When Rob and I started our joint venture or “adventure,” as the tag line suggests, I had more experience in dealing in real estate. If Rob had posed this question, my answer would have been easy: “How much you got?” I’ll try to be a bit less glib with your money. But the fact is, it’s a little more difficult to answer the question in the abstract and it depends on several factors particular to the investor. As a result, I want to look at three approaches to the question–the guaranteed way, the conventional way, and, for lack of a better term, the TwoWiseAcres way.
The Guaranteed Way
If you’re looking to buy real estate for rental income, the fact is, you’re virtually guaranteed to make money if you pay cash. At the very least, it’s a low risk approach. Even if you make mistakes, such as over valuing the property or if property values or rents decline or if you entered a partnership with Rob, the fact is you’ll be able to rent the property, cover your expenses, and make an income.
The obvious problem, however, is that you just might not have the cash lying around. But as importantly, even if you do, paying cash for a rental property is probably not even advisable. While it’s a guaranteed way to make money, it’s also a likely way to make low returns because it foregoes any increased returns through leverage.
The Conventional Way
An alternative approach is to finance the majority of an investment purchase with a conventional mortgage. Conventional mortgage lenders generally require a minimum 20% down payment (without private mortgage insurance) for investors, as well as owner-occupants. A conventional, secondary market mortgage will have a lower interest rate than a loan from a portfolio lender. So, investors looking to obtain the least cost way to finance an investment property will have to come up with the 20% cash down payment. The 20% down payment requirement is a percentage of purchase price, not value. In other words, despite lenders’ use of the misnomer “loan to value ratio”, the requirement is really loan to purchase price. Investors going this route also have to pay out-of-pocket for the costs of improvements.
Obtaining conventional financing for a real estate investment purchase provides some cost savings, and it also lowers risk. While this approach takes advantage of leverage to increase returns, for the individual investor, it still has substantial limitations on growth. Consider an investment property with a price of $100,000, minimal rehab costs of $7000, with closing costs and prepaid expenses of 4%. An investor financing the purchase with a 20% down, conventional loan will have to come up with about $31,000. While that may be do-able, a second property will not be, at least not for some time.
The TwoWiseAcres Way
Rob and I went with a more aggressive approach. We purchased our first four properties with about $20,000 out of pocket. Our goal was quite simply to acquire the most property in the least amount of time given the amount of cash that we could devote to real estate investments.
The approach is not new and our method is not complicated or exotic. In obtaining the loans, we worked with a portfolio lender that was willing to fund a purchase and rehab based on the improved value of the property. In other words, we would enter into a contract to purchase a distressed property, such as a HUD foreclosure, provide the lender with a detailed improvement plan and, of course, our estimation of the improved value. The lender would then obtain an appraisal of the property, based on the work being completed–i.e. the improved value–and approve the loan based on an 80% loan to value ratio. The lender would hold a portion of the loan to cover our estimate of improvements in escrow until the improvements were complete and the property was re-inspected.
Revisiting our example, this approach means that we could borrow the full purchase price and improvement costs of $107,000 if the property had a value, once improved, of $133,750. By and large, we made sure they did. With our purchases, we might fund closing costs and prepaid expenses with cash or even a portion of the improvements or holding costs. With each purchase, the total cash was somewhere between $0 and $7,000. For three of four of our properties, we later refinanced the properties with conventional, secondary market loans. After a year (occasionally less), we could obtain a conventional loan at 80% loan to value–improved value this time, not purchase price.
The advantage to our higher leverage approach is exactly what we set out to do–grow quickly. However, there are downsides to the approach as well. Higher leverage means higher risk–risks such as unexpected expenses or underestimating rents more easily putting a rental property in the negative cash flow territory. Also, the interest rate charged by a portfolio lender is likely to be higher than a conventional, secondary market loan. Doing a two-stage financing, like we did, also means higher costs due to the costs of refinancing.
At its core, the question of how much you need to begin is really a question of return and risk–both your perception of risk and your tolerance. In our case, we felt comfortable with using high leverage because we had experience that gave us confidence that risk resulting from error in projecting rents or assessing improved value was low. However, we also had other resources that we could draw on–whether credit or income from the day jobs–that provided options if some of these risks came about.
For new real estate investors, a more conservative approach is probably warranted. While I don’t think it is necessary, even for a new investor, to begin the conventional way (funding a 20% down payment and rehab costs), a slow start is advisable. Consider using more available cash to fund the first property, thereby improving cash flow. Make sure you spend the time to truly learn the market and the investment. Look for the best deal, and be willing to allow a decent deal pass you by. There’s always another. Finally, have reserves–cash and credit. Real estate investors can make mistakes, but having no backup source of funds is the way to make a manageable mistake an unmanageable one.