In the latest real estate blog post, I discussed the importance the lender plays in your real estate team, how to find a lender, and the questions to ask when interviewing the right partner. Today I want to take a deeper dive into the different types of financing options available for rental real estate, which are: conventional mortgages, commercial, portfolio loans, and private/hard money loans. Below is a breakdown of the different types of loans:
Generally speaking, investors who are starting out with less than 10 properties, will most likely be seeking conventional mortgages. The reason is that these loans offer the best interest rate with long amortization (as of this writing, around 5% interest, 30 year amortization). There are other terms such as 15 year amortization, and variable interest rates that increase after a set period (e.g. 5 years), however, fixed 30-year loans are the most common type of conventional loan that allows you to maximize your leverage and cash flow.
Further, these loans are regulated by the Federal Government agencies like Fannie Mae and Freddie Mac, large national banks, local banks, and credit unions typically all offer this program. By having a government backed loan program, financial institutions are able to sell these loans back to Fannie Mae and Freddie Mac if they choose to do so for a profit. Contrarily, they can also decide to service the loan in-house and keep the mortgage on their balance sheet.
The financial institutions providing the loan will underwrite the deal per Fannie Mae and Freddie guidelines as well as their own overlays (additional requirements). The basis of underwriting the loans include the financial health of the borrower (e.g. credit score, income/debt ratio, reserves) as well as the strength of the deal (e.g. debt service coverage ratio). These loans are typically easier to find across banks and you will qualify for as long as you meet certain requirements.
If conventional loan underwriting focused on the borrower as an individual, commercial loans focus on the property itself more heavily. Commercial lenders are typically lent to business entities such as an LLC, and may be a requirement prior to close. Further, the interest rates related to commercial loans may be higher than conventional loans as they are for business purposes and considered higher risk. Furthermore, commercial lenders will place a balloon payment around 5, 7, and 10 years and reduce amortization to 15, 20, or 25 years compared to a conventional loan with no balloon payment and 30 year amortization.
As the commercial lender is focusing on the health of the property/deal in question, there are 3 areas that they generally review: 1) net operating income - used to understand the profitability of the deal 2) condition of the property (turnkey, cosmetic rehab, gut rehab) and 3) location of the property (A class, B class, warzone, etc.)
Further differences between commercial and conventional lenders relate to the appraisal process. The appraisal the commercial lender orders has three types of approaches: Two of them are an income approach and a sales comparison approach. At times the commercial lender orders a cost approach. For the residential lender, his appraisal uses the cost approach and the sales comparison approach, with the latter being most widely used. The income approach used by the commercial lender is important because it focuses on the net income of the real estate property and its ability to “stand on its own.”
In commercial lending, some lenders require that the borrower has experience in owning commercial property. This factor is considered as the lender views owning rental property with a commercial loan as owning a business, which requires experience to succeed and pay back the debt. The commercial lender may also review the loan to value which is the quotient of the amount of the loan divided by the value of the property. As such, an 80% Loan to value on a hundred thousand dollar property would mean that the borrower is getting an $80,000 loan. A key difference is that commercial lenders may have flexibility in borrowing down payment funds as well as financing up to 90% or 100% LTV if the deal is strong enough.
Lastly, another key difference between a commercial real estate loan and a residential real estate loan is that commercial lenders have more strict requirements as it relates to the Debt Service Coverage Ratio (DSCR). In short, the Debt Service Coverage Ratio looks at the property’s ability to cover payments and have margin left over. Margin is important so that the borrower will have enough cash flow to pay for unforeseen expenses – plumbing, electrical, roof, vacancy, reduction in rents, etc.
Portfolio loans are offered to investors by select banks and financial institutions who are willing to lend their own money and service the loan. As they are not backed by Fannie Mae or Freddie Mac, they have more flexibility in underwriting and qualifying the borrower for the loan. Similar to commercial lenders, the portfolio lenders focus more heavily on the deal itself, the ability of the property to produce a profit and repay its debt, and the experience of the borrower. As such, if there is a strong enough deal, these portfolio lenders can lend on less down payment (5-10%) and update terms as they see fit (e.g. lower interest, longer amortization, later balloon payment). A key benefit in using a portfolio lender is the ability to obtain more loans after you have the Fannie Mae limit of 10 conventional loans per person. However, a major drawback may be that banks and financial institutions are stricter than conventional lenders and your loan request may be requested more times than not depending on the strength of the deal.
Private/Hard Money Lenders
Private lenders and Hard Money Lenders are often used interchangeably in the real estate forums and meet ups, however, I believe the key distinction is that private lenders are typically your mom and pop shop lenders whom you have a pre-existing relationship. These people can be your parents, other family members, friends, and co-workers. Hard Money Lenders, on the other hand, are sophisticated investors who purposefully pool their money, or directly lend their own money to other investors for interest and/or fee.
As it relates to the purposes and terms of these loans, they can be the same, but it differs from lender to lender based on the risk of the deal, and return these lenders would like to make on their money. For example, there are fix and flip hard money lenders who lend a minimum of 50K up to 500K for 12 months or less at 10-14% interest (based on LTV), and a $2,500 fee. Private lenders can also decide to have the same aforementioned fees, but can also decide to loan you the money at 6% interest and no fee. The beauty of private lenders is that it varies from person to person, deal to deal, so depending on your relationship, strength of the deal, and wants of the lender, you can obtain financing that is even better than conventional, commercial, portfolio, and hard money loans.
In addition to flexible terms, a huge benefits is that you can also find lenders with less paperwork requirements as their underwriting is unique. Some lenders may request documents such as W-2, tax returns, rehab budget, appraisal, inspection report, and your experience with real estate, while other lenders may give you the money simply based on reviewing the deal’s proforma. Lastly, conventional, commercial, and portfolio lenders may try to avoid properties than need extensive rehab, but a savvy investor may see potential in doing the work themselves. This creates a great opportunity for an investor to partner with a private or hard money lender to purchase the deal, fix it up, and create forced equity (appreciation) and refinance with a long-term conventional or portfolio lender.
In summary, most real estate investors will want to maximize the use of their 10 Fannie Mae conventional loans, and then seek other types of financing such as private loans, commercial, and portfolio loans. Each type of loan serves a purpose and knowing different tools will help you take down more deals, creatively, efficiently, and for maximum profit.
As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.