Real Estate Finance

Real estate finance governs how investors pay for real property they acquire. Investors can use their own funds to acquire property but will often turn to financing companies to obtain mortgages. As with any type of investing, the investor should become educated about the process of acquiring real estate and how to understand the language of lenders. The process can be complicated but is assisted by engaging competent professionals to assist. Owning real estate is more like owning a business than other types of investments because there is the question of maintenance, repairs and tenant management which require much more of the investor's time and resources than other investments. Borrowers with special assets such as IRAs may have a unique avenue for financing while the cash poor, self employed and credit challenged may have to look to other alternatives to successfully invest in real estate.

Keywords Debt Financing; Equity Financing; Lease Agreement; Loan; Mortgage; Mortgage Banker; Mortgage Servicing; Real Estate; Real Estate Financing; Real Estate Investing; Realtor

Overview

Real estate finance is a popular topic among professionals and amateurs alike. Real estate is important because it is a primary investment vehicle in the U.S. economy. In addition, there are many complex financing vehicles that make it possible to construct various types of real estate deals. Whether you are a small investor, a first time investor, experienced, interested in residential or commercial property there is something for you in real estate finance. Real estate investment requires looking carefully at properties to acquire, and knowing how to finance these properties and the management of them once acquired. Galinnelli (2005) discusses the importance of deciding what type of ownership to obtain for holding title to real estate, such as individual ownership which provides no protection against personal liability or partnerships, or corporations and limited liability companies.

Real estate is also called real property. Real estate finance begins with a tangible property of some type such as land or buildings. Real estate property for the individual investor can mean owning a home, income property such as a multi-tenant apartment building or owning commercial space for rental to businesses. Vacation homes and condominiums are other examples of property an investor might consider.

The players involved are often real estate and financing professionals and the investor. Real estate professionals specialize in the process of identifying and acquiring property. Attorneys play the role of preparing and examining legal documents and aspects of ownership. Mortgage and loan officers assist in the financing of real estate deals. Accountants can help owners manage the day-to-day finances of investment properties.

Garton-Good (1999) described the primary players in mortgage financing as:

• Primary lenders;
• Secondary market;
• Private mortgage insurance market.

Primary lenders are traditional banks and companies that provide mortgage loans, however, these entities may sell loans before they are paid off and secondary market entities may purchase these loans. Some major players in the secondary market are Fannie Mae (Federal National Mortgage Association), Ginnie Mae (Government National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation). Private mortgage insurance insures 20% of a loan against the possibility of a borrower defaulting on a loan.

Anderson (2007) discussed the importance of trust in a real estate transaction relationship. Real estate investing can be a complex process; open, continuous communication is needed to make sure the needs of the investor are met and that a win-win situation is possible for the buyer and the seller. The success of dealing with the investor often depends on the investor's expectations and the possible uses the investor has for the property. If the investor is unclear on exactly what they want, they may continue to be dissatisfied with the investment throughout the process of acquisition. Being truthful from beginning to end can help the investor and the various players in the process of obtaining real estate to find common ground.

Real Estate Finance Products

There are several types of products that can be used to finance an investment in real estate. They include the buyers own cash or some sort of leveraging of other financing. Warr (2005) encourages investors to have a goal of creating "maximum leverage to make the most of their buying dollar. Benke & Folwer (2001) encouraged maximizing leverage which means any way that the borrower can delay "cash outflow."

Mortgages

If investors do not have or want to use their own cash for acquiring property, real estate is usually financed through a mortgage. A mortgage is "a loan secured by the collateral of some specified real estate property that obliges the borrower to make a predetermined series of payments" (Morgenson & Harvey, 2002). A conventional mortgage loan is one that comes from an institution such as a bank or insurance company. A nonconventional loan comes from an unconventional source like the property seller.

There are four basic parts to a loan: the principal amount that you borrow, the length or term of the loan, the annual interest rate, and the amount that you pay each payment period (Galinnelli, 2005). Mortgages can have a fixed interest rate or one that adjusts periodically. The adjustable rate mortgages (ARM) base the adjustment on some index such as the prime rate. There are combinations of these types of mortgages as well. There are mortgage products that allow the borrower to pay the interest only for a period of time as well as products that move from fixed to adjustable and vice versa. Galinnelli (2005) suggests that investors select products based on their own situation and the profit that can be anticipated from the property. In addition, investors should compare lenders in terms of interest rates, loan to value ratios and debt coverage ratios. Loan to value ratios compare the selling price to the appraised value while debt coverage ratios which are a comparison of what the investors debt is and the impact of adding a mortgage loan.

Real Estate Investment Trusts

Real estate investment trusts (REITs) are another investment opportunity. REITs are "trusts that invest directly in real estate or loans secured by real estate assets…" (Morgenson & Harvey, 2002). Bogoslaw (2007) indicated that the housing slump in the United States might frighten investors away from real estate investments. However, he pointed to international real estate investment trusts or mutual funds with international real estate as one method of avoiding problems. Europe, Western Europe and industrial Asia are seen as areas where expansion is planned and real estate investments may make sense. Bogoslaw noted that private REITs aren't publicly traded and have more stable cash flows because they are not influenced by the stock market. Investors can also look at using their IRAs for real estate investing as well as owning a vacation home or part of one with other investors.

