To own free and clear or to use leverage as a tool to get more for your money is the age old debate amongst real estate investors.

One size definitely does not fit all.

I recently had to walk away from what would have been a great deal on a 4 unit property with residential financing, but, since the loan I intended to use fell apart because of the way the property was titled, the next best option lowered the cash flow on the deal so much that it no longer made sense to purchase.

Real estate is the only investment in the entire world that allows the average person to get a term like 30 year fixed rate interest at rates just over what the banks get.

Try getting terms like that on the purchase of some stock or a business.

This is why it’s so important to understand, and take advantage, of the most desirable financing options first, and once those are exhausted, move into more expensive financing.

Most people don’t take the time to understand how financing and underwriting work, and as a result lose out on the best options and wind up paying way too much for their loan, and sometimes even bankrupting their business due to poor loan structure or terms.

Here are some of the pros and cons of some of the best option out there for financing cash flowing real estate deals.

CASH

When people argue whether you should use debt to purchase property or pay cash, what they are really arguing is whether mitigating risk or capitalizing on every possible dollar is more important.

Cash is the least risky way to invest since the lender can never foreclose on the property since there is no lender.

It also provides the highest monthly cashflow on the property you purchase since there are no loan payments.

What you give up is the ability to purchase more assets because you are using 100% cash rather than 20% cash along with a loan for the other 80%, which would give you the ability to buy more property with your remaining dollars.

If risk were not a factor and there was a plethora of great deals, then cash would be the last option you would want to use.  In that case, you would take as much leverage as possible and keep buying all the great deals you can.

On the flip side, in a risky or unstable market where great deals are few and far between, maximizing the cash flow on the few great deals that you do get your hands on might be a better option than leveraging your cash to buy more (worse) deals.

Buying lots of crappy deals because someone is willing to give you a loan doesn’t make you a good investor.

PRIVATE MONEY and HARD MONEY

There are a lot of individuals that have made several hundred thousand dollars over the years by working a job and saving and investing in mutual funds.

Although they have accumulated a nice monetary nest egg, as a byproduct of focusing on their specific job, many have not accumulated the knowledge and experience to invest for themselves in real estate.

Therefore many of these people are willing to turn to more experienced real estate investors to deploy their nest egg at a rate of return higher than what they typically would receive in their mutual funds.

Typical rates on private money leverage can be anywhere from 8-12% which is double or triple the rate that a traditional bank might charge.

For this reason, these loans are often used for short term purposes, primarily in order to rehab a property in order to rent or sell.

A higher interest rate for a short period of time often makes sense if an investor is building value in a property at a much faster pace by making improvements to it.

In this situation time becomes one of the most important factors.

It’s very difficult to out earn the cost of the interest on a private loan passively (ie through a rental property).  These loans are much better utilized by active investors who are, on a daily basis, taking action to force appreciation.

This is why the risk level increases substantially over a cash purchase.  If anything slows down the pace of the forced appreciation (like permit, contractor, or market problems) the high interest can become unwieldy.

BANK LEVERAGE

This is the least costly form of financing a real estate investor can get and often the hardest to obtain.

The two main categories of bank leverage that most real estate investors often have the option to use are residential and commercial.

What’s the difference?

Residential

-Typically 30 year payback term

-Currently 4.5-5.5% Interest rate

-Qualification is based on the personal income and assets of the borrower

Commercial

-Typically 5-10 year payback term with payments structured as if it’s a 20-25 year loan

-Currently 5-7.5% interest rate

-Qualification is based on the asset and somewhat on the borrowers experience, but not on their personal income

As you can see, the residential loan typically has the more favorable terms, but can only be used on properties up to 4 units.  On properties 5 units or more, a commercial loan must be used.

Banks also don’t typically like to fund projects that need a lot of rehab work or are vacant, which is why many investors use the shorter term private money loans on properties needing a lot of work and then refinance into a longer term (and lower interest) bank loan after the rehab is complete.

Bank loans, especially residential loans, require more underwriting and documentation in order to qualify than a typical private loan would, due to all the regulation a bank has to adhere to compared to a private individual that wants to lend out their personal funds.

Understanding what your end state goal is before you start investing is the best way to guide which option makes the most sense.

For the investor on the verge of retirement who is looking for cash flow with the lowest amount of risk, a very low leveraged portfolio might make the most sense.

While the young investor with very little cash to invest while trying to grow their net worth at an accelerated rate, might find a lot of value in using leverage in the right investments.

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