Three Financing Fundamentals in Real Estate Investment
Real estate centers on three fundamental financing elements, namely time, volume, and type of property. Once you determine your time horizon, the rate at which you intend to buy and sell, along with the type of real estate you invest in, the right financial instruments may then be put in place.
Most real estate experts fit in the element of time in their investment approach. The element of time refers to the duration of the holding period or simply put, it is the length of time a certain piece of investment property is intended to be held. Some investors will just want to go with a short-term strategy by rehabbing houses, while others wish to go with an intermediate-term approach, which includes buying, managing, and holding rental property for three to five years. Others want to buy office or industrial buildings and hold them for long periods; 10, 20, and even 30 years.
The right step towards developing the right strategy is to establish an investment horizon before seeking financing. Know beforehand if you are going to hold the property for just a short time, many years or somewhere in between. The variable of time is useful in calculating interest rates. Time also determines whether you obtain a floating rate of fixed rate loan, as well as any prepayment penalties that may be associated with the loan. Time has a significant impact on the growth rate of your real estate portfolio. Time affects things as tax rate applicable to your gain or loss. Historically, the long term capital gains tax rate has been more favorable than the short term tax rate.
Time as a determinant in the rate of inventory turnover.
Large retailers look forward to accepting lower profit margins on item s they merchandise in exchange for a higher inventory turnover rate. Take this case for example; you earn twenty percent on each house you sell and have a turnover rate of one, or you earn eight percent on each item you sell and have a turnover rate of three. See the explanation below:
This clearly shows that an investor can accept a lower rate of return on each property bought and sold and earn a higher overall rate of return, so long as that frequency, or turnover rate, is increased. Transaction costs may or may not be significant here depending on the specific situation, but should be factored in when analyzing a potential purchase.
Investment activity volume
Volume of investment activity comes second as a significant factor that affects an investor’s strategy and the type of financing to be used. Take the case of increasing the volume of units bought and sold. It increases the investor’s opportunity to generate profits. By the same principal, increasing the volume of units bought, managed, and held in a portfolio increases the investor’s opportunity to generate income.
The downside in volume increase can significantly increase transaction costs, especially for a short-term investor. Take the case of a lender charging you one or two points every time you obtain a loan for a house you are going to flip, the costs for financing can add up quickly, thereby significantly increasing the annualized rate of interest. Another case, assume you are buying a house for $100,000 to rehabilitate then flip. Let’s assume you are good at doing this and that the average time it takes you to buy, rehab, and sell a property is three months:
As shown in the example above, although the stated interest rate of 6.0 percent would be considered very competitive rate for most investors, the effective rate of 10.0 percent in not nearly as competitive. The fact is, with a 6.0 percent interest rate environment, most investors would not be interested if the lender was offering interest rate of 10.0 percent. $1,000 may not be a killer for this investment, but when you factor in volume, instead of buying just one house, assumed you have organized a team of individuals to work for you and have increased your volume to 100 houses per year, the $1,000 will come to $100,000. Now, in that environment, you don’t want to leave $100,000 on the table for the lender.
Negotiate with your lender for a line of credit to eliminate fees. A line of credit provides you with a prearranged amount of money to draw against to fund not only the purchase of the houses, but also the repair work that will be needed.
Type of property
Type of property comes third as an element that affects an investor’s approach and type of funding to be used. Property types that yield income are most often classified as single-family, multi-family or commercial. The type of property being purchase determines the type of loan an investor would obtain for any real estate property. Loan requirements for single-family properties vary from lender to lender. Look around to compare choices available among conventional lenders or use services of a mortgage broker. Then select the one that fulfills your needs.
Taking the case of single-family properties, conventional financing is commonly available through small local banks. The key advantage of using a local bank over conventional sources such as a mortgage company is they often provide borrowers with more flexibility. For example, local banks loan money to buy rental property as well as make improvements to it. It is recommended you use a network of institutional lenders when investing in multifamily property. You can also benefit from specialty apartment lending programs.
Large real estate investments such as office buildings, retail strip centers, or large-scale apartment complexes can seek conduit loans offered by large institutional firms, such as insurance companies.
Collectively consider all the three financing fundamentals of time, volume and type of property, but not individually. A change in any of the three elements will have a direct impact on the monetary instrument used in an investment activity. The more you become accustomed with the interaction that occurs among these three variables, the better you will be able to apply them to your advantage. Also you can visit Your Personal Financial Mentor for more update information on real estate.