Some real estate investors buy a property using 100% cash, but a majority use debt. A loan may come from a bank, an institution, or a private money lender.
A loan using real estate as its collateral is often referred to as a “mortgage,” a word whose latin roots mean “engagement until death.” Real estate loans differ subtly depending on the purpose, but they have many moving parts in common.
Why Get a Loan?
Even if an investor has the cash to buy a property outright, (s)he usually uses a loan. Why do this? Several reasons:
Leverage
Buying real estate with a loan can produce a bigger return on investment. With a loan, you can use the same cash on a higher priced property than you could afford for all cash. Also, this can allow you to free up your cash to put in it a second property.
The loan gets smaller as it gets paid down, but if the property appreciates in value, you get to pocket that price increase (capital gains) at the time of sale, having invested less cash to get it.
Using debt to is get capital is called “leverage.”
Of course, servicing the debt often times reduces your cash flow. Buying with a loan, especially a big loan, carries the risk that if you can’t make the mortgage payment or the property decreases in value. You could lose your entire investment if the property goes back to the lender.
Bridge Loans
Usually a short-term mortgage at a higher interest rate, a bridge loan is one that may help fill the gap of some cash needs in a deal. A bridge loan might help you not only buy the property, but pay for repairs. Banks, private money lenders, and hard money lenders will offer bridge loans if an investor has a solid business plan and/or track record.
Who Makes Real Estate Loans?
Some types of real estate lenders are well-known; others are less well-known, and you might never think to borrow from them unless a loan broker made the introduction. Entities that lend money for the purchase of real estate include:
- Banks. The best-known real estate lenders. Banks will make conventional mortgages, commercial real estate loans, bridge loans, construction loans, and many other types of real estate loans.
- Insurance Companies. Many people don’t realize that life insurance companies often originate mortgages for the purchase of commercial properties.
- Government Agencies. Government-owned mortgage banks Fannie Mae and Freddie Mac, as well as the Federal Housing Administration, offer loans with favorable terms for the resale of stabilized commercial buildings.
- Private Lenders. Individual investors or small companies may have money to lend, either for traditional mortgage notes, bridge loans, or any purpose they see fit.
Parts of a Loan
Loan documents are fattened up by a stack of papers, most of them government-mandated disclosures. However, the typical trust deed loan itself only has two operating documents and one operating concept:
- The Deed of Trust. Deeds connote ownership. The buyer’s name on the executed Deed of Trust designates them as the “owner” of that property, but a Deed of Trust is not a free-and-clear deed. It is “encumbered” by a lien (see below).
- The Promissory Note. This document outlines the terms of the loan and its repayment, including the initial balance, interest rate, amortization, and term.
- Lien. While not a document, the deed and the note work together to create a “lien.” If the terms of the note are not satisfied, the lender has the right to seize the deed by a process called “foreclosure.” A lien is said to encumber the deed, in that the lien must be dealt with before the property can be sold to a new owner.
Types of Loans
While all real estate loans usually contain these parts, different types of loans often carry very different terms. Types of loans include:
- Traditional Loans. These basic real estate loans are seen as low-risk by lenders and usually have favorable terms for the buyer, including long terms and amortization schedules, low interest rates, etc.
- Construction Loans. Construction loans account for the fact that a property may need repairs or structures may need to be built from scratch. They are usually short-term loans with higher interest rates to account for the higher risk, but they may include terms favorable to the buyer like interest-only payments to preserve cashflow.
- Hard Money Loans. Hard money loans are bridge and construction loan offices that use investor cash, not bank credit, to make loans. Like construction loans, they are usually short-term, high-interest, with interest-only payments.
- Cross-Collateralized Loans. A cross-collateralized loan borrows against the equity of Property A to pay for Property B. This can help finance properties that lenders pass on; it can also be used to create a “no-down-payment” scenario. If the investment fails, however, both properties could be at risk of foreclosure.
Loan Terms
Real estate loans have certain terms in common, although the terms differ based on the type of loan (see above). Here’s what to look for:
LTV or LTC
“Loan to value” (LTV) is typically used to calculate the maximum loan available to a stabilized property that doesn’t require many repairs. Commercial lenders will typically lend a maximum of 80% of the appraised value of an investment property. For example, they will lend $800,000 on a property valued at $1 million.
A few lenders will go up to 85% on commercial properties. Lenders will write mortgages on personal residences of 90% LTV or even more depending on the economic thirst to make loans.
“Loan to cost” (LTC) is used when a property’s business plan requires substantial construction or renovation. In this case, the lender considers a percentage of the cost of the entire project, including purchase and repairs.
Currently, commercial lenders typically loan between 65% and 75% of the cost of the project. If a property appraised at $2 million with an anticipated $1 million in repairs, the total cost of the project is $3 million. At 70% LTC, a lender might write a mortgage for $2.1 million—more than the appraised value, but nearly $1 million short of the total project cost.
Interest Rate
The interest rate is the fee lenders charge for the use of their money, expressed as an “annual percentage rate” (APR). A lender will set interest rates depending on the risk of the project, the creditworthiness of the borrower, and market conditions.
Amortization
Real estate loans may have an “amortization schedule,” a schedule of payments of principal and interest at the end of which the loan is paid in full with a $0 balance. Complex calculations are needed to keep the monthly payment the same, but adjust the proportions of principal and interest so that the loan is fully amortized on schedule.
Real estate loan amortization schedules range from 15 to 30 years, or as many as 40 years in some cases. The shorter the amortization schedule, the bigger the payment, but the less total interest is paid.
Loan Term
Home loans tend to have terms that last until the end of the amortization schedule, but traditional commercial loans may have a term that is shorter than the amortization schedule. For example, the payments may be calculated to a 30-year amortization schedule, but the loan term ends in ten years.
At the end of the term, the buyer must either sell the property, pay the remaining loan balance in one “balloon payment,” or refinance into a new loan to pay off the original loan.
Bridge or construction loans may have even shorter terms, in the range of 1-3 years.
Recourse
Traditional home loans allow lenders to pursue any of the buyer’s assets (savings, automobiles, etc.) to make up for the default losses. The buyer’s personal liability for the lender’s losses is called “recourse.”
Larger commercial loans from institutional or agency lenders, however, may be “non-recourse.” A “non-recourse” loan allows lenders to recoup losses by foreclosing on the property, but they can’t go after the borrower’s other assets. The borrower’s losses are limited to the property itself—the borrower’s cash, automobiles, and other properties are not vulnerable to seizure by the lender. These loans often contain “bad boy” clauses that introduce recourse for the lender if the borrower manages the property with negligence or malice.
Loan Brokers
Some buyers approach lenders directly, but others use mortgage brokers. Mortgage brokers use databases and relationships to pair a buyer with the right lender and loan product for their business plan.
There is usually little downside to using a loan broker, because their fee is often paid by the lender in the form of a commission or finder’s fee, with no extra money out of your pocket. Even if a broker does charge you a fee, the broker can often justify that fee by negotiating away “loan points” or “origination fees.”
For more information on loans, read our article How Trust Deed Loans Work.
