D. 3 Primary Financing Types for Real Estate and Their Cost!
There are three primary types of real estate financing for residential deals: Banks, Hard Money Lenders and Private Money Lenders. This video discusses the Pros and Cons of each one, who should use which method, and most important of all: how to calculate the cost of each financing type so that you don’t take on financing you can’t afford for residential real estate investing! (This is important because that can make or break your deal!) Watch this short-term real estate financing video!
Video Transcript Below
Hey, Daniil Kleyman here and this is going to be a pretty quick video in which we’re going to talk about three short-term financing methods for residential deals, and we’re going to break those financing methods down in terms of who they’re for, who they’re not for, what they cost, and when they should be used. This is a video I’ve been meaning to do for a while because I constantly get asked, especially by newer investors, how am I financing my deals, how can they get started in the real estate, where should they go and look for money to do deals. So if you are not sure where to go and get funding for your real estate deals, then this is definitely the video for you.
So I do these case studies for a number of reasons. One, I want to educate for free. There is absolutely nothing wrong with paid courses and paid information, but I am primarily in the business of selling software, so the better I can educate you about real estate and the more deals I can help you do, the more likely you are going to be using our software which is my primary focus and it’s something that we’re very proud of. Obviously if you don’t even have the free version of our software, which in itself is very powerful, it’s called Rehab Valuator Lite, I’m going to give you a link at the end of this video where you can go and set up a free account, and if you already have our free software, I’m going to show you a couple of pretty cool benefits of using the premium membership as well. The promise I will make you is that every single one of my case studies is going to have a ton of useful content. You should be ready to take some notes because I am going to, in every one of these case studies, and I’m recording a bunch of them, I’m going to give you a lot of actionable information.
These are not meant to be sales pitches. I may be showing you some of my fancy software tricks and some of the powerful things that our software can do, but the primary goal of these case studies is to educate you, because the better educated you are, the more likely you are to succeed.
So the agenda for this case study. We’re going to break down the three main financing types, and we’re primarily talking about, for the purpose of this case study, we’re talking about short-term deals, buy, rehab, flip, for example. That’s really the focus of this case study, is on short-term deals. This is primarily geared towards people looking to buy and rehab houses, and after we talk about those three main financing types, I’m going to show you how to calculate the cost of each financing method, and this is really important because this will prevent you, by doing what I show you today, this will prevent you from making costly mistakes and taking on financing that you shouldn’t or cannot afford, and that’s how a lot of people get in trouble in this business is because they get into financing arrangements that they shouldn’t get into. They can’t afford to carry the debt.
So primary types of financing for residential investment real estate, and again, we’re talking about short-term deals. Buy, fix up, sell, buy, fix up maybe refinance and then hold. So number one, and this is one you’re probably very much familiar with is bank financing, and I have a picture of this bank vault with a guard here, exactly because conventional mortgages, Fannie, Freddie. Most bank financing in general is very, very, very hard for investors to get these days. But the bank financing I break down into two separate parts.
Number one you have the conventional lenders, Fannie or Freddie. So these are the typical 30 year mortgages that people usually get primarily for their homes, right? For investment properties, Fannie and Freddie limit you to 10 mortgage properties. So if you have more than 10 mortgage properties, you have no chance of getting these loans at all. They have very strict financing guidelines, and if you’re looking to buy and rehab investment properties, conventional lenders won’t lend you at all, right? So the limit of 10 mortgage properties says if you want to buy and hold a ready to go investment property, if you’re looking to buy and rehab properties, then conventional financing is out of the question, period. But just for the record, right? Even if you were to be able to get conventional financing, you need, it’s an ungodly amount of paperwork. You need to have great credit, you must have 20 to 30% down, do a background check, drug test, you got to sign over your first-born child, pledge allegiance to them. You get the idea. It’s very hard to qualify these days, especially for investors, and it is so painful to deal with conventional underwriters that I stopped five years ago and have never looked back. Again, if you’re looking to buy properties in need of rehab, investment properties, then conventional financing is out of the question, period.
So don’t go to your Wells Fargo, or Chase, or anybody else looking for loans. They will not lend to you, but with then bank financing there is a second category of lenders who actually are easier and more pleasant to deal with. They’re called portfolio lenders. These are your local community banks and credit unions. These are lenders, these are basically small banks in your home town. They are mandated to lend within their region, they’re much friendlier towards investors. They have construction loans for investors. Typically these banks are considered commercial banks and you can get credit lines from them, you can get construction loans. You can refinance your investment properties into medium-term financing. I do a lot of business with such banks within my hometown because there the underwriting process is much simpler.
