While it is true that you need money if you expect to buy a real property, we have never said it has to be your money. The obvious alternative is O.P.M.: other peoples’ money. One of the easiest ways to find funding is to work with people whose job it is to find money for you. Since your first few deals should be short-term buy, fix and sell deals, you want short term financing.
An excellent place to start looking for short-term money is through a mortgage broker, who will know what will work and what won’t. They know what they can get on the market today. Some of them will have access to private funds that require no qualifying by the borrower. Equity in the house is the only concern.
These brokers can be a valuable asset. You will want to find a broker who would loan 60 – 70% of the appraised price regardless of your financial condition. The cost may be high, but it’s worth it. In fact, it’s not the cost of funding – it’s the availability that matters. Many times certain private money sources will charge points (one point = 1% of the loan amount), sometimes as high as 10 points. The interest may be higher, as well. But consider this: if you pay the price, get the deal and make $10,000 or $20,000, how badly will it hurt that you had to pay fees and high interest. On the other hand, were you to pass on the deal because the fees and interest offend you, how much is your profit then?
Mortgage brokers work on a commission. They do not get paid unless you get paid. If you use private money, get used to the idea of paying high points and consider it a cost of doing business. We can get a high interest loan and still make money. Remember, it’s not the cost of the money that matters. It’s the availability that counts.
Some of the older investors out there got their career going when mortgage rates were double digit – they had to borrow at 18% interest, with 50% loan-to-value ratio (LTV), 6 months interest pre- payment penalty, 7 year balloon payment and 10 points up front to the broker. They still made money on every deal they did.
The Nuts and Bolts
We have stated many times before, your first step is to get a great deal under contract. You have nothing to get money for until you have a contract. Lenders rarely commit to provide you funding until they know you are serious, as your greatest proof of that is a signed contract.
Then you approach several mortgage brokers to see who will get you the best funding package. If the house needs repairs, you may not get all the money at once. The lender may escrow some of it to pay out as needed for repairs, similar to a construction loan.
The funding will be customized to the need – and you can add your own creativity, as well. For example, suppose you offer $102,000 cash on a property with a value after repairs of $160,000. The house needs some work: at this time “as is” value of the house stands at $135,000. You also estimate repair costs at $10,000. We know we can get a loan for 70% of the fixed-up or after-repair value of the property.
To sum it all up, we need $102,000 to buy the house and $10,000 to repair it, for a total of $112,000. Now we run into a hurdle. We use the word, “hurdle,” here, although many people might be tempted to us the word, “problem,” instead. We don’t talk about problems, because a problem is better seen as an opportunity. The hurdle here, however, is that 70% of $160,000 is $112,000. Your accepted offer is for that amount, but there will still be closing costs. The closing costs alone will amount to at least a little over $3000.
The opportunity within this situation affords us the chance to find out how highly motivated this seller is. We also have a chance to use one of our favorite closing techniques. We find that giving a buyer a choice between two options, either one of which is positive for us, helps us get the deal closed. Whether they choose option A or option B, we get a deal. Here is how we might go about it:
“Frank, I’m going to give you $102,000 for this house. We can do it in one of two ways. Either you cover all the closing costs, in which case you get all cash for the entire $102,000 amount at closing, or I’ll give you $92,000 at closing and $10,000 within 60 days, but I’ll take care of all closing costs. Which way would you prefer to do it?”
In the latter case, you have the seller hold a second mortgage for 60 days as security on the $10,000 that we have not yet paid. With that option we get the rest of the cash ($95,000) through a loan from a mortgage broker. It might be institutional money, or it might be private money. Either way, the seller gets cash all at once, or most now and a fraction later.
Notice that the seller will make a little more money on the sale by carrying a small note for 60 days and earning interest. As we mentioned before, those who give terms expect more money in the long run.
The kind of money a good and competent mortgage broker will get for you is generally short term. In the world of finance, short term is one year or less. Since your project is a quick turn via buy, fix and sell, it suits your purposes perfectly. In the past several years, more and more money sources recognize the value of making loans on these kinds of projects. In their minds, the credit history and the employment income of the borrower become much less important than if they were entering into a long-term relationship with a 30-year mortgage. In this case, even if your cash position is weak and your credit does not have an A rating, you can still get funding.It may help you understand the process of getting loaned funding by seeing how lenders manage their risk exposure.
