Whether buying a home or developing a large mixed-use commercial property, you’ll likely need some kind of financing. Financing is a great way to increase equity by leveraging other people’s money to acquire more property or take on a bigger project than you could on your own, through leverage. This article is US-focused unless otherwise noted.
- Note: basically, an agreement to repay borrowed money at a defined set of terms (interest rate, time period, etc.)
- Mortgage: you (the borrower) give a bank or lender a lien against real property as security to repay a note; in some cases, the lender actually holds title to the property until the note is repaid
- Interest Rate: the annual percent of borrowed money paid to the lender in exchange for using their funds (expressed annually, but usually paid monthly)
- Amortization: the time period over which a loan is repaid
- Down Payment: amount of funds paid by the borrower, usually expressed as a percent of the purchase price
Traditional bank financing is possible with at least 20% down payment; if you aren’t a US citizen or green card holder, chances are you’ll need a lot more than 20% (expect 50%+ down payment). This usually offers the best terms such as lower interest rates.
US citizens, green card holders, and a select few others such as TN visa holders with an EAD card can get an FHA loan to acquire a home with as little as 3.5% down payment. Some companies will even offer a credit on closing, further reducing the funds paid out of pocket by the borrower (lender closing credits usually comes with a higher interest rate on the loan). Some FHA loans such as 203k will also cover needed repairs to an existing structure.
US Military Veterans have options for 100%-financed mortgages, with no money down. Sometimes they can even borrow more than 100% to cover repairs to the property. Loans with less than 20% down payment require mortgage insurance that your lender can help with.
Amortization is usually 10-30 years, with 25 or 30 years most common. Your personal credit report, ability to pay, and debt burden are of primary importance when financing a personal residence or small rental property. Maximum debt to income ratios are usually 28-33%, depending on the type of mortgage.
Small Rental Properties
Residential rental properties are 1-4 units, and can be financed with the aforementioned financing instruments. That’s a great way to build equity while living in one unit and having tenants pay the mortgage. Each unit needs to be a residence to qualify for FHA insured financing; there is no hard and fast rule about mixed-use properties with retail or office units, but generally no more than 25% of floor space can be non-residential for FHA financing.
Whether a rental, a primary residence, or some other real estate project, once the structure has five or more units, it’s considered commercial in the eyes of lenders. With commercial, your personal financial situation is of secondary importance to the project itself. The lender wants to see a rental property produces enough cash flow to pay all operating expenses and the financing payments, or that the project has a clear exit strategy to cover all expenses and then some.
You’ll need to prove your ability to take on such a project and execute it successfully. If developing a property, you’ll need to show past projects you’ve completed. For a turn-key buy and hold, experience managing rentals is important. Lenders will typically only finance 60-70% of such a project, although higher loan to values are possible from non-bank lenders.
Some of the skills lenders look for:
- Construction Management
- Project Management
- Property Management
If you’re weak in one of these areas, seek the help of a partner. For example, you might need a Property Manager anyway, so find a strong and experienced Property Manager and engage in an agreement with them to show a bank.
Lenders want to know your exit strategy. Are you planning to sell a completed structure when completed? Or refinance? Careful not to take on too much debt that you will have difficulty refinancing once the project is done.
Residential or Commercial Project Financing Options
Whether you’re flipping a single-family home or developing a large mixed-use development, there are plenty of options available:
- Hard Money: short-term notes with high-interest rates usually 11-15%, and plenty of fees; usually 12 months or less, with interest-only payments
- Private Money: slightly less expensive than hard money, with fewer fees; you’ll need a network of family or industry colleagues to get someone to fund a deal with their own money
- Real Estate Funds: Investors that have pooled their money into a fund to finance projects
- Bank Financing / Mortgage: typically for financing at least $1million+, usually much higher; lower interest rates
International Financing Options
Other countries have similar options to the above, sometimes more, with vastly different terms. For example, bank financing for a primary residence in the US currently has an interest rate of around 3.8-5.5%, but in the Philippines, it’s typically around 18%.
In China, partnerships between foreign investors and local companies are common and can assist with financing and navigating local market nuances, although that has other risks.
Questions? Feel free to get in touch.