor will lend you money in return for some fixed percentage of the investment and profit. A common scenario is that an equity investor will front all the money for a deal, but do none of the work. The borrower will do 100% of the work, and then at the end, the lender and the borrower will split the profit 50/50. Sometimes the equity investor will be involved in the actual deal, and oftentimes the split isn’t 50/50, but the gist of the equity investment is the same — a partner injects money to get a portion of the profits.
Benefits: The biggest benefit to an equity partner is that there are no “requirements” that the borrower needs to fulfill to get the loan. If the partner chooses to invest and take (generally) equal or greater risk than the borrower, they can do so. Oftentimes, the equity investor is a friend or family member, and the deal is more a partnership in the eyes of both parties, as opposed to a lender/borrower relationship.
Drawbacks: There are two drawbacks to equity partnership:
- Equity partners are generally entitled to a piece of the profits, maybe even 50% or more. While the investor doesn’t generally need to pay anything upfront (or even any interest on the money), they will have to fork over a large percentage of the profits to the partner. This can mean even smaller profit than if the investor went with hard money or some other type of high-interest loan.
- Equity partners may want to play an active role in the investment. While this can be a good thing if the partner is experienced and has the same vision as the investor, when that’s not the case, this can be a recipe for disaster.
Hi J. Scott
Since you quit your job to begin investing in Atlanta, did this cause any difficulties for you in obtaining financing for your properties, or did you have a large savings acct. (or some other asset) as collateral?
JED –
Yes, we were lucky to have the cash available to boot-strap our investing. That said, if someone doesn’t have the cash, but does have good credit and/or reliable income, they should be able to figure out a financing solution that will work for them. The key to financing is to constantly be looking for money, whether you need it or not.
Dear Scott:
Thank you for putting this info online – this is very helpful.
In order to build a scalable business model around deeply discounted residential REOs and to limit personal liability on the other end makes me a bit wary of the traditional financing option. The other options appear to eat up profit margins unless you can flip rather quickly.
There are real estate companies that are active in residential housing – and not just apartment complexes. How do these guys finance ?
Generally speaking, is it possible to get a mortgage as a corporation or LLC with/without a credit history if you can show them the equity created after rehabbing in a spreadsheet with a comps analysis attached ? For other businesses outside of real estate, I heard of people buying shell companies with a good credit history in order to qualify for business loans. Would this be feasible in your opinion for REO mortages ?
How to the big real estate players finance and for what terms ? Can’t imagine there rates are much higher than personal mortgages- but I do imagine there is a size treshold and certain limitations.
After accumlating a portfolio of a number of rented, income-creating REOs, are there opportunities to refinance with a commercial mortgage in a LLC/company name that surpass a certain treshold ?
If you know the answers to my questions or have any resources to point me to, I would greatly appreciate it.
Hey Nico,
There’s really no hard-and-fast answer to your question…the big boys have many different options for financing, and depending on their situation, they can sometimes get very creative.
As you pointed out, traditional financing is the worst choice. It takes a lot of time to get the loans, the number of loans is limited, and traditional lenders don’t like to lend against run-down houses.
Certainly, the most common financing method for the big players is to bring in a number of investors, pool their investments, and use that as a cash pool for whatever they are trying to do. For example, they may find 5 investors each with $200K to invest, and they immediately have access to $1M for investment. And if you’re looking to buy relatively low-end houses, $1M can go a long way, especially if you have an exit strategy that gets you out of the deals quickly.
My strategy (which is also pretty common) is that I work with small, local banks that lend their own money. They can underwrite any deals they want, and don’t have to follow any specific guidelines. So, they can lend against a thinner deal if they know you have experience, or can lend to you on a great deal even if you have no experience. They make their own rules, so all you have to do is convince them that their money is safe with you, and you can often get financing.
While you may be able to get loans in your business name early on, you’re going to have to personally guarantee the loans. This means you’ll need at least decent credit or some assets to secure the loan. I’ve heard of people buying shell companies to have immediate credit, but lenders will recognize that and will likely ask for personal guarantees to go along with the loan.
As for refinancing many rentals, what you’ll want there is a commercial blanket loan. Basically, one loan that covers all the properties into one bundle. Many small banks will do this, as well as many traditional lenders, assuming you have decent equity to support the loan valuation.
Hope that answers some of your questions!
Dear Scott,
Do you have a sample of a legal contract/agreement for equity partnerships? My son and a friend of his have a LLC and are slowly getting into RE investing. They have several SF rentals and have flipped a couple of SF homes. The latest one (in progress), my wife and I financed on a “handshake” with the agreement that we would get 50% of the profit at closing. We would like to continue this arrangement but would like something in writing that is fair and equitable to all concerned as well as protect all concerned. Their long term goal is to keep flipping properties to establish a nestegg with which to eventually get into an apartment complex.
I just found your site a week ago and find it very informative. Any help you can give would be greatly appreciated.
Dave
More of my post above. Our participation will be limited to providing the funding. Naturally, we will look at the property and listen to what they plan to do in the rehab process, and even give an opinion if asked. But the ultimate decision will be their’s.
In effect, we will be their “bank”, not their hands on business partner.
Is it common for an equity partner to have a sliding scale as to what percentage of the profit they will receive based on the length of time the money is in use? In my mind, if I loan $70,000 and it generates a $20,000 profit in 90 days, I should receive less of the profit than if the same numbers happen after 6 months?
Thanks in advance,
Dave H.
