Real estate is an outstanding way to build wealth. But, many would-be investors believe that because they don’t have a ton of money, they can’t buy real estate. While a ton of money always helps, it’s absolutely not necessary to become an investor. As such, I’ll use this article to explain how to use other people’s money to buy real estate.
Using other people’s money means not putting your own cash into a real estate deal. You can do this by borrowing money (debt) or selling a stake in a property (equity). Most investors buy real estate with hard money loans. But, a variety of other techniques exist to use other people’s money.
I’ll cover some effective techniques for using other people’s money in the rest of the article. Specifically, I’ll dive into these topics:
- What it Means to Use Other People’s Money to Buy Real Estate
- OPM Option 1: Hard Money Loans
- OPM Option 2: Business Partners and Investors
- OPM Option 2a: Crowdfunding
- OPM Option 3: Credit Card Financing
- OPM Option 4: Home Equity Loans
- OPM Option 5: HELOCs
- OPM Option 6: Business LOCs
- OPM Option 7: Government-backed Loans and House Hacking
- Leverage Risks
- Final Thoughts
What it Means to Use Other People’s Money to Buy Real Estate
Overview
Before discussing how to use other people’s money (OPM) to buy real estate, I need to first explain what I mean when I say to use other people’s money. In broad terms, when you buy real estate, you can take one of two paths. Option 1: you use your own cash. Option 2: you use other people’s money, paying them for the privilege of using that money.
Increased ROI
With the latter option, you add the expense of these payments to your budget. That is, if you have to pay people interest or a portion of your profits to use their money, you inherently collect less money in absolute dollars. But, you also have the ability to significantly increase your return on investment, or ROI.
For example, assume you can buy a rental property for $250,000, and it generates $15,000 in net operating income every year. If you paid all-cash for this property, that would translate to a 6% return on investment, or ROI ($15,000 / $250,000). But, what if you instead used a mortgage with a 20% down payment to purchase the property? That would mean you invested $50,000 in cash and a $200,000 loan to buy this property.
Now, your loan payments would cut into your cash flow. But, you’d also increase your ROI. Assuming a 3.5% interest rate and 30-year term on that $200,000 mortgage, you’d have annual debt payments of ~$10,900. As such, your annual cash flow would now be $4,100 ($15,000 NOI – $10,900 in debt service). This translates into an 8.2% ROI, 2.2% higher than an all-cash deal! ($4,100 / $50,000 down payment).
Increased Purchasing Power
And, using other people’s money has the additional benefit of expanding your purchasing power. For instance, assume you have $20,000 you’d like to invest. With a standard 80% loan-to-value mortgage, you could use these funds to purchase a $100,000 property. But, what if you could access another $30,000? Now, you’d have $50,000 – enough to purchase a $250,000 rental property.
Yes, this is a basic example. But, the important takeaway here is that using other people’s money can increase your purchasing power. From a deal analysis perspective, as long as you can generate larger returns on that $30,000 in other people’s money than you pay to use it, you benefit financially.
Ways to Structure Using Other People’s Money
I hinted at it above, but when you use other people’s money, you can structure the deals in one of two broad ways:
- Option 1, Equity: When you use equity financing, you sell an ownership interest in your property. For example, if an investor gives you $10,000 for a 20% stake in a deal, that investor now owns 20% of the associated property. And, as a result, this investor now receives 20% of the deal’s profits. But, on the opposite side of the coin, the investor will also take 20% of the deal’s potential losses. In this fashion, structuring a deal with equity means you give up more on a profitable deal, but you don’t have to pay out any guaranteed returns in a deal that results in a loss.
- Option 2, Debt: With debt financing, you borrow money without selling an ownership stake in the property. For example, if someone gave you $10,000 at 10% interest, you would have to pay that lender back the $10,000 plus $1,000 in interest (assuming a year-long deal). And, with debt, you need to make these payments, even if the deal collapses. As such, debt means you have more downside risk, as you need to make debt payments, regardless of deal performance. Conversely, on a profitable deal, you don’t have to share any of that profit beyond the debt payments.
In the rest of the article, I’ll outline a variety of options for using other people’s money to buy real estate – both with debt and equity. And, with each of these options, I’ll outline the strategy-specific advantages.
OPM Option 1: Hard Money Loans
Overview
Hard money exists as an alternative to traditional financing (i.e. securing a 30-year mortgage from a bank) – and an outstanding way to use other people’s money. Furthermore, hard doesn’t mean challenging. Rather, it means that these lenders solely concern themselves with the “hard” asset, that is, the property itself.
