This is a guest post by Jeffrey Lucas Jr., who writes about aligning money with your life’s purpose. He left a career in investment advising to pursue his life’s passions. You can connect with him at www.jeffreylucasjr.com
Real estate investing is a great way to build wealth. Asset appreciation, streams of passive cash flow, and tax favorability, what’s not to like?
With the real estate market in most cities at crazy highs, and stock market returns over the moon, you might feel like you don’t have the cash to move into the real estate sector, or perhaps your brokerage account is doing so well you don’t want to move the assets you do have to get started in real estate investing.
You don’t really need that much money to get into real estate investing. Today we’ll look at how to get into real estate investing with very little money.
Real estate investing: A few words of caution
Real Estate investing (unlike most market investments) do take ongoing cash injection. In order to get started in real estate you should have a sufficient emergency fund, and other access to cash to ‘buy your way out of trouble’, if you should have unexpected expenses such as, repairs, legal expense or vacancy.
Some of these ideas involve partnering with others. It’s important to have very clear and signed agreements before exchanging money with anyone no matter how much you trust them. Seeking the advice of legal counsel is a good idea.
With those warnings out of the way. Let’s get going!
Design your finances for the financing in advance
Too often the way people approach real estate investing goes something like this:
- Call a real estate agent
- Look at properties
- Find one they like
- Bid on it
- Run the numbers
- Try to get a loan
This is almost exactly backward if you are trying to use the least amount of cash for real estate investing. Keep in mind the less cash you have in a deal, the higher your ROI (return on investment). You need to optimize for the loan, not the property. There are so many different loan programs, qualifications, and requirements for so many different options, it’s impossible to keep track of all of them.
If you are trying to use the least amount of cash possible, you have to design your finances for the loan you’ll use in advance. Find a mortgage broker who knows their products and can give you a few parameters that you’ll need to qualify for the specific type of real estate investing you are trying to do. Then design your finances around these requirements.
Find these details about some of the most attractive loan programs and make adjustments to your finances at least 90 days before approaching the bank for the loan.
Check your credit score
This is an easy one. Do you meet the ballpark credit score requirement for even getting the loan? You can check your credit score for free at Discover Free Credit Score. If your credit score isn’t where you want it, how can you get there? You can read more about getting your credit score improved here from my friends at the Frugal Expat.
Most primary home loans in the United States require less than a 43% debt to income ratio. This means your gross income X .43 / 12 = the MAX monthly loan payments you can have (typically including property taxes, insurance and hoa/condo fees).
For investment properties this number can be much lower.
Do the math before you get started and move loan balances around to improve your ratio. Remember, just because the bank says you can get the loan doesn’t necessarily mean you should make the purchase. You want to avoid becoming house poor.
A few ideas to improve your debt to income ratio:
- Consolidate credit card balances onto one card: If, like me, you travel hack, you might have balances on 3-4 credit cards at any given time. Even though you pay those balances off every month, each one has a minimum payment that will count against your debt-to-income ratio. Sometimes putting spending on only one card will lower that payment enough to put you under the threshold
- Move debt to a business: Credit reports run on your consumer credit. A lot of business credit cards don’t report these balances when a consumer credit report runs. If you have debt and a business, side hustle, or investments (like starting to get into real estate investing), you can likely open a business card, transfer balances to that card and the debt payments won’t show on your credit report. You can open up a legal entity or often just use a sole proprietorship under your own Tax ID. And this debt will still not appear.
- Move debt to a partner: If you are married or have a partner, you could also consider moving all the debt to the person with the lowest income. Remove your name from any joint credit cards you might have. When you approach the bank you will attempt to underwrite the loan in just your name and the debt won’t show because it is now solely under your partner.
- Utilize lines of credit: This can be both a powerful and risky move. If you already have a mortgage you can refinance it into a home equity line of credit. Most of these lines only require interest payments. This will greatly lower your required minimum payment that reports to the bureaus and possibly give you access to equity in your home for a down payment. Just realize that you are moving from a fixed interest rate to a variable one, and you will need to be intentional about principal reduction if you want to pay off the mortgage. Some banks also offer personal unsecured lines of credit that could help in a similar manner (with a higher interest rate).
- Increase your income: Get a new job or negotiate a raise. Ramit Sethi has some good thoughts on how to negotiate a raise. Keep in mind if you are self-employed the bank will likely average out your last two years’ tax returns. You could decide to write off fewer expenses the next time you file your returns in order to have a higher average income. Just make sure the additional income to get the loan would be worth paying the taxes.
Secure the down payment
This is where the rubber meets the road. How do you get the money to make the purchase? This will likely be the single biggest factor to consider as you decide what loan program is right for you. You’ll want to know the required down payment amount for your purchase price, then add 10% or so to give yourself wiggle room for any surprises and closing costs.
Here’s a few things to consider when deciding where to get your down payment from:
- Loans and lines: If your debt-to-income ratio has room for more payments, but you’re short on cash, you can consider getting an unsecured line of credit, a personal term loan, or a home equity line for the down payment. You’ll want to secure this loan at least 90 days before you approach a bank, and in a lot of cases, you’ll want to be able to show this money in a checking or savings account (as opposed to available credit on an unused line).
Be sure to calculate the cost of servicing this debt as you decide if the purchase will be a profitable decision for you. I once bought a condo with a 0% credit card convenience check as my down payment. Three years later I sold that condo for a $40,000 profit, with none of my own money in it.
- Outside investors: There’s a lot of talk in the real estate community about using OPM (other people’s money), the truth is if you are just getting started in real estate investing you have very little to offer the people with the money. One thing you may be able to offer is loan program qualification.
Are you a veteran, first-time home buyer, or could you be an owner-occupant? Real estate investors don’t have these programs available to them. Could you leverage your ability to get a special loan program in exchange for a down payment? Be sure to discuss cash flow distributions, exit strategy, and loss responsibility and have the agreement written down. I’ve known several people who purchased 1-4 unit dwellings with owner-occupied loans (while living in one unit). The down payment requirements were lower and they were able to get first dibs on putting in an offer.
- Skill in lieu: Are you a tradesman? Do you have a skill that a landlord, flipper or real estate agent needs? Could you offer to partner with someone in a deal by contributing your skills for a piece of the action instead of a fixed fee?
Even if the payout is less than you would normally charge for your service, you would get the experience of being in a deal and some starter cash for your first solo deal.
- Cash-out: If you have some cash or investments but you just don’t really want to tie it all up in real estate you can purchase real estate with cash with the plan of subsequent cash-out. I once bought a house and within a year had refinanced 125% of the purchase price due to a favorable appraisal (the house next door had sold for twice what I paid for mine). The property still cash-flowed well even with the additional debt and I got all my cashback plus what I spent on repairs back out of the property in less than 12 months. That money was ready to go back to work from me in no time. Just remember, nothing is guaranteed, interest rates could spike, housing values could fall and your cash could end up stuck.
Secure your reserves
A lot of people aren’t aware that when you buy property you don’t have to just come up with a down payment, but banks want to see that you have ample funds in order to make the payments for a certain period of time (normally six months with investments). Often banks will include retirement accounts, brokerage accounts and other non-cash accounts as part of this, but they may apply less than 1:1 credit towards your reserve requirement.
Position cash accordingly.
Sometimes it can make sense to park some debt from a line of credit into your bank account to show the reserves and then pay back the line after the loan closes or even borrow money from a private party.
You don’t have to put up a lot of money to get started in real estate investing. Asset appreciation, principal reduction and cashflow are all passive wealth builders that can move your financial picture forward once you secure your first property. Get creative, think ahead and you could add real estate to your portfolio, even in a hot market.