A Primer on Real Estate Investing
First, of course, the legal disclaimer
Please note that the information
in this guide is not to be used as consulting, accounting, or legal advice. The
following information is provided with the understanding that this article is not
a substitute for professional advice, and is merely for informational purposes.
TheFinanceResource.com is not responsible for the use of any information contained
below or for the factual accuracy of any statements made below.
Real estate is a very complicated
world. You may be familiar with late night advertisers hawking “no money, no credit,
no problem” schemes that seem almost too good to be true. In fact, an over familiarity
with Carleton Sheets is a common sign of insomnia (just kidding). The truth is that
those programs are extremely high risk investments that prey on those that want
to get rich quick. True real estate investing is a slow way to become wealthy. It
can be an extremely rewarding venture provided that the investments are done in
a safe manner. One of the best aspects of real estate is that you can safely leverage
your investment so that the final payoff will be several times the down payment.
Additionally, a constant stream of income can be provided as well. While the rewards
of real estate are wonderful, the risks can be extremely high. If you read other
books/articles about real estate investing, they will tend to play up the benefits
of the asset vehicle without properly examining the risks. This part of the text
is devoted to the financing of real estate and alternatives to the outright purchase
of properties. If you decide to build a real estate portfolio then you should consult
several professionals and texts before any serious investment plans are implemented
as this article is just a brief primer on the complexities of real estate financing.
When you purchase an apartment complex,
home, or commercial building, the chance that you will only put down a portion of
the overall cost is extremely high. Banks and finance companies love lending money
to real estate investors because the collateral (the building itself) is easily
sold in the event of a default. Unlike a business loan, where the lender can lose
all of their investment, real estate is tangible. In a typical real estate scenario,
you will be required to put down at least 10%-20% of the net cost of the building.
No money down purchases are completed by having the owner of the building provide
the down payment for the property in the form of a second mortgage. This increases
the risk dramatically because now there are two mortgages to pay. The owner held
mortgage usually carries a much higher interest rate than the traditional bank loan
because in the event of default, the previous owner is second on the list of creditors
to be repaid.
In certain exceptions, the lender
may extend more credit than the usual 80%-90%. These loans are generally used to
rehabilitate old, broken down homes that are going to be sold once the building
is renovated. “Rehabbing” a building has significant risks. This type of investment
scenario is the most commonly hawked product on late night infomercials. Wealthy
borrowers with exceptional credit may be able to receive higher leverage ability
because of their overall financial resources.
There are several types of financing
methods available for purchasing real estate. The route that you chose will depend
on what type of real estate transactions that you will engage. Real estate finance
can be quiet complicated, but it can also be the most creative aspect to finance
that you will encounter. As you engage in larger real estate deals, the financial
aspect will become exponentially harder. It is important to work with a lending
institution that understands the needs of real estate investors. Some lenders tend
to frown upon furious acquisitions of property regardless of the cash flow produced
from the tenants.
Local banks tend to be the first
stop among novice real estate investors because it seems to be the most convenient.
It is important to shop for the best rate before you accept a loan from a loan officer.
Mortgage brokers offer a wide range of loan products. The benefit of using a broker
versus a banker is that they are not bound by any lending institution. A mortgage
broker works for you, and not a bank. There has always been a debate as to whether
or not a mortgage broker is more expensive than a direct lender. Typically, the
fees associated with using a mortgage broker are in line with what you would pay
at a bank or with an independent mortgage banker. Brokers receive discounts on the
mortgages that they originate and then add a certain fee to the overall cost. These
fees are known as points, and are charged against the overall amount of the loan.
For example, two points on a $100,000 mortgage is $2,000. The drawback to the broker
is that they do not fund their own loans and nor do they make the decision to lend
money to you. Mortgage brokers simply act as your liaison among several lending
They will pull your credit report,
negotiate the interest rate and loan covenants, and close the deal on the behalf
of the lending institution. Mortgage bankers are independent lending institutions
that originate loans and then sell them to a group of investors. Unlike a mortgage
broker, a mortgage banking company directly lends money to you to purchase real
estate. Similarly, the mortgage banker will add a fee to the loan that you will
pay at closing. Mortgage bankers that sell their loans make additional money upon
the sale of the loan to an investor. If you are planning to do a lot of real estate
business then it would be in your better interest to retain a good mortgage broker.
Brokers may be able to solicit equity and bridge financing when needed, which is
not usually done by mortgage bankers.
Real estate investment trusts (REITs)
are another way to enjoy the benefits of the asset without exposing yourself to
the risks of borrowing or the hassle of managing properties.
