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Real estate investing: How much do you need to get started?

Peter Miller
The Mortgage Reports contributor

Real estate investing for beginners

Real estate investing interests large numbers of people, especially when home prices are rising. And that’s been the case in recent years. According to the latest figures from the Federal Reserve, “The median net worth of homeowners increased 15 percent between 2013 and 2016, whereas that of renters or other non-homeowners fell 5 percent.”

Logically, if homeowners are doing so well, then doesn’t it make sense to own more than one house? If you want to be an investor, you’ll need real cash. But how much do you need? In some cases, as we shall see, the answer is very little.

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Cash needs for real estate investing

The cash needed to purchase investment property will vary according to many factors. The three big items to watch are the cash needed for a down payment, the cash needed to close, and the cash immediately required for moving and repairs. Additionally, buyers should always have reserves in case something unexpected takes place.

Owner-occupants typically finance a home with one of four options: FHA mortgages, VA financing, conforming loans that can be bought by Fannie Mae and Freddie Mac, and USDA mortgages.

For investors, most of those programs are off-limits. Neither FHA nor VA programs allow pure investor mortgages. The property must be owner-occupied to be eligible. On the other hand, with just 3.5 percent down (FHA) or even zero down (VA), you can finance a property with as many as four units if you live in one unit as your prime residence.

Fannie Mae and Freddie Mac do allow investor loans, but buyers must be highly-qualified and bring a larger down payment.

Related: Investor property mortgage rates: How much more will you pay?

There are situations where real estate investing can be done with less cash. Some options to consider include:

Seller contributions

Many loan programs allow owners to provide a seller contribution, from 2 to 6 percent of the sale price. Typically, such contributions can be used to offset closing costs and mortgage borrowing. However, there is a minimum down payment that must come from the buyer.

Gifts

While seller contributions typically cannot be used to pay some or all of the down payment, that is generally not the case with gifts. Gifts – especially from friends and family – can offset down payment requirements.

To make sure a gift is really a gift and not a disguised loan, lenders require a “gift letter” from the donor stating that the money is a gift and that no repayment or interest is required. They also often want bank statements from the gift-giver to prove that he or she has the money to give you, and a paper trail showing that the money exited the giver’s account and entered yours.

Co-buyers and co-borrowers

If cash is a problem, perhaps the answer is to find a financially-strong co-buyer. With an equity-sharing agreement, you have an occupant-owner and a non-resident investor owner.

Both partners pay their share of mortgage costs, taxes, repairs, etc. However, the owner-occupant pays rent. For tax purposes, the rent is income to both parties, and the mortgage interest, property taxes, depreciation and other costs count as deductions from that income.

The property may generate positive cash flow to both parties, create paper losses to be deducted from other income — or even both.

When the property is sold, the owners divide the profit or loss. A written equity sharing agreement is a must – speak with a real estate attorney for details.

Private lenders

Those with an interest in flipping often need to act quickly, or they’ll lose a property. Private lenders, historically known as hard money lenders, can often fund transactions in 10 days or so but such loans require a lot of cash. According to the Housing News Report, “Private lenders often have terms which include 70 percent loan-to-value (LTV) ratios, 3 to 4 points, interest from 8 to 13 percent, and a length of one to two years.”

Related: equity sharing mortgage (SEM) helps family get into a home

Financing from private lenders tends to be short-term because the assumption is that flippers will quickly re-sell properties. However, stalled repairs, surprise problems, unexpected costs, and changes in market demand can delay sales and make flipping very risky. An alternative funding approach is to team with other investors, pool money, and buy property for cash.

Assume financing

Today’s FHA and VA home loan programs allow qualified borrowers to assume existing mortgages for investment property purchases. For VA home loans, you don’t need to be eligible for VA financing yourself. you don’t have to be in the military or a veteran.

The upside is that you can save money on mortgage origination costs, and may get a better interest rate than is currently available. (This depends on when the existing mortgage was taken, and how much the home seller is paying.)

However, you’re likely to need a sizable down payment. The reason is that the loan balance has been paid down by the current owner, while the home value is likely to have increased.

If your seller has a 3.75 percent interest rate, that’s much better than you can get right now. That rate was available in 2016. So let’s assume that the current seller paid $200,000 for a home put 5 percent down. Three years later, the loan balance would be about $188,000. meanwhile, if the property value increased at 5 percent per year, it’s worth $231,525. You’d need $43,525 to make up the difference.

Secondary financing

Rather than one loan, why not purchase with two? This is not only a way to reduce cash needed, but it can also eliminate mortgage insurance costs.

For example, you want to buy a $300,000 property. You could buy with $60,000 down (20 percent) and a $240,000 mortgage (80 percent). Alternatively, you could buy with a $240,000 mortgage and a second loan for $45,000. Now you have $285,000 in financing and need just 5 percent down in cash – a total of $15,000 plus closing costs.

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