The single greatest obstacle most new real estate investors are confronted with is the inability to obtain financing for their first deal. Traditional loans, while widely and readily available, are fraught with time constraints and convoluted underwriting. At the very least, traditional mortgages have developed a reputation for making things more difficult for investors to expand their own portfolios. As a result, investors have increasingly turned to alternative strategies to secure working capital. Otherwise known as creative financing, alternative sources of money are paramount to the success of today’s investors. Meanwhile, creative financing makes it possible for many investors to secure deals they otherwise would have had to pass on.
Creative financing is a reference to subsequent methods of securing capital that aren’t synonymous with a traditional banking system. In its simplest form, creative financing is essentially any alternative means of financing a real estate deal that doesn’t involve an institutionalized lender. As its name suggests, creative financing draws from sources that the general census is typically unaware of—hence the “creative” moniker. It is worth noting, however, that creative financing isn’t relegated to a single source of capital, but instead includes numerous sources.
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Investors will encounter several types of creative financing techniques over the course of their careers. While there are a number of viable funding strategies to consider, they almost all have one thing in common: it doesn’t take money to make money. Great investors already know to use other people’s money, and it’s about time everyone else did. It is, after all, entirely possible to fund real estate deal using any of the following sources:
As perhaps one of the most underrated creative real estate financing techniques used in today’s market, seller financing remains a very viable strategy for funding a respective deal. Otherwise known as owner financing, seller financing eliminates the need for a third-party lender. Instead of enlisting the services of a traditional lender, investors will finance the purchase through the home’s current owner. In order to do so, however, the current owner must own the property “free and clear.” Seller financing is only possible if the owner has paid off their mortgage and remains in a 100 percent equity position.
Seller financing works very similar to that of a traditional bank loan, only the seller is acting as the bank. As a result, borrowers will proceed to make payments to the seller for the duration of the loan. Without a third party entering into the equation, both the buyer and seller are able to draft more favorable loan underwriting terms. Most notably, seller financing may make an impending transaction more economically viable for everyone involved. The owner, for example, can simultaneously sell the property, make money on interest, and limit their tax liability by receiving payments in incremental installments. Buyers, on the other hand, may negotiate more favorable terms, not the least of which may include zero money down.
Hard money lenders are the single greatest means of financing a deal today’s investors have at their disposal; they represent the pinnacle of creative financing strategies exercised by real estate investors of nearly every level. As organized semi-institutional lenders, hard money lenders award real estate investors with the professionalism and structure that has become synonymous with traditional banks, but without nearly as many hoops to jump through.
Hard money lenders base their decisions almost entirely on the subject property. Otherwise known as asset-based lending, hard money lenders will determine whether or not to lend funds based on the property’s potential. As a result, inquiring borrowers may qualify for a hard money loan with bad credit, a pending foreclosure, or “insufficient” income. While lenders will evaluate borrowers, they are traditionally more interested in how promising the deal looks. Therefore, borrowers are more likely to receive funds if they can land an attractive deal with good spreads.
Of course, hard money lenders will want some form of collateral for their own investment. More often than not, they’ll ask to be named on the insurance policy of the subject property as a means of mitigating risk. Additionally, hard money lenders will require borrowers to give them a promissory note and a mortgage or trust deed to the property. That way, the lender is guaranteed some sort of compensation in the event a deal doesn’t come together for whatever reason.
In addition to collateral, hard money lenders will typically request upwards of 11 to 15 percent in interest, and perhaps even an addition three to five points (a subsequent upfront percentage fee based on the original loan amount). To put things into perspective, the “going rate” for a hard money lender is roughly three to four times that of a traditional bank. That said, hard money lenders give investors two things banks can’t come close to competing with. While the price is high, investors receiving hard money loans typically won’t borrow for more than six months; the duration of the loan is considerably less. Likewise, investors may gain access to hard money funds a lot faster than bank loans. Whereas a bank can sometimes take months to transfer funds, hard money lenders can put the money in the hands of investors in as little as a few days—if not hours. Therein lies the greatest benefit of securing hard money: speed of implementation. Often times, it’s the speed in which an investor may receive capital that determines whether or not they land a deal.
Private money lenders, not unlike their hard money counterparts, represent one of the many outlets for real estate investors to tap into creative financing. Likewise, private money lenders function very similarly to hard money lenders; namely, they too are often willing to give high-interest, short-term loans to any investor who can bring them a promising deal. That, however, is where the similarities end. Unlike hard moneylenders, private money lenders are not licensed to lend money to real estate investors, nor are they organized or semi-institutional. In fact, private money lenders aren’t in the business of making loans to begin with; they are simply anyone with enough money and a penchant for investing.
In order to mitigate risk, private money lenders will typically require the same collateral as hard money lenders: they’ll ask to be named on the insurance policy of the subject property and request borrowers to give them a promissory note and a mortgage or trust deed to the property. That way they are off the hook if the investor doesn’t complete the deal. Private money lenders will also ask for anywhere between six to 12 percent in interest. While cheaper than hard money lenders, it’s important to note that private money won’t typically come with the professionalism of licensed investors. Remember, private money lenders aren’t licensed to lend money, so their funds may come at the cost of some efficiency. That said, there is no reason a good private money lender can’t have the funds in an investor’s hands within a few days, or even hours.
Nowhere else is creative real estate investing more pronounced than borrowing from a traditional retirement account. Unlike every other creative financing option on this list, tapping into one’s own retirement account will allow them to use their own capital, as opposed to someone else’s. Perhaps even more importantly, the Internal Revenue Service (IRS) has made it clear investors may pull from their own retirement account early without penalty if the funds are invested in real estate. Therefore, anyone with money in a 401(k) or Individual Retirement Account (IRA) may self direct their funds into real estate, as a means of improving their potential return on investment.
Retirement accounts may be used to fund both rehab and acquisition costs. In order to do so, however, the custodian of the retirement account must allow its holder to self-direct it. Therefore, creative real estate investors will first need to make sure their retirement accounts can be self directed before withdrawing any funds. In the event the retirement account is capable of being self-directed, investors will gain access to one of today’s greatest creative financing strategies.
It is worth noting that this particular method of creative real estate investing comes with a few caveats. For starters, the IRS still views the funds as a retirement supplement, which means any money earned from renting or selling property must be placed directly into the IRA from which the funds originated. Not only that, but there are limitations on the types of real estate transactions that may be carried out with funds from a retirement account.
Despite these limitations, borrowing from one’s own retirement account is a great way to invest in real estate. In addition to financing every cost associated with a deal, there’s one more significant advantage of self directing retirement funds: any profits made on a real estate investment that go back to the retirement account are tax deferred.
For one reason or another, there are far too many new investors who don’t know where the capital for their next deal will come from. Whether it’s a lack of experience or effort, it’s entirely possible to miss out on one of the best principles of real estate investing: it doesn’t take money to make money. Instead, today’s greatest investors use other people’s money as a source of creative financing to fund their deals. Remember, investing successfully has less to do with how much money an investor has, and absolutely everything to do with knowing how to leverage other people’s money to fund their next deal. There’s no reason new investors shouldn’t be able to use the previously discussed sources of creative financing to fund their deals.