It’s true. You can profit in real estate without much cash—especially if you’ve strengthened your credit score. But even when you lack platinum-power credit, you’ve still got a variety of little-or-no-cash-down
Why Low-Cash Deals Magnify Your Returns
Before we go into little-or-no-cash-down techniques, you need to see why deals with small down payments can magnify your returns. Even if you’re hoarding a pile of cash, you may still choose to hang onto your money as you benefit from the power of leverage.
The Power of Leverage
Leverage (other people’s money, commonly referred to as OPM) means that you buy (or otherwise control) a property that’s worth perhaps 10 times as much as your original cash investment. To illustrate, suppose you invest $10,000 in a $100,000 rental property.
You finance this investment with a 30-year, $90,000 mortgage at 7.75 percent. After eight years you will have paid down your mortgage balance to $81,585. With 4 percent a year appreciation for eight years, your property’s value will have grown to $136,860. When you subtract the balance of $81,585 from the property’s appreciated value of $136,860, you’ll find that your original $10,000 investment has increased more than fivefold to $55,275 of equity.
That result gives you an annual growth in equity of around 24 percent . Through the power of leverage,you gained a return six times larger than the 4 percent rate of appreciation. Now you see why real estate investors call leverage the eight wonder of the world.Sometimes leverage can even yield much higher returns. And used foolishly—as you will soon see—leverage can magnify your losses.
But, over the long run, the great majority of homebuyers and investors gain tremendously from leverage. That’s why even wealthy real estate moguls like Donald Trump and the late Harry Helmsley (past owner of the Empire State Building) always relied heavily on borrowed money to acquire and finance their property investments.
Leverage Can Also Magnify Your Annual Cash Returns In addition to multiplying your profits from appreciation, leverage mag- nifies your annual returns from cash flows. Say you find a seller who is asking $100,000 for a rental property that yields a net operating income (called NOI) of $10,000 a year. If you paid all cash for this property, you would receive a return of 10 percent:
Example 1: $100,000 all-cash purchase
Now let’s say that you also want to compare your all-cash returns to those you would receive using 75 percent and 90 percent financing, respectively. Assume that you can borrow money at 6.5 percent and pay it back over a term of 30 years. Here’s how leverage boosts your annual returns from cash flow.
Example 2: $25,000 down payment; $75,000 financed. Yearly mortgage payments equal $6,607 (75 X $7.34 X 12). Net cash flow after mortgage payments (called cash throw-off) equals $3,394 ($10,000 NOI less $6,606).
ROI = 3394$ / 25000$ = 13.6%
Example 3: $10,000 down payment; $90,000 financed. Yearly mortgage payments equal $7,927 (90 X $7.34 X 12). Net cash flow after mortgage payments (cash throw-off) equals $2,073 ($10,000 NOI less $7,927).
ROI =2073$ / 10000$ = 20.7%
With the figures in these examples, the highly leveraged financing (10 percent down payment) yields a cash-on-cash rate of return more than double that of a cash purchase. In principle, the more you borrow and the less cash you invest in a property, the more you magnify your cash returns. Of course, these examples merely illustrate the principle of leverage. The examples show how leverage may
boost your returns. In practice, the properties you find may produce numbers that look better or worse than those returns you see here. Still, the fact that nearly all wealthy investors finance their properties with large mortgages proves that leverage works.
Leverage Can Increase Risk
Savvy investors reap the benefits of leverage. Foolish investors can lose their shirts. What makes the difference? Financial discipline and cash reserves.
Financial Discipline If you can’t handle money responsibly, borrowing to the hilt can swamp you with debt. Never try to substitute “nothing down” for financial discipline. It doesn’t work that way. before you invest in real estate, make sure you’re living below your means.
Learn to carefully manage your everyday spending and borrowing. Don’t let the real estate gurus suck you into believing that high leverage alone can make you rich.No! High leverage can help you get started.
High leverage can boost your returns. But without financial discipline, high leverage can push you into foreclosure or bankruptcy.
Cash Reserves Foolish investors always view the future through rose colored glasses. These investors never anticipate an unexpected streak of vacancies, a roof that needs to be replaced, or a spiked increase in property taxes.