As stated, traditional 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 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. Traditional mortgages typically require 45 days or more to close . You can close a hard money loan in less than a week or two.
ARV Appraisals and Hard Money
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 traditional 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.
Major Benefits
- Speed: With traditional mortgages, you generally need 30 to 45 days to close a loan. Hard money loans typically close in one to two weeks. This provides you the ability to quickly seize deals as they arise.
- No Financial Health Requirements: Hard money loans also do not require the same “soft” assets that a traditional mortgage does. As long as you don’t have bankruptcies on your record, you can secure a hard money loan for a good deal. Credit scores, employment history, debt-to-income ratios and all the other personal financial metrics don’t matter, making hard money a great option for new investors.
- Property Condition Flexibility: Hard money loans also provide tremendous flexibility when it comes to property conditions. Compared to traditional mortgages, which impose strict property condition requirements, hard money lenders have very low standards for current conditions. Rather, they want to ensure solid conditions after the rehab. For investors looking to use other people’s money to flip houses, this is a critical characteristic of hard money.
OPM Option 2: Business Partners and Investors
Overview
This option represents one of the primary sources of other people’s money. That is, you can seek business partners or outside investors to help fund a real estate deal. 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.
Major Benefits
- Downside Protection: When you bring on business partners (more active involvement) and/or investors (passive, or “silent,” partners), you typically do so in an equity capacity. That is, you sell them a stake in your real estate deal in return for a cash investment. As discussed above, this means that, if a deal goes poorly, you don’t owe them more than their equity interest. So, if they invest $10,000 and get $9,000 due to a loss on the deal, you don’t have to pay them the additional $1,000.
- Potential to Partner with Experienced Investors: Additionally, many new investors partner with more experienced investors. Typically, these more experienced individuals want to invest without dealing with the day-to-day operations. As such, they can provide advice and guidance while still allowing you to learn from and execute the deal.
OPM Option 2a: Crowdfunding
Overview
According to the Securities and Exchange Commission, or SEC, crowdfunding is a method of: raising money via the Internet to fund a variety of projects. And, these investments can only be made through an online platform operated by an intermediary (a registered broker-dealer or funding portal). These intermediaries link potential investors to companies seeking crowdfunding investments.
In simple terms, rather than pitch single investors, crowdfunding allows you to list a real estate deal in an online portal to solicit numerous, smaller investments. In this fashion, crowdfunding somewhat democratizes finding investors, as anyone with a well-developed deal can post a deal on a crowdfunding platform.
Major Benefits
- Potential Investor Reach: When you pitch individual investors, you must depend on A) your relationships, and B) your time. That is, if you don’t know wealthy investors, you’ll struggle to raise money. And, even if you do know these potential investors, individual pitches take up a ton of time. With an online crowdfunding platform, you dramatically increase the reach of your potential investor pool.
- Streamlined Technology: Related to this reach, many crowdfunding platforms have streamlined software technology to 1) upload deal information, 2) sign contracts electronically, and 3) facilitate the transfer of funds from and to investors.
OPM Option 3: Credit Card Financing
Overview
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 strategy for using other people’s – the credit card company’s – money.
Major Benefits
- Easy: If you’ve had a credit card for an extended period and don’t regularly max out your revolving credit, you’ve likely been offered a credit card loan. As credit card companies already understand your credit score and borrowing habits, a reliable borrower can quickly apply for and receive a credit card loan.
- Don’t Give Up Ownership: And, when you use credit card financing, you use other people’s money (the credit card company’s) without giving up an ownership interest in the deal. Yes, you eventually have to pay back these loans – as with all real estate debt. But, as long as the projected returns on your deal exceed the interest on the credit card loan, you win.
OPM Option 4: Home Equity Loans
Overview
With a home equity loan (a.k.a. a second mortgage), you borrow against your home’s equity. More precisely, with a home equity loan, you receive a single lump sum, and you pay off that loan balance over time (similar to your initial mortgage). In this respect, home equity loans provide a level of predictability. You’ll lock in an interest rate for the duration, so you’ll make the same payments every month.
Major Benefits
- Low Interest: Due to the fact that a home equity loan uses your primary home as collateral, you can command far lower interest rates than you would in an unsecured loan (e.g. credit card or personal loans). Second mortgages typically have slightly higher rates than primary ones, but you’ll still find far better terms than with many other borrowing options.
