Chapter 7

Identifying Sources of Capital

In This Chapter

Moving beyond the no-money-down myth

Knowing what you need to get going in real estate

Locating cash when starting out and for experienced investors

For many people, the trouble with real estate investing is that they lack the access to cash for the down payment. The old adage that “it takes money to make money” is generally true in our experience. Most real estate investing books make one of two assumptions. Some assume that you have plenty of money and just need to figure out how to buy, add value to a property, and then sell. Of course, it would be great if that were true, but not everyone is flush with cash. The other common assumption is that you have no money and must resort to scouring the real estate market in search of sellers so desperate to sell that they or their lenders don’t require any down payment. We assume neither.

So how do you get started in real estate if you don’t want to own distressed properties in the worst neighborhoods, and you don’t have a six-figure balance in your bank account to pay top dollar in the best neighborhoods? You muster all the patience you can and embrace a long-term vision. You don’t have to be wealthy or have great savings to begin making attractive real estate investments. In this book, we present a wide range of investment options, so there’s something for virtually everyone’s budget and personal situation. Our method of building real estate wealth over time is to create investment returns that are sustainable and provide generous returns on your investments.

Calculating the Costs of Admission

At some point in your life, you’ve surely had the experience of wanting to do something and then realizing that you don’t have sufficient money to accomplish your goal. Perhaps it was as simple as lacking the pocket change to buy a chocolate bar as a child. Or maybe it happened on a vacation when you ran low on funds and tried to do business with a merchant who only took Visa when you only carried American Express. No matter — the world of real estate investing is no different. You can’t play if you can’t pay.

In the following sections, we discuss the realities of the cash requirements to be a successful real estate investor.

Forgetting the myth of no money down

The title of this chapter says it all: To invest in real estate, you need capital, and likewise you need a source from which to gather said capital. On late-night infomercials, at seminars, on audiotapes, and in some books, you may hear many self-appointed real estate experts tell you that you can invest in real estate with literally no money. And if that’s not enticing enough, you may hear that you can buy properties where the seller will put cash in your hands.

Have such no-money-down situations ever existed among the billions of completed real estate transactions in the history of the modern world? Why, yes they have. Realistically, can you find such opportunities among the best real estate investing options available to you? Why, no you can’t.

Think of the people you know who still haven’t found the perfect mate after decades of searching. Mr. and Ms. Perfect don’t exist. Ditto the ideal real estate investment. If you use our sensible criteria when seeking out properties that’ll be good real estate investments and then add the requirement that you can only make such investments with no money down, you’ll probably waste years searching to no avail. We’ve never made a no-money-down real estate investment because the best properties simply aren’t available on that basis.

Our experience is that the no-money-down properties we have seen aren’t properties we want to own. And if you receive cash out of escrow upon closing on a property, you’re either buying a severely distressed property that will soon require major cash infusions or you’ve overleveraged the property. If it sounds too good to be true, it is too good to be true! For a more complete discussion of no money down, please see Chapter 5.

Determining what you need to get started

Most of the time, real estate investors make a down payment and borrow the majority of the money needed to complete a purchase. That is the conventional way to purchase real estate investment properties and will be the most successful method for you in the long run (as it has been for us).

In order to qualify for the most attractive financing, lenders typically require that your down payment be at least 20 percent of the property’s purchase price. The best investment property loans sometimes require 25 to 30 percent down for the most favorable terms. Lenders tend to be more conservative and require larger down payments during periods of falling real estate prices such as most areas experienced in the late 2000s.

For most residential investment properties, such as single-family homes, attached housing such as condos and townhomes, and small apartment buildings of up to four units, you can get access to the best financing terms by making at least a 20 to 25 percent down payment. (Mortgages on non-owner-occupied property tend to be ¼ to ½ percent higher). You may be able to make smaller down payments (as low as 10 percent or less), but you’ll pay much higher interest rates and loan fees, including private mortgage insurance. (We cover the topic of financing in Chapter 8.)

You won’t find such wonderful financing options for larger apartment buildings (five or more units), commercial real estate, and raw land. Compared with residential properties of up to four units, such investment property generally requires more money down and/or higher interest rates and loan fees. See Chapter 8 for more details.

