Experienced real estate investors will tell you: financing is king. The best deal in the world doesn’t matter if you can’t pay for it. As such, new investors frequently ask me how to finance your first real estate investment.
Regardless of investment strategy, the most effective way to finance your first real estate investment property is with a hard money loan. Lenders issue these loans based on the hard asset—the property. As a result, you can qualify for a hard money loan without outstanding financials.
In the rest of the article, I’ll explain how hard money loans will help you finance an investment property. Specifically, I’ll dive into the following topics:
- The Problem with Traditional Financing
- Hard Money Loans as an Alternative
- Financing Your First Real Estate Investment with Hard Money
- Gap Financing to Cover Additional Cash Needs
- Questions to Ask a Hard Money Lender
- Final Thoughts
The Problem with Traditional Financing
To understand the best ways to finance your first investment property, it helps to understand traditional financing first. More precisely, investors need to understand why this financing doesn’t work for investment properties. With these mortgages, lenders like banks and credit unions issue loans based on two broad criteria:
The Borrower’s “Soft” Assets
These include the borrower’s general financial picture. Lenders will want to ensure that credit scores, income, debt-to-income ratios, and cash reserves all meet certain minimum standards. Basically, lenders want as much assurance as possible that the borrower has the ability to continue making payments.
This soft asset verification automatically disqualifies many first-time investors. Simply put, people often decide to buy investment properties because they don’t want to pursue a traditional career. Accordingly, these same people often haven’t spent years A) building their credit scores, B) raising cash reserves, and C) establishing long track records of W-2 income. Lacking these elements, investors will find it extremely difficult to meet a traditional lender’s strict underwriting standards.
The Property Itself
If a borrower defaults on a loan, the bank still wants its money bank. For this reason, lenders require formal home appraisals during the mortgage loan closing process. They want to make sure that they’re not lending you more than the house is actually worth. That way, if you stop paying, they know that they can foreclose on and sell the property, with the proceeds paying off the loan balance. In this vein, most traditional lenders will not provide mortgages for homes in need of major repairs.
And, most residential investing strategies inherently depend on a property’s distressed nature. In particular, both of the following commonly embraced strategies rely on purchasing a distressed property, one that likely wouldn’t qualify for traditional financing:
- Fix & flip: With this strategy, investors find a distressed property – typically at a deep discount. They purchase this home and renovate it to a standard that will meet traditional financing standards. Once renovated, these investors then sell the property to someone using a traditional mortgage, normally a primary homebuyer. Investors pocket the difference between this sale price and their acquisition/rehab/holding/transaction costs as profit.
- BRRR: This stands for buy, rehab, rent, refinance. And, these investors look for a similar property to the above, that is, a distressed home at a deep discount. Next, they complete the rehab process, but they have an aim to rehabbing a home for tenants – not owners. Once renovated, investors then lease the home to quality, long-term tenants. Once leased, investors can refinance their short-term, high-interest hard money loans into long-term, traditional mortgages. As such, they profit three ways: 1) cash flow from tenants, 2) property appreciation, and 3) loan amortization.
In addition to being common investing strategies, both of the above clearly hinge upon finding distressed properties in need of major repairs. And, if investors can’t use traditional mortgages to finance these properties, what can they do?
Hard Money Loans as an Alternative
Enter hard money loans! Regardless of whether you opt for a fix & flip or BRRR strategy, hard money loans provide a means of financing a deal.
An Overview of Hard Money Loans
More precisely, hard money exists as an alternative to the above traditional financing. And, hard doesn’t mean challenging. Rather, it means that these lenders solely concern themselves with the “hard” asset, meaning the property itself.
As stated, conventional 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 and BRRR 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. Most traditional mortgages typically require 30 to 45 days to close. You can close a hard money loan in two weeks or less.
I touched on it above, but hard money lenders only have a few criteria regarding personal background when reviewing an investor’s loan application:
- Not in collections: If you have an outstanding judgement against you and are in the collections process, most hard money lenders will not provide you a loan. These individuals simply pose too much of a risk of repayment.
- No bankruptcies: If you have a bankruptcy on your record, you also likely won’t qualify for a hard money loan – for the above reasons.
- No major criminal background: Hard money lenders will absolutely run a criminal background check on investors. Minor misdemeanors can be waived on a case-by-case basis, depending on the nature of the crime. However, if you have a felony on your record, it’s highly unlikely that a lender will approve your hard money loan.