Over the long term, your rent collections and property appreciation will put hundreds of thousands of dollars into your bank accounts Over the short term, rent shortfalls and unbudgeted expenses can cause unprepared investors to miss their mortgage payments and suffer foreclosure, or perhaps force them into a quick sale at a loss (to an opportunistic investor such as you?).
To benefit over the long run, you must successfully navigate through the storms you’ll encounter along the way. When high seas are trying to drown you, your cash reserves will prove to be your life jacket.With these words of caution now in view, we next turn to the best type of high-leverage financing currently available.
Minimize Your Down Payment with Owner-Occupant Financing
By far, the easiest, safest, surest, and lowest cost way to borrow all (or nearly all) of the money you need to invest in real estate centers upon owner-occupied mortgage financing. In other words, lenders give their most favored interest rates and terms to investors and homebuyers who live in their properties (for a minimum of 12 months). Numerous high LTV (loan-to-value) owner-occupied loan programs are readily available for single-family homes, condominiums, townhouses, and two- to four- unit apartment buildings.
Owner-Occupants Get the Lowest Down Payments
Many owner-occupied loan programs offer 3 percent, 5 percent, or even 0 percent down payment loans. With sterling credit, some lenders will even loan you 125 percent of a property’s purchase price (if you agree to live in the property).
In contrast, if you do not plan to live in the property, many mortgage lenders (banks, mortgage bankers, savings institutions) often require investors to put 20 or 30 percent down. However,since the late 1990s, some lenders have allowed investors to finance their rental properties with only a 5 or 10 percent down payment.
When property markets soften, though, these liberal lenders will probably shut their easy credit windows and force investors to put more cash into their deals and dance through more hoops. Besides offering low-down-payment financing, lenders also qualify owner-occupants with less exacting standards.
Plus, interest rates for owner-occupants can sit below the rate charged for investor loans. If lenders are charging, say, 5.5 to 6.5 percent for loans to owner-occupants with strong credit, the rate for most creditworthy investor loans will probably range between 6.75 and 7.5 percent.
As a beginning real estate investor, you definitely should explore owner-occupied mortgage loans.
Owner-Occupied Buying Strategies
If you don’t currently own a home, you can begin building your wealth in income properties very easily. Simply select a low-down-payment loan program that appeals to you (the most popular ones are described later in this chapter).
Buy a one- to four-family property, live in it for (at least) one year, then rent out your living unit and repeat the process. Once you get your owner-occupied fi-
nancing, that loan can remain on a property even after you move out and move a tenant in.
Because the second, third, or even fourth homes you buy and
move into will still qualify for high-LTV financing,you can quickly accumulate several rental properties as well as your own residence—all without large cash investments.
Although you will be able to go through this process two, three,maybe four times, you can’t execute it indefinitely. At some point, lenders will shut you off from owner-occupied financing because they will catch on to your game plan.
Nevertheless, buying houses (or 2–4 unit apartment buildings) and holding on to them as you successively move in and move out makes a great way to accumulate your first several investment properties.
Current Homeowners, Too, Can Use This Method
Even if you already own a home, you too should definitely weigh the advantages of using owner occupied financing to acquire your next several properties. Here’s how: Locate a property (condominium, house, 2–4 unit apartment building) that you can buy and move into. Find a good tenant for your current home. Complete the owner-occupied financing on your new property and move into it. If you really like your current home, at the end of one year, rent out your recently acquired investment property and move back into your former residence. Or alternatively, find another “home” to buy and again finance this property with an owner occupied mortgage.
Why One Year?
To qualify for owner-occupied financing you must tell the lender that you intend to live in the property for at least a year. Intent, though, does not mean guarantee. You can (for good reason, or no reason) change your mind. The lender will find it difficult to prove that you falsely stated your intent at the time you applied for the loan. Nevertheless, to succeed in real estate over the short and long term, you must establish, maintain, and nurture your credibility with lenders— and everyone else. Always build your deal making on a foundation of trust. When you sidestep agreements, slip through loopholes, make false promises, or connive in any similar slights, you will water down your credibility. Unless you really do encounter an unexpected turn of events, honor a lender’s occupancy requirement. When you establish and nurture your credit and credibility, you will attract money as a magnet attracts iron filings.