Determining how much cash you need to close on a purchase is largely a function of the negotiated purchase price, including all closing costs and fees. Suppose you’re looking to buy some modest residential housing for $100,000. For a 25 percent down payment you need $25,000, and adding in another 5 percent for closing costs brings you to $30,000. If you have your heart set on buying a property that costs three times as much ($300,000 sticker price), you need to triple these amounts to a total of about $90,000 for the best financing options.

Getting in the door with good credit

Don’t underestimate the importance of establishing good credit because the best returns on real estate rely upon the use of credit to obtain the leverage of using OPM (other people’s money). Lenders, property sellers, potential partners, and so on all prefer to deal with you if you’ve established a reputation for paying your bills. Good to great credit is essential. Why pay more for money when you can show the ability to handle it properly and be rewarded with a lower price?

Both of us began building our credit through the responsible use of credit cards in our 20s (paying monthly bills in full), and to this day, our high FICO scores have allowed us to borrow at favorable rates and terms and save tens of thousands of dollars per year in financing costs. And that difference will sometimes enable you to make a deal work that otherwise won’t. We cover the importance of good credit and ways to establish a reputation of responsible debt payments and how to remove unsightly blemishes on your credit history that may keep you from getting solid interest rates in Chapter 9.

Rounding Up the Required Cash by Saving

Most successful real estate investors that we know, including us, got started building their real estate investment portfolio the old-fashioned way — through saving money and then gradually buying properties over the years. Many people have difficulty saving money because they don’t know how to or are simply unwilling to limit their spending. Easy access to consumer debt (through credit cards and auto loans) creates huge obstacles to saving more and spending less.

Investing in real estate requires self-control, sacrifice, and discipline. Like most good things in life, you must be patient and plan ahead to be able to invest in real estate.

As young adults, some (but not most) people are good savers out of the gate. Those who save regularly are often folks who acquired sound financial habits from their parents. Other good savers have a high level of motivation to accomplish goals such as retiring young, starting a business, buying a home, having the flexibility to spend time with their kids, and so on. Achieving such goals is much harder (if not impossible) when you’re living paycheck-to-paycheck and worried about next month’s pile of bills.

If you’re not satisfied with how much of your monthly earnings you’re able to save, you have two options (and you can take advantage of both):

• Boost your income: To increase your take-home pay, working more may be a possibility, or you may be able to take a more lucrative career path. Our main advice on this topic is to keep your priorities in order. You shouldn’t put your personal health and relationships on the back burner for a workaholic schedule. We also believe in investing in your education. A solid education is the path to greater financial rewards and leads to all of the great goals we discuss here. Education is key not only for your chosen profession but also for real estate investing. Consider getting a real estate license or learn to be an appraiser or property manager — skills that not only help you with your property investing but that also may allow you to take on part-time work to supplement your income.
• Reduce your spending: For most people, this is the path to increased savings. We have both routinely generated cash flow for investments by living well beneath our means. Start by analyzing how much you expend on different areas (for instance, food, clothing, transportation, insurance, and entertainment) each month. After you’ve got the data, decide where and how you want to cut back. Would you rather eat out less or have a maid come less often? How about driving a less expensive (but not less safe) car versus taking lower cost vacations? Although the possibilities to reduce your spending are many, you and only you can decide which options you’re willing and able to implement. If you need more help with this vital financial topic, consult the latest edition of Eric’s bestseller Personal Finance For Dummies (John Wiley & Sons, Inc.).

Overcoming Down Payment Limitations

Most people, especially when they make their first real estate purchase, are strapped for cash. If you don’t have 20-plus percent of the purchase price, don’t panic and don’t get depressed — you can still own real estate. We’ve got some solutions — you can either change your approach, allowing you more time to save or lowering your entry fees, or you can seek other sources of funding. In the following sections, we lay out your options.

