Chapter 16: Financing (Show Me The Money!)
The Newbie lament is “I don’t have any money.” Exactly! That’s why you’re starting a real estate investment program – so you never again have to lament that you have no money. Recall that I’ve already admonished you to invest as though you have no money even if you do. If you don’t write large checks, it’s hard to lose.
We’ve considered a few examples where you didn’t need money to start investing. Even though you probably don’t yet believe me, you will encounter numerous sellers that are just willing to sell you their house for what they owe against it. When you buy income property, frequently you can schedule the closing date such that you get money back as well as the title to the property. But because these concepts must still seem foreign to you at this moment, let’s start with a plain vanilla example.
You’ve found a property that you like. You see significant profit potential but you just don’t have the money for the down payment and closing costs. What do you do? There are two approaches: you can try to self-fund the down payment or you can borrow the down payment from a partner or lender. How would you go about self-funding if you have no money? Try a credit card. I know folks who borrow the down payment from their credit card and then try to flip the property to a new owner before the credit card bill comes due. Others find a buyer who then puts up the down payment before the escrow closes so that they do not need any of their own money. If it’s income property and the rents are collected on the first of the month, you could arrange to close on the 4th or 5th of the month in order to collect the majority of the rents through escrow. Then you’d use those rent pro-rations to help cover the required down payment. Note that since rent is paid in-advance, you as the buyer are entitled to a prorated share of the current month’s rent as received by, but not yet earned by, the current property owner. So far, you’ve not had to involve anyone else in your transaction.
I met a fellow years ago who had over 1100 credit cards at that time and was gaining still more cards by the day. He could raise $1 million for a down-payment by just taking cash advances on some of his cards. If he couldn’t close his escrow by the time the card payments were due, he transferred the balance to other cards that gave him another grace period before being due. I am certainly not advising that you do this. I only tell you this to show the lengths some folks will go to come up with creative financing.
The other major option is to team-up with a financial partner. Typically, one person does all the leg work and handles the day-to-day activities. The other person puts up all the cash required. Then they split the profits when the property is sold. Again, you’ll just have to take my word for it for now, but there are more people out there wanting to loan you money than you’ll have properties available to split with them. And after you’ve done a few of these splits, you’ll quickly conclude that you’re giving away half the profits unnecessarily.
Still another way to obtain the necessary funds is to go to a hard money lender. These are folks that will loan you cash at exorbitant interest rates. If you plan a short holding period, the interest rate doesn’t matter. Typically you’d be able to borrow enough money to buy and renovate a property if you purchase that property at the correct price. Remember our formula for determining how much you’d be willing to pay? You determine the fair market value of the property after it is fixed-up and is in good shape. You deduct 30% to 40% of that fair market price and then further deduct the repair costs. This final number is the most you would be willing to pay for the property. Typically, hard money lenders are willing to loan 60% to 65% of the final fair market value so the property itself completely supports the collateral required against which to make the loan. You not only are able to borrow the purchase price, you also borrow all the cash you need to repair the property. You accomplish all of this with absolutely none of your own money. It is that simple.
One of the ways I like to finance the purchase and renovation of properties is though my self-directed IRA. As you probably know, there is what is known as a traditional IRA created by the ERISA Act of 1974. Later, the Roth IRA concept was introduced in the early 1990s. With a traditional IRA, you get a tax deduction each year in which you contribute to the IRA. Then when you start taking money out of the traditional IRA, you pay ordinary income tax on your withdrawals. With the Roth IRA, you do not get a tax deduction for your contributions, but when you start to withdraw, all of the money you take out is tax-free (not just tax-deferred).
But remember what happened with the tax law changes in 1986? In addition to limiting deductions from real estate to just $25,000 over and above the real estate generated income, they dramatically reduced other tax benefits previously associated with real estate ownership. Up to that point in time, the government always “grand-fathered” the prior programs already in operation. This time, they reneged and made the new laws retroactive. With the stroke of a pen, the Federal Government wiped-out 30% of the then market value of investment real estate. As a result, I no can longer afford to trust the government. However, I’m also smart enough to realize that you have to play the game according to the rules, regardless of whether or not you like those rules or how often those rules are changed.
When the Roth IRA was first introduced, I couldn’t figure out why that would be of interest to anyone above, say, age 35. If a person had already accumulated a sizable Traditional IRA, it made no sense to liquidate the Traditional IRA, pay the tax and then put the remainder into a Roth IRA (defer – defer – defer). It might make sense to start a new Roth but it didn’t make sense to close-out a Traditional IRA and have to pay the tax to do so. My concern was that as soon as you transferred your Traditional IRA and paid the income taxes on that transfer, the Federal Government would again change the rules and the Roth IRA proceeds would no longer be tax free. That hasn’t happened of course – yet. Then the era of self-directed IRAs came into effect. Whether you have a Traditional or Roth IRA now, the chances are your IRA is at a stock brokerage or insurance company; possibly a bank. They call it “self-directed” but your only choices are the financial products offered by the stockbrokerage or the insurance company or the bank. Try asking Merrill Lynch to let you invest your IRA funds in your own real estate (not one of their REITs or RELPs) and see what happens. Fortunately, a few companies have been formed to allow individuals to really choose whatever investments they want as long as those investments are not specifically prohibited by the IRS. Enter direct real estate investments.
