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How Much Money Do You Need to Start Investing in Real Estate?

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.

{ 16 comments… add one }

  • Mr. Cheap November 15, 2007, 2:29 am

    Look for the best deal, and be willing to allow a decent deal pass you by. There’s always another.

    I’m always amazed at people who are just starting out at real estate and they think they’ve come across the deal of the century with the first property they look at. I think you’re totally right, there are always other deals in you future, and they’ll probably be better deals. A buddy of mine (who answers a lot of my real estate questions) says that every deal he does is his “best so far”.

  • Mike-TWA November 15, 2007, 8:54 am

    To be honest, Mr. Cheap, I sometimes have a problem with this one myself. When you make up your mind to buy and you’re actively looking for the next deal, it is difficult to prevent yourself from that internal reasoning of “got to have this one” that leads to incrementally reasoning your way into a higher offer and worse deal. For new buyers, it’s good to keep in mind that you have limited funds to invest. Those funds can buy a good deal, but if you make sure you buy your best deal (within the range of reality), you’ll be able to get to that second buy that much quicker. How about you, Mr. Cheap? Ever find yourself a little over-anxious when looking at the property that presents itself at a given moment?

  • Mr. Cheap November 16, 2007, 2:43 am

    Over-anxious in what way? The only deal I’ve done by myself was for a condo. From a “personal purchase” perspective I got a heckofa good deal (I could sell it right now and make money, even after paying agent and legals fees). From an investment perspective, it wasn’t a particularly great deal (I’m paying about 60% of the rent in expenses, BEFORE the mortgage).

    It was the best deal I could work that met my criteria when I was looking (a condo, with low maintenance requirements, that I could live in myself if it turned out investing wasn’t for me).

    The building I bought with my friend (its in another town, so I’m very much a “Rob” in the arangment) is doing WAY better then the condo from a financial perspective (although its only in its second month so I don’t want to count my chickens yet…

    I think I’d be nervous enough about hidden problems and management issues that it would keep me in check if dollar signs were dancing through my mind (yet the dancing dollar signs entice me enough that I’m willing to take the risk). My fear and greed seem to be balanced ;-).

  • Terry November 29, 2007, 11:49 pm

    I enjoyed this article.

    It’s impressive how quickly you could acquire those 4 properties. I was wondering if, after refinancing, you were able to have a positive cash flow from your rents?

    I’ve had to go with a zero cash flow on some properties until I’ve had them a few years. Then I can start to gradually raise the rent.

  • Mike-TWA November 30, 2007, 12:37 am

    Thanks, Terry. You raise a good question about cash flow. With leverage at the level that we purchased our properties, cash flow is likely to be very low positive to break even. We are at positive cash flow on all properties save one–one we’ve referred to as the “Problem Child”. However, the cash flow for even our first two years of acquiring these rentals is low, as we anticipated. We intend to have some articles coming up on using lease options to increase short-term cash flow and then decrease leverage longer term. I hope you check back in.

    By the way, I just read your article explaining tax deductibility of repairs versus capital improvements. It’s a good synopsis for landlords.

  • Terry November 30, 2007, 7:35 pm

    Mike,

    That’s for the positive comment on my article.

    I’ll look forward to your upcoming post on lease options. It’s a topic I’ve wanted to learn more about.

  • ConnieBrz December 2, 2007, 1:22 pm

    Great article :) One question– can you go into more detail on portfolio lenders?

    Are you talking about local banks and/or credit unions? Does that description included hard money lenders? And with the lenders you’re working with, how much higher are the closing costs and interest rates?

  • Mike-TWA December 2, 2007, 4:21 pm

    Thanks, Connie. By portfolio lenders, I’m referring to any commercial bank that provides mortgage loans that are not re-sold in the secondary market. Since the loans are held by the originating lender, the lender can set criteria without conforming to the FNMA criteria–which, for our purposes, means funding a higher percentage of purchase and improvement costs based on true loan-to-value percentage rather than loan-to-purchase price.

    For terminology, a portfolio lender could be banks, credit unions, and hard money lenders providing non-secondary market financing. We, however, have not dealt with nor needed hard money loans (more for the house flipper with considerably higher rates).

    Great question on the interest rates and closing costs. But let me beg off on that one until a future article.

  • Evaine April 16, 2008, 10:54 am

    Good post. You make some great points that most people do not fully understand.

    “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.”

    I like how you explained that. Very helpful. Thanks.

  • Dave July 11, 2008, 2:39 pm

    Were these FHA 203(k) loans or just some other type of special loan? How did you convince the bank to give you this loan? Did you walk in and say, “I want to buy this property, here is an estimate of the repair cost, here is an estimate of the value after repairs?” or use some other approach?

  • Mike-TWA July 12, 2008, 4:34 pm

    Dave,

    They weren’t 203(k) loans. Several years ago, I assisted a friend in purchasing a property financing the repairs with a 203(k). To my recollection, the 203(k) is for owner-occupants.

    As to finding a bank to finance on the basis of improved value, I have two basic suggestions. Ask around and call around. If you know someone who has invested in residential real estate, ask who he used for financing and whether he financed improvement costs. Look up lenders in your area and start dialing. Forget larger retail lenders. You want smaller banks that don’t resell their loans. Set up a few meetings with the people that handle commercial real estate loans in these smaller lenders. If you have any track record with real estate investing, have that information available for your meetings. Even in the telephone conversation, ask direct questions. Tell them you’re planning to purchase a property, your criteria in terms of purchase price to improved value, etc. And if you’ve identified a specific property, prepare a detailed list of repairs and your estimated costs. In our case, we identified a portfolio lender who loans on this basis to approved investors, and we absolutely provided the bank with our estimate of improved value and comparable sales to back it up. After the first property, this same lender financed another three for us in the following year and a half.

    Good luck!

  • Dave July 12, 2008, 11:26 pm

    Thanks, Mike. This blog/site is a great resource. The books I’ve read so far have been very helpful (and I highly recommend reading a lot of books), but I think the authors have become so successful that they’ve lost touch with the issues rookies face. Your articles provide a way to see how all of these concepts and ideas work in the “real world” for people just starting out.

  • Luc B. May 15, 2010, 5:51 pm

    I am thinking about getting into real estate investment and do find your articles to be educational. Where should I start first? I did and is continuing to read books by Tom Butler and others but still need additional info. What product is best to invest in, pre-forclosure or short sales? and what are the draw backs?

  • Luc B. May 15, 2010, 5:53 pm

    to add to my first question, i do work in the home insurance field so i am equipped to calculate rebuild. how may i utilize this experience when speaking to banks?

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  • Dreamer July 16, 2011, 4:25 am

    Hi,

    Quick question, I am new to this subject, but right now am thinking of investing in a rental property. The problem is that I just bought my house a little more than a year ago. So I want to know, for the rental property, how much income do I have to have for the bank to even consider giving me any financing. As far as cash on hand I got about 80k, but my income is only about 3200 per month, gross. And my current mortgage is already 1150.

    Is it better for me to just go in with cash? Is there a way for me to get started with this dream or anyone know a better approach?

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