Changing your approach

Some ways you can alter your approach without having to find money elsewhere are as follows:

• Seek low-money-down loans with private mortgage insurance: Some lenders may offer you a mortgage even though you may be able to put down only 10 percent of the purchase price. These lenders will likely require you to purchase private mortgage insurance (PMI) for your loan. This insurance generally costs several hundred dollars per year and protects the lender if you default on your loan. (When you do have at least 20 percent or higher equity in the property, you can generally eliminate the PMI.)
• Delay your gratification: If you don’t want the cost and strain of extra fees and bad mortgage terms, postpone your purchase. Boost your savings rate. Examine your current spending habits and plan to build up a nest egg to use to invest in your first rental. Often real estate investors get started by actually buying a new home and simply keeping their old home as a rental. Robert did this when he and his wife bought a new single-family home in anticipation of the birth of their first child while retaining the condo they had purchased and lived in when they were first married.
• Think smaller: Consider lower-priced properties. Smaller properties and ones that need some major work can help keep down the purchase price and the required down payment. For example, a duplex where you live in one unit and rent out the other is also a cost-effective way to get started. We know many people who have used this entry strategy into rental property ownerships to achieve two goals: an owner-occupied place to live and a rental property that is convenient to manage.
• Turn to low entry cost options: For the ultimate in low entry costs while adding real estate to your investment allocation strategy, real estate investment trusts (REITs) are best. These stock exchange traded securities (which can also be bought through REIT-focused mutual funds and EFTs [exchange-traded funds]) can be bought into for several thousand dollars or less (you can invest even less in ETFs). REIT mutual funds can often be purchased for $1000 or less inside retirement accounts. (See Chapter 4 for more on investing in REITs.)

  Lease options represent another low cost (although more complicated) opportunity. With these, you begin by renting a property you may be interested in purchasing down the road. In the interim, a portion of your monthly rental payment goes toward the future purchase price. If you can find a seller willing to provide financing, you can keep your down payment to a minimum. Turn to Chapter 3 for more on lease options.

Tapping into other common cash sources

Saving money from your monthly earnings will probably be the foundation for your real estate investing program. However, you may have access to other financial resources for down payments. Before we jump into these, we offer a friendly little reminder: Monitor how much of your overall investment portfolio you place into real estate and how diversified and appropriate your holdings are given your overall goals. (Refer to Chapter 1.)

Dipping into your retirement savings

Some employers allow you to borrow against your retirement account balance, under the condition that you repay the loan within a set number of years. Subject to eligibility requirements, first-time homebuyers can make penalty-free withdrawals of up to $10,000 from IRA accounts. (Note: You still must pay regular income tax on the withdrawal, which can significantly reduce the cash available.)

Borrowing against home equity

Most real estate investors that we know began building their real estate portfolio after they bought their own home. Conservatively tapping into your home’s equity may be a good down payment source for your property investments.

You can generally obtain mortgage money at a lower interest rate on your home than you can on investment property. The smaller the risk to the lender, the lower its required return, and thus, the better rates for you as the borrower. Lenders view rental property as a higher risk proposition and for good reason: They know that when finances go downhill and the going gets really tough, people pay their home mortgage to avoid losing the roof over their heads before they pay debts on a rental property.

Unless your current mortgage was locked in at lower rates than are available today, we generally recommend refinancing the first trust deed loan and freeing up equity that way versus taking out a home equity loan or line of credit.

A variation on the borrowing-against-home-equity idea uses the keep-your-original-home-as-a-rental strategy. You build up significant equity in your owner-occupied home and then need or want a new home. Refinance the existing home (while you still live there, for the best owner-occupied rates) and then convert it into a rental. Take the tax-free proceeds from the refinance and use that as the down payment on your new owner-occupied home.

Before you go running out to borrow to the maximum against your home, be sure that you

• Can handle the larger payments: In the first edition of this book, we said,

  “We don’t recommend borrowing more than the value of your home, as you may be enticed to do with some of the loan programs that pitch borrowing upwards of 125 percent of the value of your home. We hear these programs being routinely touted as not only a way to free up equity and pay down consumer debt, but also encouraging people to borrow in excess of the current value of their home so they can invest in more real estate. This excessive leveraging is dangerous and could come back to haunt you!”

  We’re proud to have provided this sage advice well before the real estate crisis hit home in the late 2000s. Please see Chapter 1 for the big picture on personal financial considerations.