Now, there are less restrictions. The whole idea is these are called portfolio lenders because they keep these loans in-house. Instead of selling the loans to the secondary market and having to have these loans be within the restrictions of Fannie and Freddie, these banks they issue you a loan and then they actually keep that loan in their books, and because they’re keeping that loan on their books, they can create their own lending criteria. So there are far less restrictions, they’re friendlier towards investors, they understand the business much better. You’ve got much less bureaucracy to deal with there. Usually if your loan is under a certain amount, you’re dealing with a loan officer who sometimes can just make credit underwriting decisions himself on your loans. The whole process is just much simpler, buy you still must qualify based on income, credit, global cashflow, and have a good balance sheet. So there are less restrictions, but they will still check your employment, they’ll still make sure that your income qualifies you, that you have decent credit, that you don’t have a portfolio of other bad debt or risky debt, et cetera, et cetera.
So again, these are mostly commercial lenders, which means these loans instead of being a 30 year fixed rate loan, they’re going to carry short-term calls, three, five, 10 years or resets. So they will give you a loan. Let’s say you want to buy a rental property, they’ll lend you money, but instead of fixing that rate for 30 years, you’re either going to have a call in three, five, or 10 years typically, or you’ll have an arm, where after five years your loan will start resetting based in market interest rates. So that’s something to keep in mind. By dealing with these banks you’re avoiding a lot of headaches of dealing with conventional lenders, but, and you can get long-term financing for your real estate or medium-term to long-term financing, but you’re taking on some interest rate risks down the road, five, seven, 10 years out.
Then you’ve got the hard money lenders. So if you’re looking to buy, rehab and sell a house for example, hard money lenders will typically gladly finance you, and they’re even easier to deal with than local community banks because hard money lenders typically don’t care as much about your credit, about your income, they care about the deal itself. They’re asset-based lenders. That’s what’s called an asset-based lender, but hard money is very expensive and it’s only short-term money. Typically you can only borrow money for 12 months or less, and if you carry that loan longer than 12 months, there are usually severe penalties, and when I say money is expensive, you’re typically paying four to eight points upfront. Points means percent of the total loan. So hard money lenders are in the business of turning their money and turning loans over quickly. So they want to make you a loan and get that money back as soon as possible. So they’re charging you four, five, six points or percent of your loan upfront no matter how long your loan takes. Sometimes with certain hard money lenders, you can pay those points in the backend, which means instead of giving the money upfront, they’re going to say, “When you pay us back the loan, we’re going to tack on this four, six, eight points on the final amount that you owe us to pay us back.”
Then on top of that you’re going to have a pretty high interest rate. 12 to 16% typically is what that interest rate runs. Again, expensive money and you have to have an assured exit strategy and a very solid deal before taking on hard money. That’s really the best advice I can give you. If you can’t get out of that loan in the time agreed, you’re interest rate is going to jump up even higher because there’s going to be a penalty, or the lender will foreclose on you. So it’s very easy to get in trouble if you don’t know what you’re doing when dealing with hard money lenders.
Then the third type of short-term financing for investors is private money lenders. Now, private money lenders are basically you’re borrowing money from individuals, from other people just like you, and I have a picture of a guy mowing his lawn because that could be your private lender. That could be your neighbor, that that could be the guy mowing his lawn in a Sunday afternoon, and he’s got some idle cash sitting around. He has a full-time job, he doesn’t know how to invest in real estate but he’s not happy with the returns that he’s getting in the stock market, and you have a few conversations with him. As it turns out, he wants to put his money into real estate but he doesn’t know how or he doesn’t have the time for it, and maybe he partners up with you and lends you money on your next deal, right? So these are regular individuals, these are friends that you meet through networking, charity, church, synagogue, from work, your dentist, your accountant. These are not professional lenders. Hard money lenders are professional lenders. If you Google hard money lenders Denver, hard money lenders Austin, you’re going to see a ton of listings in Google pop up because these are professional lenders who advertise themselves. You will never see true private money lenders advertise themselves online. You have to build those relationships, you have to find those lenders.
So again, private money is when you borrow money from other individuals. There are fewer regulations, documentation requirements are really up to the lender, usually little, and the terms, the best thing about private lending is the terms can be completely flexible. If you’re looking to borrow a 100% of your purchase plus cost of renovations, it’s impossible to do it with the community banks, it’s very hard these days to do it with hard money lenders, but with private lenders you could structure a deal that way. So for example, and I’m going to show you how to calculate the cost of each one of these scenarios. Let’s say you want to buy, fix up and flip a house, and let’s assume these numbers. You’re going to purchase the property for $100,000. It’s going to cost you $40,000 you’re projecting is going to be your rehab budget. You project that it’s going to take you three months to renovate and then another three months to put the house in the market and sell it.