- Longer Terms: And, related to this, a home equity loan allows you to take advantage of far longer terms, generally paralleling the 30-year terms available with primary mortgages. These longer terms translate into far lower monthly payments, meaning you can more effectively cash flow a rental property or other investment.
OPM Option 5: HELOCs
Overview
Home equity lines of credit, or HELOCs, are another great financing strategy for using other people’s money. 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.
Major Benefits
- Access to Revolving Credit: With a home equity loan, once you use the funds and pay off the debt, that’s it. With a HELOC, you can use the line of credit as long as you want. As soon as you pay off your outstanding balance, you have access to the entire credit limit again. For house flippers, this essentially provides you a revolving piggy bank of funds to use for well-executed deals.
OPM Option 6: Business LOCs
Overview
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 financing option.
Major Benefits
- Separate from Personal Credit Reports: If you have an established business, you can likely secure a business line of credit separate from your personal credit report. This potentially allows you to access funds even if you have lackluster credit personally.
OPM Option 7: Government-backed Loans and House Hacking
Overview
It seems like there’s a “hack” for everything these days, and housing is no different. With house hacking, you use part of your primary residence as an income-producing property. In a single-family home, especially if the homeowner is either single or a couple without kids, there’s likely an extra bedroom. While you can use this extra bedroom as storage or a guest room, you can also turn it into rental income.
With house hacking, this extra bedroom can be rented out to a tenant – either a friend or a screened applicant – to generate income. The ultimate goal is for this tenant’s monthly rent to cover your monthly mortgage. Once someone else starts covering your monthly mortgage payment on your primary residence, all the money that you would have paid to the bank can now be used to save or invest in other properties.
So how does this relate to using other people’s money?
With a conventional mortgage on an investment property, you generally need to make an at least 20% down payment. However, with government-backed mortgages for primary residences (e.g. VA or FHA loans), you can secure a home loan for 0% to 3.5% down. And, with the house hacking approach of turning this home into a partial investment property, this means you can access from 16.5% to 20% extra financing.
Major Benefits
- Ease of Access for New Investors: Both of these government-backed mortgages are designed for new homeowners. This means that, if you want to get into real estate investing, this approach lets you A) use other people’s money to buy real estate, and B) get your start as a real estate investor – without needing to secure an investment-related financing source.
Leverage Risks
While completely using other people’s money to buy real estate can dramatically increase your return on investment, it also poses some risks. As with all investments, the greater the reward in real estate, the greater the potential risk. And, while using other people’s money to buy a home increases your potential returns, it exposes you to market risk.
For people who remember the Great Recession, you likely have heard the phrase “underwater mortgage” before. Simply put, a borrower is underwater on a mortgage when he or she owes more than the home is worth. And, when this happens, you lose the ability to A) refinance the property, and B) recoup all of your outstanding loan balance when you sell.
In “normal” times, home values won’t completely collapse in the six months or so that it takes you to buy, rehab, and sell a flip. But, it’s worth understanding the potential risk if something like this does happen (as it did in 2008-09).
As discussed, hard money lenders issue loans based on a property’s ARV. So, assume that you secure one of these loans in January, when the ARV is $300,000. Due to some economic factors outside of your control, say that in July, when you’re ready to sell the property, it is now only worth $200,000 – unlikely, but possible.
At an exit price of $300,000 – the ARV – you could sell your property, pay off the hard money loan ($210,000 plus accrued interest) interest, and still net a nice little profit. But, at $200,000, you cannot A) sell the property and pay off the hard money loan, or B) refinance it into a permanent mortgage to convert the property into a rental. As a result, you’d now be stuck with a high-interest hard money loan without the ability to completely pay it off, either via other financing or a sale.
In this situation, you have two options, both of which are bad. Option 1: you default on the loan and enter the foreclosure process, crushing your credit score in the process and losing any cash you have in the deal. Option 2: you sell the property at a loss and pay off the remaining hard money loan balance with cash.
While this level of market volatility generally doesn’t exist in real estate (as it does in stocks), it’s still worth understanding the potential risks of entirely financing a deal with other people’s money.
Final Thoughts
If you don’t have a lot of money, you can still become a successful real estate investor. Actually, I would argue that the most successful investors don’t use their own money. Rather, experienced real estate investors understand the value of using other people’s money to buy real estate. Not only does it increase your potential returns, it allows you to preserve your own cash for other investment opportunities. And, while hard money loans represent the most effective ways to leverage other people’s money, as the above article illustrates, plenty of other options exist.
Learn how to make money flipping real estate with us by attending our next webinar.
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