When we speak with clients and investors who are looking to get into real estate investing for the first time, there are typically two obstacles that stand in their way: One, they lack the funding to do their first deal. Two, they lack the knowledge to execute the deal. These obstacles are not mutually exclusive. Real estate investing is complicated and one bad deal can result in substantial financial losses.
Equipped with the right knowledge and appropriate funding, successful real estate investing can result in excellent cash flows while simultaneously building equity and net worth. Add in the tangibility of an asset, and it is truly unlike any other investment.
Here at Black Diamond Realty, we have decided to release a series of blog posts detailing the ins and outs of real estate investing. These posts will paint a detailed picture of how to get started in real estate investing and ways to lessen the exposure and financial risk. As always, we highly recommend you consult your financial advisor or accountant prior to beginning your real estate investing career.
Simply put, finding the funding to get a deal started is difficult, especially in the current financial climate. Prior to the financial collapse of 2007-2008, investors could more easily get banks to lend and provide leverage. Today’s banking climate is much more restrictive and thorough in the vetting of real estate opportunities. This should be seen as both a positive and a negative for new investors. Banks tightening their underwriting guidelines prevents novices from engaging in a bad deal, but it also makes it much more difficult for an investor getting started. This has forced investors to get creative. Below are some of the ways to get a deal funded.
Cash is king. The easiest way to get started in real estate investing is to have a sizable amount of cash on hand for the down payment on an investment property. This allows flexibility when it comes to analyzing deals, negotiating terms with a lender and managing risk. Those with substantial net worth oftentimes negotiate more favorable terms with the lender to increase leverage and the potential rate of return on the investment. Some institutional investors only engage in all-cash deals, which minimizes the potential returns but simultaneously minimizes risk for the investors.
In this lending environment, banks typically lend around 75 percent of the property’s value, requiring the buyer to come up with the remaining 25 percent down payment. Lenders will want to see all the pertinent information on the property’s financial performance to be able to accurately underwrite the deal. At the very least, as an investor, it is important to request the following information:
(We will show you how to analyze a deal using this information in an upcoming blog post.)
Mezzanine financing or a “mezz” is a loan that bridges the gap between the balance of the first mortgage and the purchase price. A “capital stack” with the inclusion of mezz financing is illustrated below:
In this example, the purchaser is coming to the table with $5,000 in equity (cash), the primary lender is issuing a note for $75,000, and the mezz lender is issuing a note for $20,000. The mezz lender understands that it is taking a subordinate position to the primary lender, and will justifiably charge a higher interest rate and shorter loan term for taking on the risk of a second position. However, if executed correctly, mezz financing can be an attractive option for investors that are short on equity.
Seller Carry-Back Note
Some sellers are anxious to unload a property. Maybe they’re in a tough financial situation or simply ready to liquidate and retire. If, after analyzing a property, you determine it’s a worthy investment, ask the seller if they are willing to “carry-back” a note on the property. A “carry-back” note is simply owner-financing on a portion of the purchase price. For example, say the lender is willing to pledge 75 percent towards the purchase price. As the buyer, you would approach the seller and ask him if he’s willing to finance the remaining 25 percent to get a deal done. This can be an attractive option for the seller for two reasons. One, he liquidates his investment and receives a substantial portion of his equity back as cash. Two, he will receive interest payments on the remaining 25 percent for a specified term, leading to a larger final payout. The drawback to this type of deal structure for the seller is that he is still financially tied to the property, and a default by the purchaser leads to a complicated legal situation. It should also be noted that many banks want an investor to have some “skin in the game”. They may require a collateral pledge and/or not permit you to 100 percent leverage an asset.
A real estate sponsor or syndicator is someone who finds a real estate deal, pools together multiple passive investors, and puts together an investment structure that rewards those investors profit from the real estate investment each year while managing the property. The syndicator makes money via their small equity stake and management of the property. This is a more sophisticated type of investing structure, but can be highly profitable if one has the connections to those with substantial net worth.
Friends and Family
This type of funding is least recommended. While we know of many investors who got their start using a loan from a friend or family member, this type of funding can permanently ruin relationships if the investment fails. Ensure that you have the proper legal loan documentation in place before accepting funds from friends and family.
While there are other ways to get your deal funded, these are sources we see most often here at Black Diamond Realty. In order to obtain financing for a real estate venture, one must have some cash on hand, an attractive balance sheet and solid credit. Once you’re financially ready, our Black Diamond Realty team will be able to assist you in finding the ideal property to get the ball rolling. In our next blog post, we will talk about how to analyze a deal. If you have questions you may contact the Black Diamond Realty team at (304) 413-4350.