So your first option is going to be a local community bank or credit union, and you can go there and get a construction loan, a short-term construction loan assuming you can qualify based in your income, credit, and assets. Or find a credit partner to partner up with you in a deal and go on a mortgage if you can’t qualify yourself. Local community banks will typically charge you between one and two points upfront, one and two percent of the loan amount, and then these days interest rates will range between four and six percent. They’re typically about one point over what conventional lenders charge. Your loan will be six to 12 months. It’ll be interest only and then if you’re rehabbing and flipping, you’re going to pay the property off, you’re going to sell the house and you’re going to pay your lender off. If you’re rehabbing and then you want to hold the property as a rental, then a lot of these local banks will give you what’s called a mini-perm, which is basically interest only loan while you’re renovating and then once you get a lease in place, the loan will convert to a 20 year amortizing loan, and it’ll typically have a three, five, or a 10 year call.
So let me show you a quick way to calculate your cost of money so that you can see exactly what this financing method will cost you. Okay, so in the Rehab Valuator software, this is going to be your typical input screen for a deal, and if you don’t have the free version of the software, I’m going to give you a link at the end of this video where you can go and set up your account and you’ll be able to do everything I’m about to show you. So you’re going to see your assumption panel, which is going to have purchase assumptions, rehab budget, and then short-term financing assumptions, and next to each section there is a video tutorial that pops out, that walks you through every step of the way and you can also click these little question marks. So let’s go through this really quick. Our purchase price is a $100,000 for this deal. We’re going to enter some lump sum closing costs. Now, you can enter detailed closing costs as well if you want, but for now we’ll just enter lump sum closing and holding costs, and then our rehab budget again, with the premium version you can enter a detailed budget like this, but with the lite version you can just enter a lump sum budget here. It’s going to take us three months to renovate, and then under the financing you’re going to select instead of all cash, financing.
So our typical community banks and credit unions will usually finance no more than 80 or 85% of the total cost of the project. So here under drop-down you will select cost from this drop-down box. So they will finance usually 80 to 85% of acquisition plus renovation. So we’ll assume 80. We’ll assume one origination point, and then another one point for closing costs. So again, a point is 1% of the total loan amount. That’s what the bank is going to charge you as their fee, right? And then some additional closing costs for the loan to close. Points and closing cost with local banks are usually paid upfront, and we’re going to assume a 4.5% interest rate. Here this gives you the option whether you have to make interest payments during the loan or they accrue for the end of the loan.
So look, over here we’re going to select three months to sell, we’re assuming a $200,000 value after the property is renovated, and so you can immediately see what your projected profit will be, what you total loan amount will be, how much cash you will have to come up with, and whether you have the free version or the primum you can click on view reports and generate this project summary, and immediately you’re going to see exactly how this deal is going to work. Purchase price, rehab costs, holding and closing costs, financing costs, total project cost basis, how much you’ll finance, how much cash you have to come up with, projected result price, projected cost of sale, this is what you’re going to earn, and in here, your breakdown the financing costs to the penny. This is your total cost of financing for this method. $4,760 assuming your assumptions are correct.
So let’s go back to our slides, and you can see that I’ve already entered this. For the community bank our cost of money will be $4,760. You have to come up with $35,760 in cash, and this will be your projected profit on this deal. So now let’s look at hard money. Hard money lender is your second option, and if the deal is strong, you don’t really need to qualify based on your own credit, income, or assets. They may still look at it to make sure you’re not going through bankruptcy or going through any special situation like a divorce, but typically hard money lenders they’re asset-based lenders they care about lending on a strong deal. So again as I said, the money is pretty expensive and you must be able to rehab and then sell or refinance the house under the terms specified, six to 12 months or you may risk losing the house to the lender or paying much higher interest rates. So typically what I see with hard money lenders is they charge between four to six points, 12 to 18% interest rate, and six to 12 months total time to repay the loan.
So let’s plug those numbers in really quick and see how that stacks up. So here we’re going to click return to inputs and let’s update these numbers. Hard money lenders will typically do about the same. They’ll lend at most 80% of your total cost. Sometimes they’ll lend based on just acquisition and they won’t finance your rehab, but let’s be optimistic and also assume that they will lend 80% of your total cost, purchase plus rehab. We’re going to assume five points, another point for closing costs. We’re going to assume that they’re going to roll these points and interest into the backend of the loan, and we’re going to assume a 14% interest rate. So money is more expensive, but you don’t have to come out of pocket with as much money because we’re going to roll in the closing costs and the interest into the backend of the loan so when you sell the house, that’s when you pay that money off. So let’s quickly go to our summary and see how this financing method stacks up. Well, you can see, you still have to come up with $31,000 in cash. Your cost of financing just went up significantly and your projected flip profit went down. So let’s enter those numbers really quick.
