Rental Property Part Three: The Power of Leverage
- Written by Allison Karrels
Before buying rental property, you need financing. There are several places to get it. I will describe what I did and what someone getting started might do.
For our second investment property I asked my bank for financing, but it would not lend for investment properties in Florida. I wasn’t sure where to go next so I turned to the internet and found Quicken Loans. They were more than happy to give me a 30 year fixed loan for 25% down.
With good credit it is not difficult to get financing for a rental property. But the financing company will charge a higher APR than if it was your primary residence. Generally 0.75 – 1.25% points higher. They also expect you to place a larger down payment, between 20-30% in total. This is because the bank considers an investment loan to be riskier than a loan for a primary residence.
A larger broker might want 30% but a smaller, local lender might accept 20%. On our third rental I used a local mortgage broker who was recommended by our real estate agent. While working with the local broker I told her my plan of purchasing a house every 2-3 years until I had enough cash flow to retire early. Perhaps this helped me get a better deal on a 30 year 5/1 ARM mortgage than I was getting at other companies.
In the end I had such a great experience with the local broker that I told her that for my next house I would be checking with her for rates first. Now I consider her part of my real estate team. Don’t be afraid to shop around to get the best interest rate and terms you can find.
An Offer They Can’t Refuse
Now that you’ve found the home and you have pre-approval for a loan, you are ready to make an offer on the house. The final sales price and the mortgage terms will be the last pieces of the puzzle, and the most important influence on your investment returns. The best way to improve your cash on cash return is to negotiate better deals and financing.
Don’t let the excitement of this final step ruin what you have spent time working towards. Saving a couple thousand off the purchase price or getting a 0.5% lower interest rate will save you significantly more over the length of the mortgage, so don’t be intimidated by negotiations.
Work with your real estate agent to make a solid offer. You can offer lower than you might on your personal home because now you are thinking in terms of monthly cash flow and how to maximize your profits not just how much you love the house.
If the real estate market is slow or the house has been on the market for a long time you can really start off low and see how willing the seller is to negotiate. Don’t forget that your real estate agent is working for you and if they understand that you will be buying more properties in the future they will be working hard to keep your business.
Get An Inspection
After you reach an agreement with the seller you can have your home inspector walk through the property with you and write up their report. Your purchase contract should have addendums for any major issues that come up during the inspection and then you will have to discuss with the seller who will pay for any repairs.
I like to ask questions when walking around with the inspector and to watch shows on HGTV like Holmes on Homes to get an idea of what is behind the drywall and common issues contractors find in homes. The more homes you look at the easier it gets to spot things like cracks in the foundation, pipe leaks, mold, and roof issues.
All of this helps you spot issues earlier in the process when looking at your next investment. This will also help you decide if you should move on to a better investment or offer a lower purchase price because you will have a larger renovation cost.
Once under contract, the paperwork fun begins. If you have never purchased a home this can be a daunting process. Banks require credit reports, bank statements, pay stubs, tax returns, proof of down payment, proof of reserves in case you need to pay the mortgage and can’t find a tenant, and so much more.
Right before the closing date they will pull your credit score again to make sure you have not opened any new lines of credit that would affect your loan approval. It is easy to get overwhelmed with the small details the bank wants to know about you while they try and determine if you are worth the risk.
A few years ago if you had a pulse you could get a mortgage with zero down but now the banks are actually doing their job of assessing loans and managing risk. I don’t mind jumping through a few hoops if it helps to avoid the next major global market meltdown.
Leveraging Other People’s Money
Now that we are discussing mortgages we can talk about the concept that sets real estate apart from other investments: leverage. Leverage is simply using other people’s money to make more money for you.
In the stock market you pay 100% of your money to control 100% of your investments. In real estate you pay 20% of your money to control 100% of a property. When you sell that property or generate monthly income on that property, you are making money against the full value of the investment. Your returns are multiplied.
To understand how leverage works, let’s look at the example of three people who have $100,000 to invest in real estate.