Today, instead of tolerating 5% to 10% returns in IRAs from your stockbrokers’ program, you can command much larger percentages from your own real estate investment program. Furthermore, you can now earn unlimited profits tax free (not a misprint). Even if you have a Traditional IRA, open a Roth IRA, too. Then use the Roth to make tax free money in real estate forever or until the Feds again change the law. Here is how it works. Say we’re buying an option on a property. Only a small dollar amount need be used from the Roth to purchase the option. Later when the property is sold for thousands of dollars of profit, the entire profit goes tax-free back into the Roth. Your out-of-pocket contribution to your Roth is limited but the profits that your Roth can earn are unlimited. The same concept works in the case where you get a deed for just taking over the existing financing. The profits go into your Roth tax free. You can buy tax liens over and over again with IRA funds. If you buy them in one of the states in which I work, you’ll earn 25% interest every 6 months on those Roth IRA funds. How’s that for supercharging your retirement funds?
The “standard” way most people use to borrow money for real estate is to simply go to a bank or savings & loan. I tend to resist this way because I’m tired of having to disclose my personal financial information and then pay all those garbage fees. However, consider using bank loans for long-term holdings. If you’re turning over your projects quickly, it’s foolish to pay the extra costs to a bank. If you plan to own a financed property for many years, a bank loan is probably the least expensive approach.
Have you ever considered how much you’d have to earn on your investment just to break even with your bank loan? If you borrow $100,000 from a bank for 30 years at a fixed interest rate of 6%, how much do you then have to earn on that $100,000 to just break even over the life of the loan? Using a financial calculator, we determine that the monthly payment on the $100,000 loan is $599.55 per month for 360 months which equals $215,838.19. That means you must repay $2.16 for every $1 you originally borrowed. The question is “What rate of interest must I earn on the $100,000 so that is becomes worth the $215,838.19 I have to repay the bank?” Again using the financial calculator, we determine that we only need to earn 2.6%. How can that be? How can we afford to pay 6% interest while only earning 2.6% interest and still break even? The secret is the difference between simple- and compound interest. When you borrow money on real estate, you pay what is called simple interest. You only pay interest on the remaining balance of the loan and that balance gets smaller every month. Meanwhile, you’ve invested your $100,000 lump sum that you just borrowed at 2.6% per year compounded so that you’re earning interest on interest on interest. In English, you borrow $100,000 against your real estate and then invest that $100,000 into a municipal bond paying 2.6% interest tax free and break even. That’s your risk. Anything you can earn over and above 2.6% is a profit for you that you don’t have to share with the bank. So you simply invest that $100,000 into your real estate program. It’s called making money with OPM – Other People’s Money or Financial leverage. You’re using someone else’s money to make still more money for yourself.
You buy a property for $100,000 and pay cash. The property appreciates 10% in value and is now worth $110,000. You make $10,000 or 10% on your investment. I buy the $100,000 property next door to you but I only invest $10,000 of my money and borrow the other $90,000 to purchase the $100,000 property. During the same time period, my property also appreciates 10% or $10,000. However in my case, I only have $10,000 invested so I make $10,000 profit on my $10,000 investment which is a 100% profit to me. Note that I don’t have to share one penny of that $10,000 profit with the lender from whom I got the $90,000 loan. So to really put OPM to work, I borrow the $100,000 and then go out and buy ten (10) $100,000 properties putting $10,000 down on each. This is another way to supercharge your real estate empire. Of course, you need to be sure that you will have a steady cash flow from the real estate investments from which to make the monthly loan payments during the holding period.
Earlier in this chapter, we discussed some reasons for using other peoples’ money to acquire real estate. We also discussed IRAs. One interesting way to obtain money for down-payments and operating/fix-up costs is to borrow the funds from another person’s IRA. In this example, your private lender arranges to loan you money from his self-directed IRA. Your repayment of that loan plus interest goes back into his IRA so he pays no current tax on the interest or profits generated. If you find yourself needing to borrow money from others in order to do more deals than you can directly fund with your own money, simply ask people if they’d like to earn a higher interest rate on their IRA money. As I write, my current offer is 8% to 10% interest if the lender wants monthly payments. If the lender will allow me to defer payment until the project is sold, I’ll pay up to 12% interest just so I don’t have to make monthly payments. Those rates are significantly higher than the 2% to 3% paid by U.S. Treasury bonds and the loans are secured by real property.
NOTE: Stay tuned for Part 17 - The Dreaded apaperwork