Risk Management for a Lender
All investing involves risk; otherwise, there would be no return. Lenders earn a return by investing cash to borrowers under specified terms. If there were no risk involved they could not earn anything from the money they lend. However, they will always do what they can to manage the risk by balancing the relationship between risk and reward. In other words, people who get a loan despite bad credit and without proving income should expect to pay a little more for the privilege. By doing so they increase the bank’s reward to offset the bank’s increased risk. Risk and reward must balance, and the lender manages risk with the following decision factors:
Rate of return (i.e., interest)
We have a commonly observed example of the role that term plays in risk management. The conventional conforming mortgages that people use to buy a home come with either a 15-year of a 30-year term. If you take a 15-year term, your interest rate will typically be 1⁄2 to 3⁄4 percent less than with the 30-year term. Why? The loan underwriters perceive much less risk when the time frame when the money is out the door becomes half as long. They are married to you for only 15 years, not 30. A lot could happen in the second 15 years.
Most investor loans are short term. This allows the lender to be more flexible with regards to your credit and financial strength. If you only have the lender’s money for 60 to 90 days, they can fore- see that the national economy is not likely to change drastically.
The essential thought here is that lenders mitigate their risk by limiting the amount of time that the money is out of their hands. Shorter term equates to less risk in the mind of the lender. The kind of loan that you would get for a buy and sale or a buy, fix and sale project would be short term. In return for restricting the length of time you get the money, the lender becomes willing to make money available to you despite your questionable credit or lack of high income. Even if your credit history is excellent and your annual income ranges in the mid to upper six figures, there will always be deals that might stretch your ability to borrow under a conventional mortgage. The fact that private lenders will cut you a break while keeping the terms short is a good thing.
Although mortgage loans from the FHA generally go for 97% of the purchase price of the home, the borrower must invariably purchase private mortgage insurance (PMI) to ensure that the amount of the mortgage above 80% will be paid if the loan goes into default and the property goes to a foreclosure auction. A lender expects that a house in a foreclosure action will sell for approximately 80% of its value. The insurance is required to make up the difference. The same principle applies to conforming conventional loans; these are loans that go into the secondary market where companies like Fannie Mae or Freddie Mac purchase them from the lender.
This insurance is not normally required on a non-conforming conventional loan. These are the category of loans that your investor-type loans fall into. This is also an area where your credit history enters in. Borrowers with excellent credit might still get a high percentage of the value of the property. With weaker credit, you might still get 70% or more. The lender wants to retain a 30% equity cushion with those weaker borrowers for safety’s sake.
The private loans that you can get for quick-turn deals lend against the collateral, rather than against your credit-worthiness. If you default on a loan made at 60% of the value of the collateral property, the lender knows he or she can simply foreclose, take the property and either get it fixed up to sell for full price or sell without repair for enough to get the investment capital back with profit.
An axiom commonly stated among investors of all kinds tells us “risk determines reward.” The reward in this case comes as a return on investment capital. The more that one’s investment capital is exposed to risk, the higher return on that capital one expects to receive.
Every decade or so people run after the great high-return investment: in 1980s people bought all the junk bonds they could find, and in the late 90s stocks in high-tech companies with no business plan grabbed all the attention. Timing was everything, of course – those who got out in time made a lot of money: the others lost a bundle.
A bank sets the rates on its various loans according to its own cost of funds but also the perception of risk involved with that kind of loan. Credit card rates are normally high because the bank has no collateral and the owner of the card can use it over and over again – which is as long a term as you can find. If you use a certificate of deposit as collateral, your interest rate will be only 2%: the bank bears no risk in the kind of loan – it places a hold on the money in the certificate: if you fail to pay the loan at the end of the term, they take the money out of the certificate.
To review, lenders adjust to the risk involved in a loan by working with the term of the loan, the amount of equity in the property as measured by the loan amount compared to the value of the property – the loan-to-value ratio, or LTVR.
When you look around for funding for your project – particularly a quick turn profit-making project, your friendly mortgage broker may well set you up with a hard money source. Maybe it does not offer us the most desirable way to get cash, but hard money works. As we pointed out earlier, it’s not the cost of the money that matters; it’s the availability of it. Hard money is available. It costs more,but it’s there. Hard money lenders will provide an amount ranging from 60% to 70% of the property’s after repair value: it’s not 97%, of course, but you don’t need to have a high credit score and high personal income to get it. You should find cheaper money if you can, but hard money works, too.