Where Can You Find Low-Down-Payment, High-LTV, Owner-Occupied
Everywhere! Look through the yellow section of your telephone book under “mortgages.” Then start calling banks, savings institutions, mortgage bankers, mortgage brokers, and credit unions. Also, many mortgage lenders advertise in local daily newspapers.1 Check, too, with your state,county, or city departments of housing finance. Homebuilders and Realtors also will know various types of low- or nothing-down home finance programs. An hour or two on the telephone will turn up dozens of possibilities.
Although space here doesn’t permit a full discussion of all low- or no-down-payment possibilities, here are a variety of widely available programs.
Don’t Overlook FHA
The Federal Housing Administration (FHA) offers the most well-known low-down-payment home finance plans. Yet, somewhat perversely, many homebuyers believe that FHA limits its loans to people who earn low or moderate incomes. For instance,one of Florida’s largest newspapers continues to describe FHA as a program for “low-income homebuyers.” Not true. No matter how much you earn, FHA may provide the key to your home financing.
When Realtors and mortgage lenders talk about an FHA loan, they are typically referring to the FHA 203(b) mortgage. With close to 1 million new FHA 203(b) loans made last year alone, this program is the largest single low-down-payment loan available throughout the United States. You can get into this type of FHA mortgage for just 3 or 5 percent out-of-pocket cash—sometimes a little more, sometimes less. On an $85,000 property you would pay around $3,250. To finance a $125,000 property you’d pay approximately $6,000, and a property priced at
$175,000 would require cash of around $8,250.
How Much Will FHA Finance?
FHA sets loan limits for each locale around the country. In high-priced cities such as Los Angeles, San Diego, Washington, D.C., and Boston, the FHA maximum loan currently tops out (for single-family houses, condos, and townhomes) at $290,319. In the lowest priced areas of the country, the maximum FHA home loan comes in at $160,176. Because FHA limits vary, consult with a Realtor or mortgage loan advisor in the area where you would like to own. Then compare these limits to property prices to see if FHA 203(b) can work for you. (Note: Much higher FHA limits apply in Hawaii. You can also check the maximum loan amounts for any county in the country at HUD.gov.)
Buy Rental Properties
As another choice, buy a duplex, triplex, or fourplex. As long as you live in one of the units, you still get a low down payment. Here are some examples of maximum FHA loan figures for 2–4 unit properties:
If you buy a 2–4 unit property, you won’t have to qualify for the loan using just your monthly earnings. The rents that you collect from the property also will count. Because my first investment property was a five-unit apartment house, I strongly favor this approach to getting started.
Other FHA Advantages
Besides offering a low down payment, FHA borrowers enjoy many other advantages:
- You can roll many of your closing expenses and mortgage insurance premiums into your loan. This cuts the out-of-pocket cash you’ll need at closing.
- You may choose from either fixed-rate or adjustable-rate FHA plans. (FHA adjustable-rate mortgages give you lower annual caps and lower lifetime caps than most other ARM programs.)
- FHA authorizes banks and other lenders to use higher qualifying ratios and easier underwriting guidelines After you’ve shaped up your finances, FHA will do all it can to approve your loan.
- If interest rates drop (and as long as you have a clean mortgage payment record for the previous 12 months), you can“streamline” refinance your FHA loan at lower interest rateswithout a new property appraisal and without having to requalify.
- If you can persuade your parents or other close relatives to “gift” you the down payment, you won’t need to come up with any closing-table cash from your own pocket. (Undoubtedly,many “gifted” down payments are really loans in disguise.)
- Unlike most nongovernment loans, FHA mortgages are assumable. Someone who later agrees to buy your home need not apply for a new mortgage. When mortgage interest rates are high, an assumable low-rate FHA mortgage will give your home a great selling advantage.
Whether you currently rent or own, if you’re cash-short, I urge you to seriously consider the advantages of financing your next investment property with a low- or no-down-payment owner-occupied loan.
In fact, even if the amount of your bank balance climbs up to six figures or more, remember the great (potential) benefits of high leverage. Whatever your financial situation, before you invest, carefully weigh the advantages of owner-occupied financing.
But if you can’t or don’t want to go for this type of easy financing,take heart. You’ve still got many other low- or no-cash possibilities.