Our cost of money now is 14,792, cash invested into the deal is 31,000, and our projected flip profit is, you can see here 28,207. So you can see how much more expensive hard money would be on the same identical deal. Your cost of money just went up by $10,000 and your projected profit went down by $10,000, and you have to come up with just a little bit less cash. So let’s talk about private money next. So this is your third option, get a private money loan. A private money loan is simply a loan made by one individual to another, usually backed by real estate. The terms between you and your private lender are completely up to you. The typical private money transaction, you the borrower receive a loan for X amount of dollars from a private lender in exchange for a monthly interest rate payment based on X percent interest, a deed of trust or a mortgage on the property, depending on your state, and a promissory note for the amount of the loan promising to repay the loan after agreed term, and the terms are completely up to you. Whatever interest rate, number of points you can negotiate. Normally I would recommend don’t pay any points at all. If you’re a good and you have a good relationship, you should be able to get a 100% of your deal financed at a fairly low interest rate with private money lenders.
So let’s look at a typical case study of a private money scenario for the same deal. So again, if we click return to inputs, in an ideal private money scenario, your lender is financing a 100% of your deal. Again, it depends on your negotiation skills and depends what kind of rapport and credibility you’ve built with your lender, and how much they trust you, but the goal with private money should be 100% financing, zero origination points, no real closing costs to speak of, and then a reasonable interest rate like 8%, and I typically like to actually make interest rates during my loan.
So let’s go back to our summary and see what a massive difference this makes. So I’ve made a couple of key assumptions here again. I’ve made the assumption that even though we’re getting a 100% financing, we’re going to come out of pocket with some closing and holding costs for this deal. The software lets you roll in those costs into the loan as well. So let’s go ahead and assume that, and now take a look at these numbers. My cost of financing just went down to 5,697. The only cash invested into the deal is my interest rate payments to the lender, 5,696, and my projected profit all of a sudden is 37,303. So how did these numbers stack up? Well you can see the total results here, right? But let’s analyze this in a little bit more detail, right?
Community bank, your cost of money is going to be the lowest because you’re paying a low interest rate, but you’re going to come up with high dollar out of pocket because banks are conservative. Now, in absolute dollar amount, out of these three options you’re going to have the highest potential profit, but it’s not going to be your best return on investment because your return on investment is so high, right? You would take basically $38,000 and divide it by 35,000. So you’re still making a very good return on your money, but because you’ve put so much money, so much cash into the deal, your ROI goes down.
Hard money, as I said, very expensive. This is going to be by far your highest cost of money. You still have to come up with a lot of money out of pocket and this will give you your lowest projected profit, and with private money here is what happens. You’re going to end up paying a higher interest rate. So 8%, so your overall cost of money is a little bit higher than with a community bank, but you’re only putting $5,700 cash into the deal, and you could probably negotiate with the private lender to defer the interest payments till the end of the loan. So your projected profit, even though in absolutely dollar terms it’s less, a little bit less than community bank, it’s by far your highest return on investment because you’ve only invested $5,700 cash into the deal, and on that $5,700 in cash, you’ve earned $37,000. So private money here is by far your best option. It’s the highest long … Far in the way your highest return on investment is the private money option. And play around with the software. You can plug in all sorts of scenarios and play around with the software to determine which option is going to work best based on the scenarios that are given to you by the different lenders you’re dealing with.
So in the next video I’m going to show you how to structure your private money deals and get lenders to chase you. This is going to be a phenomenal video. If you watch just one of my videos, this is going to be the video to watch, and I’m going to show a lot of good numerical examples and case studies. Here’s what I want you to do next. Please click, if you feel this information is going to be helpful for your friends and colleagues, please click and share and share this video on social media with your friends. Leave me your comments, questions, thoughts below. I always love hearing from you, and if you have any suggestions on what to record additional case studies on, let me know. I’d love to record more of these. If you don’t have the free version of the software, everything I just showed you, you can do with the free software. So if you don’t have that software, go to RehabValuator.com and set up your free account, and of course if you’re already an account holder you can upgrade to Rehab Valuator Premium and one of the thing that you can do with the premium software is create really good persuasive deal funding proposals for your hard money and private money lenders, and even banks, and I’m going to demonstrate that in the next video. All right, that’s it. Thank you very much for watching.