Private–or “hard money”–lenders are private individuals with surplus money available for investment. Some have deep pockets while some have limited resources. Based upon their own personal criteria, they lend this surplus money, primarily on a short-term basis, to real estate investors who use it for a variety of profitable purposes including buying and repairing distressed
What Hard Money Is
The term “hard money” could possible confuse you, so let’s look at it briefly. Hard money is not hard to find or even obtain, if you know where to look. In reality hard money is easy to find and to get as long as your deal justifies it. In this case, your deal on the property justifies your deal with the lender.
The word,” hard,” is a financial term. Financial people refer to money as either “hard”” or “soft.” Hard money requires strict terms and a clearly defined repayment schedule. Softer money has easier terms and a more flexible repayment schedule – much like a revolving credit line. With soft money, the borrower can service the debt based on available cash flow. In the case of private financing, the terms for hard money loans are very short and well defined with very low loan to value ratios (LTV’s), higher than market interest rates, and a lot of upfront points. The points are money paid up-front out of the loan proceeds back to the lender: one point amounts to 1% of the loan amount.
Terms with Hard Money
Hard money terms vary from lender to lender. They might also depend upon your level of experience and the length of your relationship with that lender. Obviously as one lender gets to know you better, the trust factor will affect the terms you get.
Loan to value ratios can range from 50% to 75% of the value of the house has when it has been fixed up and is ready for the market. This value is typically called after-repaired value (ARV) or future market value (FMV). This ratio will primarily depend on the nature of the current market: when house values appreciate rapidly, the lenders will accept a higher loan to value ratio; when prices drop the ratio drops, as well.
Interest rates go anywhere from 12-21%. The loan will also come with an up-front financing fee of anywhere from 1 to 10 points (percentage points of the loan balance).
The loan term is most often short – 6 month to a year, although sometimes the term can be for as long as five years. The question is, why would you want to keep the loan for so long if you are doing a quick buy-and-sell transaction? Also, who wants to accept 18% as a long-term interest rate?
Of course, these terms are set by the lender, and will change from deal to deal. You may get an interest only loan, other times the lender will amortize the loan into monthly installments. Some lenders will include money for the fix up and repairs, others don’t. Often the repair money will be placed in escrow, and you make draws on the escrow as the repairs are done, and in other cases, you get it up front. In some cases, closing costs are included in the loan, and in other cases, you pay them out of pocket. You simply need to look around for someone that you feel comfortable working with and who will give you the kind of terms you need.
Where Are These Lenders?
People who make money by lending money generally make themselves somewhat easy to find. It is a business for them and businesses tend to advertise themselves. A first action you can take is to do a web search for “hard money” or “investor lending.” It would be good to add the name of the community you are investing in to the search query: “hard money Albuquerque.”
You should market yourself, as well. The members of the real estate investors club in the community certainly know where to find money, and can advise you, even giving you personal referrals.
A few years ago we attended a church Christmas dinner in a large hall with round tables. We sat next to a neighbor couple that we knew well, and also at that table was another couple that we did not know. Our friends introduced us and a little later, the husband confided in me that the other couple were hard money lenders. They had sold a family business, becoming financially independent, and were increasing their wealth in that way.
Suddenly we had an excellent contact. Incidentally, we did not discuss real estate and lending at the Christmas dinner – somehow it did not seem entirely appropriate, but we did mention that we invest in real estate and would love to talk to them. The follow up is as important as the contact.
As you check local classified ads you are likely to find items indicating money to lend. You can easily imagine that mortgage brokers advertise themselves heavily: it is a highly competitive business and many who start cannot stay with it, so they have to make themselves known. Furthermore, the really good ones work with multiple sources of money, from the giant, nationwide mortgage companies such as Quicken or Wells Fargo down to one-man-band lenders, such as the couple from the Christmas dinner.
If possible, it would become extremely convenient for you to work with the same mortgage broker to obtain your own funding, both short-term for flips and long-term for income properties, as well as sending people from your buyers’ list to in order to get your houses sold to them quickly and easily.
In short, any effort you put into creating relationships with people who facilitate money flow to you or your buyers pays off handsomely in financial rewards down the road.