Financing real estate investments

By: Pat Curry: Bankrate.com
Although the stock market has rebounded recently, many investors still are looking for solid alternatives, and few things are more solid than real estate.

That's why some are looking to buy single-family homes, duplexes or condos, either to rent out or to renovate and resell.

"The stock market bubble a few years back led to a lot of insecurity in stock investing," says Mark Hancock, executive vice president and chief credit officer at Piedmont Bank in Atlanta. "When it's insecure, people fly to quality, and real estate has been quality in this decade."

But before you head out with a real estate agent to pick out your nest egg, there are a few things you should know about the financing. Buying real estate for investment is different from getting a mortgage for your own home.

"They need to understand that the interest rates they see all over the place don't apply to them," says David Finkel, co-author of "Making Big Money Investing in Real Estate." "People ask, 'Why wouldn't I get 6.5 percent?' It's because people who have nonowner occupied properties have a higher default rate."

It's true, Hancock says. If times get tight and a person has to choose between paying his own mortgage and making the monthly payment on his investment property, he's going to keep the roof over his own head every time. Hence, lenders consider investment property a riskier loan and will charge a higher interest rate or points than in a traditional mortgage.

Depending on how much you put down and your personal credit rating, expect to pay from 1.5 percent to 2.5 percent more than the going rate for owner-occupied mortgages, says Barbara Sama, regional branch operations manager for New York-based American Mortgage Network.

You should also be prepared to make a much larger down payment than was required for your own home. As a rule, banks will be looking for at least 20 percent.

That's why Finkel considers banks his third choice for financing.

Seller-financing tops the list
"My first source of financing always will be the seller. That will always be cheaper," he says. "The seller won't charge me points, PMI or loan origination fees. They'll be thrilled if I give them 6 or 7 percent on a first mortgage. That's lower than I get from the bank. They'll let me make interest-only payments, and I can always prepay the principal."

Finkel often offers sellers a balloon note to get their full payment within 60 months. At that point, he can refinance through traditional channels.

His second choice for financing is private lenders, people with cash who are losing money in the stock market or making 1 percent to 2 percent in certificates of deposit. An investment that returns 7 percent to 8 percent with a house as collateral is an attractive alternative.

Regardless of who's providing the financing, you'll need to put together a loan package that outlines the viability of the investment. An appraisal of the property will need to include not only information on comparable sales in the neighborhood but a rent survey of the area.

Finkel includes a photograph of the property, a rent survey for a quarter-mile radius, projected income and expenses, and a projected vacancy factor (how long the property could remain unrented) based on the area's vacancy rate. All the estimates are conservative, he says, because that's how bankers make their projections.

"That done, I'm going to show the banker it will pay for itself, plus something else," he says.

That's especially important if you're going to the traditional lending market because the requirements have tightened for banks that sell their mortgages, says Robert Galbraith, an attorney in Rochester, N.Y., with more than 15 years of experience in handling residential and commercial mortgages.

The more experience you have in managing rental property, the stronger your application for a traditional loan will be, Galbraith says. Your level of experience may determine how much of the rental income they include as your income for the loan.

They also want to see sufficient reserves to cover the payments if it's not rented for an extended period, Sama says. Or they may require rental-loss insurance.

"You need the skill and experience to manage (rental property) and the financial wherewithal to pay for them," Galbraith says. "People come in, buy a duplex, run it into the ground and wind up losing it in foreclosure."

Renovation projects
While the application process for rental property is fairly similar to that of an owner-occupied mortgage, the financing for renovating and reselling houses is completely different, Hancock says. Loans for rental property will be long-term notes, usually for 30 years. Rehab projects are short-term loans, generally no longer than a year, to cover the necessary time to complete the renovations and sell the property.

"It's a whole different ballgame," he says.

The down payments will vary by the deal and will depend, in large part, on how much work needs to be done on the house.

"If you're taking off a roof, I promise you your banker will look for a bigger down payment," Hancock says. "A lot of time on rehabs, when you start construction, the value of property goes down. If you demolish the house, you have a vacant lot. We have to cover the bank's position if you don't build."

The loans on rehabs will vary based on the prime rate, with fees in the 1 percent to 1.5 percent range "depending on the financial strength of the buyer," he notes.

The buyer's experience in residential renovations also figures prominently in the deal, he says. He looks carefully at the borrower's list of suppliers and subcontractors and flatly refuses to lend money to weekend remodelers.

"They have to have experience in this particular area," he says. "The collateral I have will be good collateral. It sounds silly, but I've had pilots with major airlines walk in and I've shown them the door. Just because they're rich doesn't mean they're a home builder."

Sama recommends that buyers consider two other options. You may qualify for a Fannie Mae long-term rehab program called the HomeStyle Loan. It allows buyers to roll rehab costs into their mortgage, putting the money into an escrow account that a contractor can draw from to perform the work.

"I love this program," she says. "The rates are a touch higher (than a regular mortgage), but not much."

The second option is for a buyer to use the equity in his own home for a credit line. That gives him maximum flexibility to use the funds as he sees fit.

"It's a great way to do it," she says. "Of course, you have to be able to withstand the extra debt. This is for the borrower with pretty good credit and income."