Assuming you clear the above hurdles, hard money loan approval really just comes down to two items. First, what loan-to-value (LTV) terms will a lender offer. That is, how large of a loan will they provide, based on a property’s ARV. This leads directly into the second item hard money lenders closely scrutinize: a property’s ARV.
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 conventional 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. With The Investor's Edge, we actually call these “evaluations” because they’re a bit different than a standard appraisal.
Financing Your First Real Estate Investment with Hard Money
In the above sections, I provided the background information on using hard money loans to finance an investment property. Now, I want to outline a hypothetical example of how a first-time investor could use one of these loans to finance a real estate investment. Ideally, this example – combined with the above information – will provide you a framework for hard money financing for real estate investments.
Assume you find a great deal on a distressed property. It’s selling for $120,000, and you think that with a $100,000 renovation and sale budget, you’ll be able to sell it for $310,000. With a little back-of-napkin math, that’s a nice $90,000 profit.
But, as you don’t have $220,000 cash for the purchase and repairs, you apply for a hard money loan to cover these costs. While you think you can get $310,000 for the property after the rehab period, the hard money lender will need assurances from an ARV appraisal. You submit your contractor bids, and the professional appraiser determines ARV to be $300,000 – $10,000 less than your initial estimate.
With a $300,000 ARV, the hard money lender (assuming 70% ARV loan, which Do Hard Money offers), will lend you $210,000 ($300,000 ARV times 70%). However, your deal budget totals $220,000. This means that, to move forward with the deal, you’ll need to put in $10,000 cash to cover the difference between the $210,000 hard money loan and your total budget.
If you have the cash on hand to cover this $10,000 extra, you can contribute that to the deal. If not, alternatives exist, which I’ll discuss in the next section.
Gap Financing to Cover Additional Cash Needs
This above example covers a common situation with hard money loans. That is, you’ll typically need to find funds in excess of your hard money loan. Frankly, it’s extremely difficult to find the sort of awesome deal that a hard money loan will 100% cover. This reality means that most investors have other financing techniques to meet their budget needs above a hard money loan. While not a comprehensive list, investors can do the following to cover the gap between a hard money loan and deal budget:
Credit Card Financing
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 gap financing strategy.
Alternatively, you can seek a business partner. 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.
Home equity lines of credit, or HELOCs, are another great gap financing strategy. 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 gap financing option.
There’s also the option to get an unsecured line of credit, which means you’re not using a business or your home as collateral. It will be based on your credibility as a borrower. These will have higher interest rates, but if they help you get a deal it can be worth it.
Questions to Ask a Hard Money Lender
Before jumping into a hard money loan application with the first lender you find, you should be aware of some potential pitfalls. That is, make sure to do your due diligence prior to committing to a specific lender. In particular, I recommend that you ask – at a minimum – the following questions:
What is the maximum LTV you will offer?
Depending on the amount of cash you’re willing to contribute, this will make or break a deal. And, from a return on investment perspective, the more leverage you can use in a deal, the larger your return on contributed capital. (NOTE: Increased leverage also increases risk, which is why we harp on the importance of properly analyzing deals before committing).
What is the maximum loan amount you will offer?
This relates directly to the above question. For instance, a hard money lender may offer 75% LTV loans – a fairly high standard. At first glance, this seems like a great opportunity, as you can finance a larger portion of a deal than a 60% or 70% lender will allow. But, if that same lender caps maximum loan amounts at $150,000, you’ve significantly limited your pool of available deals.
Do you finance a particular type of property?
Many hard money lenders focus their lending on a particular property type, normally something with which they have a lot of experience. I made this mistake as a new investor. I found what I thought were great deals, but I couldn’t find a lender interested in those properties. As such, I learned the hard way – it’s better to find out what sort of properties a lender will finance before you go out looking for deals.
How do you handle loan repayments?
This is a hugely important question. Some lenders require monthly interest (or principal and interest payments) after a certain amount of time. This can seriously challenge your cash flow and disrupt your deal’s budget. Alternatively, at Do Hard Money, we accrue all interest up front, meaning that investors pay everything off at once at the end of a deal, which simplifies the budgeting and cash-flow process.
Bottom line, as a new investor, the best bet for financing your first real estate investment is working with a hard money lender. With an excellent deal, you can 100% finance the entire investment with hard money loans. But, even in situations where the hard money loan doesn’t cover all costs, you can still finance the entire investment with a good gap financing strategy.
If you need help analyzing potential deals, we’d love to help!
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