Person A bought a $100,000 rental property outright. After taxes, insurance and property management fees, the property generated a cash flow of $500 a month. At the end of the year Person A will have made $6,000, a 6% return on investment.
Person B invested $20,000 into five different rental properties. After mortgage payments, taxes, insurance and property management fees, the properties generated a cash flow of $200 a month per house. At the end of the year Person B will have made $12,000 – a 12% return on investment.
Not only is Person B making more money than Person A but she also controls $500,000 worth of real estate, compared to only $100,000, which means more opportunities for home value appreciation and lower risk since Person B is better diversified with five different renters.
The more homes you own, the more diversified you become. Owning one unoccupied rental home when super storm Sandy floods your house means losing money. With five rental homes and one unoccupied, the four others will provide an income buffer for you until you can get the home rented out. Also you can diversify by picking different neighborhoods, different sized homes or different renter types.
Person C invested all $100,000 into the Vanguard REIT (VNQ), the stock market was flat for this example year but they still earned 3.30% in dividends. At the end of the year Person C made $3,300, a 3.30% return on investment.
Person C had the lowest risk of all since she was diversified into hundreds of real estate holdings inside the REIT but also had no control over what the REIT invested in, what rent to charge, and who they rented to. The advantage Person C has is liquidity of her investment.
If she needs her money out now she simply sells her shares and in a few days the money is there. With real estate, selling a home is a much longer process which is why I would never tie up money in real estate investments that I might need in the next several years.
Real estate makes up 30% of my net worth and the remaining 70% comes from workplace 401ks, IRAs and savings. I treat real estate almost like having a long term bond allocation. My goal is consistent, monthly income and gradual home value appreciation.
Leverage is an awesome tool, but it can work against you. There could be times when real estate values decrease several years in a row and you could find that you owe more than the home is worth. You could find yourself “underwater” on your mortgage, especially if you invested with 0% or 5% down which was common prior to 2009.
If rent prices stays stable you can ride out the storm and wait for the housing market to start improving while still covering all your expenses. But if the market really crashes, you could find that rents go down as well which can eliminate your profit margin and cause additional downward spirals of the housing market.
The key is to find your personal balance between leverage and your tolerance for debt. Personally I don’t think I will ever feel comfortable with more than five mortgages at one time because I don’t want the stress of all that debt.
I know there are lots of investors out there who have hundreds of homes in their portfolios and are all highly leveraged. I balance my risk by saving up to buy the next property while at the same time adding extra payments to my highest interest mortgage until that is paid off.
This lets me find my personal balance between having several homes paid off and several mortgaged homes. It might not be the absolute best allocation of my money but it is one that gives me solid returns and lets me sleep well at night.
A real world example of how you can maximize leverage is how we purchased our third rental home. I purchased the house from an investor who was moving away from the area and did not want to manage his rentals from a distance.
The house was a great four bedroom home in good condition and in my favorite neighborhood. A young family was already renting and wanted to stay in the home. I knew this was going to be a great opportunity. No renovations, no repairs, just instant cash flow!
My issue was that I wasn’t planning on buying a rental home that year. I was saving up to buy one the following year and I didn’t have the cash on hand for the down payment and closing costs.
But what I did have was two other rental properties that were paid off. I refinanced one of my properties for $40,000, used that money for the 25% down payment and closing costs on the third home and then financed the remaining 75% to obtain the property.
There are not many other investments where you can do that. You can’t buy $100,000 worth of Apple stock agreeing to pay Apple a few hundred dollars a month for the next 30 years at today’s price.
You’re almost done! You have found a home to invest in and have navigated the financing needed to acquire your rental property. In my final article I will discuss how to have long term success and form your real estate team.
Rental Property Part Four: Forming A Real Estate Team
If you want to build up a portfolio of rental properties, forming a real estate team will make the process easier.
Are You Ready To Be A Landlord?
Real Estate Investing Part Two: The Math Behind Investing
The money and math behind investing in real estate. If you want to invest in real estate you will need to be able to do some basic math.