• Understand the tax ramifications of all your alternatives: Borrowing more against your home at what appears to be a slightly lower rate may end up costing you more after taxes if some of the borrowing isn’t tax deductible. Under current tax laws, interest paid on home mortgages (first and second homes) of up to $1 million is tax deductible. You may also deduct the interest on home equity loans of up to $100,000.

  Be careful to understand the tax-deductibility issue when you refinance a home mortgage and borrow more than you originally had outstanding on the prior loan. If any of the extra amount borrowed isn’t used to buy, build, or improve your primary or secondary residence, the deductibility of the interest on the excess amount borrowed is limited. Specifically, you may not deduct the interest on the extra amount borrowed that exceeds the $100,000 home equity limit.

• Fully comprehend the risks of losing your home to foreclosure: The more you borrow against your home, the greater the risk that you may lose the roof over your head to foreclosure should you not be able to make your mortgage payments. That’s exactly what happened to too many folks during the late-2000s real estate market decline. Although you need to use your cash for investing in and improving real estate, our advice always includes keeping some cash in a checking or money market rainy day account (for example for a new roof, painting, and so on) and not cutting things so close that you could lose it all.

Moving financial investments into property investments

As you gain more comfort and confidence as a real estate investor, you may want to redirect some of your dollars from other investments like stocks, bonds, mutual, and ETFs into property. If you do, be mindful of the following:

• Diversification: Real estate is one of the prime investments (the others being stocks and small business) for long-term appreciation potential. Be sure that you understand your portfolio’s overall asset allocation and risk when making changes. Please see Chapter 1 for more details.
• Tax issues: If you’ve held other investments for more than one year, you can take advantage of the low long-term capital gains tax rates if you now want to sell. The maximum federal tax rate for so-called long-term capital gains (investments sold for more than they were purchased for after more than 12 months) is now 20 percent. If your modified adjusted gross income exceeds $200,000 for single taxpayers or $250,000 for married taxpayers filing jointly, you have to pony up an extra 3.8 percent to help pay for the Affordable Care Act (also known as Obamacare). Investors in the two lowest federal income tax brackets of 10 and 15 percent enjoy a 0 percent long-term capital gains tax rate. Try to avoid selling appreciated investments within the first year of ownership. Be sure to check on the latest tax laws because there’s no guarantee these rates will continue in the future.

Separating investments from cash value life insurance

You may own a cash value life insurance policy — one that combines a life insurance death benefit with a savings type account in which some money accumulates and on which interest is paid. In addition to being a costly cash drain with its relatively high premiums, cash value life insurance investment returns tend to be mediocre to dismal.

You’re best off separating your life insurance purchases from your investing. If you need life insurance (because others are dependent on your income), buy a term life policy, which is pure, unadulterated life insurance. But don’t cancel your current cash value policies before replacing them with term if you do indeed need life insurance protection.

Robert had a $500,000 whole life policy that he was sold when he was much younger and more naive — and before he knew of Eric and his financial advice! He ultimately decided to cash out the policy, the proceeds from which he used to invest in an apartment deal. So rather than earning a meager few percent per year in a cash value life policy, Robert has since enjoyed double-digit annualized returns in a good real estate investment.

Capitalizing on advanced funding strategies

Sophisticated investors who develop an extensive real estate investment portfolio can employ more complicated strategies. In this section, we outline those along with our advice for how to make them work.

Leveraging existing real estate investments

Over time, if the initial properties you buy do what they’re supposed to do, they’ll appreciate in value. Thus, you may be able to take extra tax-free cash from your successful investments to make more purchases. This tactic is called hypothecating your real estate. As we discuss in the section “Borrowing against home equity” earlier in this chapter, many investors begin by employing this strategy with their owner-occupied home. They buy a home, it appreciates over the years, and then they tap that equity to fund other real estate purchases. By the same token, as you acquire more properties and they then appreciate, you can tap their equity for other purchases.

As you build a real estate empire, exercise care not to overextend yourself. The downside to continually pulling equity out of appreciated properties is that your fortunes may change. If the local real estate market or economy hit difficult times as happened in some areas in the late 2000s, you may find yourself with vacancies and falling rents. In the worst cases, excessively leveraged real estate investors have ended up losing some properties or even going bankrupt.