Hi Dave,
I don’t have any contracts that I can send you and given that I’m not an attorney or contracts expert, please take anything I suggest and check with an attorney before you do anything…
That said, there are a couple issues to consider:
1. First, you should probably ensure that any money you lend is actually secured by the asset (the property) that the money is used to purchase. While this might not be necessary if it were just your son you were working with, the introduction of a non-relative probably makes this a good idea. In essence, this means that you should either hold a mortgage on the property (you’d be just like a bank lending on the property and could foreclose if you don’t get paid) or you should be put on the title of the property, either by yourself or jointly with your son and his friend. That way, you can be guaranteed that your money is secured by something physical that you get ownership of if your son and his friend don’t live up to their end of the bargain.
2. Second, you will need some kind of contract with your son and his friend that lays out (in detail) the roles and responsibilities of each of the parties involved in the deal. The contract can be a Partnership Agreement between you and them, or, if you think this will be a longer-term relationship, you might consider setting up a business entity (LLC, corporation, etc) that is jointly owned by the three of you. If you set of a business entity, there will be business documents (Operating Agreement, Bylaws, etc) that would need to lay out these roles and responsibilities that I mentioned above. Additionally, it would be in the contract or business documents how specifically the profits (and/or losses) would be split among you and the other two.
Those are the two basic things you need to consider, and I would highly recommend consulting an attorney who specializes in contracts to help you figure out the details.
Thanks J. I think we’ll take your advice.
Cash follows the deal not the other way around. Your article shows this principle nicely!
First off, thanks for all the excellent articles and advice!
The burning question I have now is: how do you decide whether or use cash or financing for your flips? I’ve been looking through your results and it seems mixed. Do you have any guidelines?
Nate –
I tend to use cash when I expect a short hold time (less than 90 days) and financing when I expect a longer hold time (more than 90 days). Also, if I believe I’ll be doing a lot of buying in the near future, I’ll use financing as much as possible just to keep cash available for more projects.
Hi J. Scott,
Where I can find Hard money investor? I live in Tampa Bay Area Florida and I would like to invest in realstate. I found a really few good deals but my credit score went down and I don’t have any money to start. But I have been told you can start with no money finding other financing sources.
I don’t know where to start. Any advise from you?
Vildana –
I would highly recommend attending a local real estate investors association (REIA) meeting. Most cities have them, and they generally have quite a few lenders who come to the meetings to find investors to work with.
Hi J Scott,
I wanted to circle back on my last post in regards to your ability to own 3 properties at the same time without income coming in. I know you mentioned you used your own money for some of the purchases, but the biggest and most common one was private investors, I’m curious to understand how the investor gets paid for their money. Do they get a percentage of the proceeds after the sale or are they giving a percentage of the money they actually invest? In my example, I have a private investor willing to give $25k to the project, so I am trying to figure out if I give them 20% of their investment back after the sale or should I be paying them a percentage of the actually profit made on the sale which in this case figures to be $15-$20k? Thank you and I look forward to your reply.
Hi Tony,
It can be done several different ways. The two most common are:
1. The private lender makes a loan, just like a bank. You pay interest on the loan for the period of time you’re using the money. They have a mortgage on the property, so that if you default on the loan, they can foreclose on you. Again, just like a regular bank loan, but through a private individual.
2. The private lender becomes more of a partner, where they get a percentage of the profits after the project is done. Of course, doing it this way, the lender takes more of a risk — if the project doesn’t generate much in profits (or if it loses money), the private lender doesn’t make any money (and may lose money).
There are other ways to do this, but these two are the most common.
I have a question if someone may please help. I’m currently about to lose my job and wanted to invest in a home to flip with my brother. I would like some input on how tat works, for example what percent should I receive after the house is sold or do I charge interest on the amount I loan? Any information is welcome, thank you for your time
Diego,
It can work any way you want it to. If you want to loan the money, you can get a fixed interest rate (just like a bank). You’ll have the house as security, so if you don’t get paid, you get the house. Or if you want to be a partner, you can put in the money and then get a piece of the profits. This was has less security (you make money if the deal is profitable and you lose money if the deal is not), but you have the possibility of much higher profits this way if the deal goes well.
And there are lots of ways in between. It really depends on what you want, what your brother wants, and what you both need out of the deal…
Hi Sir,
I would like to begin by saying I really appreciate your site as you provide a lot of valuable information. I would like to know how do feel about owner financing for investment properties. I am looking to purchase two properties in my town which would total 30k for the both. One of the properties need full renovation in which I was told would cost me around 35k. It is in an upscale neighborhood and would be worth approximately 160k when complete. The other needs some rehabbing also but not nearly as much. I think I would use this one as a rental. My question is how do you feel about owner financing and do you think it’s a good idea for these properties as I would rather put my money into fixing it up and paying it off with the profit. The houses are lein free and no mortgages are owed on any.
Hi M Taylor,
First, I’m a big fan of owner financing. If the owner is willing (and able) to hold a note, it’s a great way to get into a property for minimal cost and also to generate maximum ROI. The key is that you need to be certain of your exit strategy — if you can’t repay the loan as promised, the owner could get the property back…with all your repairs.
Now, that said, if you’re buying a property for less than $30K and it only needs $35K in renovation (that’s not very much), I find it hard to believe you’ll be able to resell it for $160K. That would be a homerun deal, and that would mean that the seller must be absolutely desperate, as he could probably find another investor to pay a good bit more if he had even a couple weeks to look for one.
So, I’d be concerned that this deal is too good to be true at those numbers — you should verify the rehab costs and the ARV.
Hello Scott, I own a distressed house in need of major repair. I believe that the Hard Money Investor would be great for me. I can not get help from the banks due to my low credit, low income but also the house is Not my primary residence! Where can I find an investor in New Jersey area? Thank You!
Hi Rachel,
I would recommend visiting your local real estate investor association meeting and network with the lenders and other investors there…