REIT’s are traded on the stock exchanges,
or they can be purchased privately through certain broker-dealers. When you purchase
a REIT, you are obtaining a piece of many properties that are usually high quality
Class A real estate. Other REIT’s specialize in the origination, sale, and investment
in mortgage notes. These funds are similar to bonds because they payout the money
received from debtors. When interest rates rise, mortgage and property REIT investments
tend to do poorly. This is especially true for investment companies that purchase
mortgages. When a REIT lends money to purchase a building, they are not lending
their own money. Usually, these businesses borrow money in the form of very large
lines of credit. The interest earned on the mortgage goes toward paying the interest
expense on the line of credit. These borrowing facilities (formally called mortgage
repurchase facilities) are typically tied to a floating interest rate such as a
treasury yield. Interest rate hikes make the spread between the cost of borrowing
and the interest received from debtors to narrow, which causes lower profitability.
If the debtor has a fixed rate mortgage, the investment company can lose money should
the market interest rate increase past the rate on the fixed mortgage loan. The
prospectus of each REIT will discuss in length the risks associated with their holdings.
Sometimes, REIT managers will use interest rate derivatives to obtain the same income
regardless of the interest rate environment.
The rates of return on REITs tend
to be less than what you would receive for purchasing properties outright. This
is because the expenses of maintaining high end real estate are much higher than
a local apartment complex. Also, these management companies tend to hire seasoned
experts to manage financing, appraisal, and tenant relations in order to have stable
occupancy rates. Part of the reason that the returns are lower is because the risk
associated with REIT is significantly lower than purchasing real estate outright.
Additionally, the leverage normally used in real estate is not used. Debt to equity
ratios are much lower for publicly traded REITs. There are complicated tax implications
created by real estate investment trusts. Investment trusts are required to pay
out 90%- 95% of their total earned income so that they can avoid the double taxation
of dividends. Your tax specialist will be able to determine whether or not the dividend
paid to you from the management company is a qualified dividend.
Real estate limited partnerships
are another way of gaining entry into the real estate world without having to manage
the property. These partnerships also offer limited liability from banks and lenders
should the properties default. One of the aspects of a limited partnership is that
the depreciation and gains/losses are passed directly to your income statement.
There is not a double taxation provision, and in some instances you may be able
to credit the depreciation and gains/losses against your ordinary income. However,
the tax code has changed significantly over the last few years and a law that has
separated passive income from ordinary income now exists. As always, a tax advisor
will show you what deductions and taxes are associated with limited partnership
investing. The minimum required investment for these partnerships can vary from
$25,000 to millions of dollars. Higher end partnerships incorporate a plethora of
managers and expertise. Unlike securities based hedge funds, real estate partnerships
may be unregistered investment vehicles that do accept non accredited investors.
Real estate management companies may not fall under the provisions of the Securities
Act of 1933. When dealing with investment partnership agreements, you should consult
a lawyer and accountant about the language used in these documents. Partnership
agreements tend to be very complicated documents, and a real estate lawyer will
help you understand the language used in these agreements. A real estate limited
partnership operates in a similar way to a hedge fund. A managing partner handles
all of the day to day operations of the business and then passes the profits or
losses to the individual partners.
Your success in real estate will
also depend on your ability to negotiate a deal. This type of investing is complicated
because there are no definitive rules or strategies that can make your real estate
successful. Unlike a stock exchange where prices are determined by a market price,
real estate investments are difficult to value. Additionally, real estate agents
have a conflict of interest as they do not work on your behalf. They are paid on
a commission basis, and it is in their best interest that you pay a high price for
the property. Later in the article we will look at conflicts of interest in real
estate investing. When determining a building’s value, make sure that you have a
licensed appraiser help you in determining fair worth. It is important to also check
on the prices of homes that are comparable in the same neighborhood, area, etc.
Time is a very important element
in real estate. Investments in brokerage accounts work automatically after you’ve
implemented your strategy. Real estate is different. You may have to deal with nonpaying
tenants, lackluster property management firms, taxes, contractors, etc. If you are
overwhelmed with other activities in life then it may be in your best interest to
purchase REIT vehicles versus actual buildings. An alternative to managing your
own properties is to allow a property management company to do the work for you.