Bringing in partners or other investors

If smaller, lower-priced properties don’t satisfy your desires, you may be able to find a partner. For example, find a duplex and get a partner where you both initially occupy the property and make the payments, because duplexes are typically more cost-effective per unit than unattached properties.

Especially to accomplish larger deals, you may need or want to invest with a partner or other investors for the sake of diversification and risk reduction. Bringing in a partner can also provide additional financial resources for down payments and capital improvements as well as greater borrowing capability.

Partners can be either the best thing or the worst thing that ever happened to you. Although the additional financial resources are essential when you’re starting out in real estate, attempt to find partners with complementary skills to really take advantage of the potential of real estate investment partnerships.

For example, Robert has focused on establishing partnerships where each partner brings a needed skill to the table. One partnership consisted of a top local real estate broker who identified properties along with a partner who was a real estate lender and knew the ins and outs of lending. Robert’s company provided the property and asset management to reposition the property and create value. This team used their complementary skills to successfully purchase, renovate, and later resell a 48-unit apartment building while providing cash distributions to the partners during the holding period.

With the assistance of a good attorney, prepare a legal contract to specify (among other issues) what happens if a partner wants out. A buy/sell agreement makes a lot of sense because it outlines the terms and conditions in advance for how partnership assets can be redistributed. With life events (death, divorces, new marriages, lawsuits, and business failures) constantly changing partnerships, having a buy/sell agreement in place at the time the partnership is initially established prevents bickering down the road. Partnership disputes often enrich attorneys and accountants, rather than the partners or their intended beneficiaries.

Family members sometimes make good partners. Parents, grandparents, and perhaps even siblings may have some extra cash they want to loan or invest. But some families aren’t suited for partnering to buy and operate real estate. Disputes over management style, cash distributions versus reinvesting in the property, and how and when to sell are difficult in any partnership but particularly in families where there may be different goals based on the age or personal or professional desires of the family members. If you already don’t get along well at family gatherings, throw in a real estate partnership to really get the fireworks going! To minimize the potential problems, we strongly suggest documenting any real estate investment or lending relationship in writing just as diligently as you would with a non–family member. When working with family, you may be better off borrowing money with a promissory note, a repayment plan, and interest payments. Always document any agreements in writing. Check out Chapter 14 for more on partnerships.

Seeking seller financing

You may be able to find some properties that your research suggests offer potentially attractive investment returns and for which the seller may be willing to extend financing. Some property owners or developers may finance your purchase with as little as 10 percent or even less down. This method can be an extremely beneficial way to buy real estate when your cash position is limited. You can often set up the transaction as an installment sale so that the seller has the added benefit of stretching the reporting of income over a period of time and thus reducing her tax liability. You conserve your cash; the seller reduces her taxable income.

The drawback with seller-financed properties is that you can’t be as picky about what you get; a limited supply is available, and many properties offered with seller financing need work or haven’t yet sold for other reasons. Often these are reasons that only become apparent after you’re the owner!

Avoid properties that are distressed (have major problems and flaws). Don’t get sucked in by great financing alone; only consider purchasing a property with seller financing that you would be willing to buy conventionally. The seller financing should just be an extra benefit, not the only benefit! Please see Chapter 8 for details.

Taking on margin debt

In the section “Moving financial investments into property investments” earlier in this chapter, we cover selling some of your non–real estate investments in order to raise capital for property purchases. If you own stocks and other securities in a brokerage account, you can actually borrow funds against those investments. For example, if you’re the proud owner of $100,000 worth of so-called marginable securities in a brokerage account, you may be able to borrow up to $50,000 at attractive interest rates, typically a little lower than on fixed rate mortgages for a home.

In addition to providing you with a relatively low-cost source of funds, utilizing margin debt for real estate purchases also enables you to hold onto more securities, which can better diversify your real estate holdings.

Be careful when using margin debt. Stocks, bonds, and other investments can drop in value, sometimes sharply. When that happens as it did in 2008, you may face what is known as a margin call, where you have to increase the equity in your brokerage account, either by adding cash to it directly or by selling some of your securities. Having to sell during tough times can force you to liquidate shares at low prices. To add insult to injury, a significant stock market decline like the ones that occurred in 2008 or in the early 1990s, can coincide with a slumping real estate market.