A property management firm will handle all of the aspects of your building for a
fee. This fee can be as high as 10% of the gross rent collected. If you do not have
the time to manage a property effectively then a property management company is
The other element to real estate
is the people. Real estate people can be pushy as their income depends mostly on
commission income. There are very few rules to making real estate deals, and this
can make things rather complex. This industry is a jungle, and it is not for the
faint of heart. Unlike the securities industry where advisors, investors, and traders
are bound by a seemingly endless amount of rules, real estate investors have very
few legal restrictions in the methods of which they can deal. For instance, it is
not illegal to trade on inside information with respect to real estate deals whereas
it is a very serious offense to profit from inside knowledge of a stock transaction.
One of the problems with real estate
investing is that a lot of the people that operate in real estate have conflicts
of interest. Real estate agents are the worst offenders. When purchasing a property,
it is in the real estate agents best interest for you to pay a higher price as they
are paid on a commission basis. Typically, there are two agents that are involved
in any transaction: an agent for the seller and one for the buyer. In most transactions,
the two agents will split the commission received for the sale. You can see where
the conflict of interest exists. It is in the best interest for your real estate
agent to have you pay a higher price for a property despite the fact that they are
representing you. However, the real estate brokerage industry is going through some
great changes. The internet is causing many ‘brick-and-mortar’ brokerages to lower
their commission schedules. Discount brokerages are also becoming popular. The average
seller will pay six percent of the sale price to the real estate agents. This is
an extremely high price to pay for not much work on the part of the brokerage firm.
Imagine, if you were selling a building/home for $500,000 then your agent be paying
$30,000 to your real estate agent.
Doesn’t this seem a little high
for how much work your real estate agent actually does?
Discount brokerages have begun charging
two percent or less for their services. As competition increases, I am certain that
the rates of real estate brokerages will continue to decline.
Mortgage brokerages work in a similar
manner. Their interests are in direct conflict with your interests in securing a
reasonably priced loan. These brokers are paid on a commission basis, and therefore
finding you the best rate on a loan is not always their top priority. In certain
instances, certain brokers may receive compensation from the lending institution
that grants the loan. An ethical mortgage broker should provide you with a summary
detailing their compensation for the loan. Mortgage banks and commercial banks profit
from your loan in two ways. When you close a loan at a lending institution the bank
or finance company will often charge points on your loan directly to you. Additionally,
the loan will be sold to another investor such as Fannie Mae at a markup that can
range anywhere from one to three percent of the total value of the loan. Banks and
finance companies rarely hold loans very long anymore. The primary source of income
for financial institutions is fees and not interest income. These institutions are
not required to disclose the amount of money they receive from selling your loan
to another investor. However, this industry is also going through changes. Many
of the direct lending institutions are beginning to charge flat fees instead of
a percentage of the loan amount. This is especially true with lenders that loan
money in the form of home equity loans and second-lien mortgages. The competition
to close loans has intensified with the decline of interest rates over the last
five years. This is a direct result of financial institutions selling their loan
assets into secondary markets. These institutions are now dependent on an increasing
number of deals instead of receiving revenues from interest payments from borrowers.
Credit scoring is an important part
of your success as a real estate investor. Although your real estate purchases may
be made through a corporate entity, your debts will almost always have to be personally
guaranteed. Only after you have proved years of success will a bank or finance company
offer you the ability to borrow without having to personally guarantee the loan.
Your credit score will be an important factor when approaching a lender for a loan.
One of the interesting things about the proliferated use of credit scoring is that
it has made lending much more of a quantitative science. Years ago when a person
wanted a loan from a bank or finance company was at the mercy of their banker. Additionally,
the credit scoring system has equalized the lending markets. The credit scoring
system is primarily based on a set of algorithms developed by Fair, Isaacs, and
Company. Credit scores are also referred to as FICO scores. The exact methodology
for computing credit scores is not known, but in order to have a good credit score
you must pay your bills on time, and not have over extended your existing credit
lines. Small discrepancies or negative remarks on your credit report can dramatically
FICO score. Before approaching a
lender when seeking a loan, you should obtain your credit report. If you fix all
of the negative items before applying for a loan, you will have a much smoother
Banks and finance companies do not
lend solely on credit scores. If you plan to purchase a piece of real estate for
investment purposes then it is important to have projected cash flows and a brief
market analysis. This analysis should be built in the same manner as you would for
a business plan. In addition to being a worthy credit risk, banks and finance businesses
want to ensure that you are knowledgeable about your future venture. Finally, real
estate investing can be one of the best investment vehicles that you use, but it
can and will come with a number of headaches. Disputes relating to real estate purchases
can be tied up in courts for years, and so anything done in this world should always
be carefully planned. Always retain the services of a good lawyer and accountant
before starting any real estate venture, and remember that some of the people that
you will employ for your real estate investing have interests that conflict with