Why People Invest In Real Estate & Considerations For Successful Investing

People often invest in real estate because they see it as a financial benefit. If a person wants to transition from renting their own home to owning it, this can be a powerful financial reason for owning a home. Others may see owning property as a long term investment or business venture that can be taken on while the individual is still employed in some other occupation. Some see real estate as a way to grow a nest egg for the future and to have retirement income from tenants. However, many investors are unaware of the responsibilities and requirements of owning and managing real estate.

Knowledge Requirements

Teger (2007) applauded investors who want to own real estate but likened owning real estate to owning a small business. Teger recommended having a plan just like a small business to avoid becoming overwhelmed with the great responsibility involved in owning and managing property. Understanding and planning for owning real estate means having a great understanding of the property, local market rates for rent and the length of time it may take to rent unoccupied space. Owners of real estate must know the impact of a vacancy on their overall profits. Galinnelli (2005) suggested that before even purchasing a property that investors compare the possible purchases based on the cash flow and long term profitability. Asking the right questions up front can avoid problems later.

Lease Agreements

Leases are agreements between owners and tenants and spell out the responsibilities of each. Understanding the language and terms of the lease are important should any legal action or eviction be required. Owning the property is just the beginning, Teger felt that owners needed to be certain that lease agreements provided for sufficient increases to help the property owner make a profit. Management of tenants requires understanding each lease in detail. Owners have responsibilities to collect rent and tenants need to provide notice if they are moving. All of these details are contained in lease agreements.

Creating a Desirable Property

Besides tasks connected with managing tenants, there are other tasks related to the actual upkeep, repair and improvement of the property. While owners may spend a lot of time thinking about how to collect rent from tenants and whether or not those rents will provide a profit for the owner another consideration is making the property a desirable one to live in or work in, in the case of commercial property. As with any other tangible property, real estate buildings require repair and upkeep. The owner is responsible for those tasks and must complete repairs in a timely fashion or risk vacancies as tenants who are dissatisfied leave.

Strategies for Property Investment

Migdal (2007) advised investors in real estate to prepare strategies in advance of purchasing. These strategies involve planning, looking at various purchase and financing scenarios and examining the possible profit from various real estate purchases. Teger (2007) suggested that owners think of themselves as business owners, write a business plan and have a good supporting team of professionals. These professionals include attorneys, accountants and relationships with skilled professionals to perform repairs. Thinking of owning real estate as an investment only misses many of the key requirements in this type of business venture. Migdal (2007) agreed that the real estate market moves so quickly buyers have to rely on professionals well versed in all aspects of the real estate process and transaction.

Galinnelli (2005) agrees with Teger that a plan is necessary to be a successful investor in real estate. Investors should consider real estate a long term investment avoid the concept of flipping "properties for a quick profit." Bromiley (2007) calls flipping houses "buying, renovating and quickly selling for a profit." Bromiley advises: Know what you are getting into before buying and renovating a property, make sure you know what defects or problems the property may have and understand the types of permits required and work that needs to be done on the property.

Steps to Choosing a Property

There are three steps that an investor should take to identify the types of properties in which to invest (Galinnelli, 2005).

• The first step is to identify a price range based on the cash and financing available for the purchase and the amount of money that might be needed immediately for repairs and a cash reserve.
• The second step is to select a location for the property. Galinnelli cautioned novice investors from quickly hiring a management company for property. Novice investors need to understand the process of management and can only learn this by doing. In addition, management companies can be costly and eat away at profits. Investors need a base of knowledge in the area they are investing to determine where to get tenants, what the turnover rate is likely to be and how long they can expect before a vacancy is filled.
• The third step is to select the type of property. Many types of property are available for sale including single family homes, condominiums, multifamily properties with two to four units, multifamily properties above four units, commercial office, commercial retail, commercial industrial and other investments such as vacant land, hotels, and mobile home parks. Investors must consider the pros and cons of each of these types of property and understand their local market, if investing locally, for the type of property being considered. Investors might look outside their local area to invest if prices are lower or there are other advantages but must weigh that against being physically away from the property. Galinnelli (2005) emphasized that investors should only choose properties within their skill levels.

Garton-Good (1999) suggested that real estate purchasers prepare for the purchase by reducing debt. The investor can increase the chances of getting a loan approved and getting favorable rates by paying off debt, paying down debt, refinancing high rate loans, consolidating loans and avoiding excessive credit card spending. Lenders can make suggestions for potential borrowers as to what actions might help the process of being approved for a loan. Once a loan has been approved, there are many categories of closing costs that the investor needs to understand and be prepared to pay. The smart buyer also knows that these fees can be negotiated and possibly reduced.

Viewpoint

Options for Financing of Real Estate

There will always be investors for real property and as a result, there will always be many different financing options for these investors. Selecting from among these alternatives is challenging and forces the investor to become educated on these options.

Individual Retirement Accounts

Garton-Good (1999) noted that first time homebuyers can withdraw up to $10,000 penalty free from an IRA for a down payment or closing costs. Knight (2007) felt that opportunities exist for investors to use their IRAs (Individual Retirement Accounts) to purchase real estate. Knight said over $2.4 trillion in IRA rollovers is expected between 2003 and 2010 and high net worth individuals can use real estate to diversify their portfolios. Investors interested in this option would have to open a self-directed IRA meaning that the owner is making all the investment decisions. The self-directed account is managed by a custodian well versed in IRAs holding real estate investments. Self-directed IRAs are funded by 401K rollover, with money from an existing IRA or from a profit sharing plan.

Once a property is purchased, the IRA will be shown as the owner or owners if multiple people use their IRA or a loan can be made to the IRA. Knight noted the benefits of IRA financing of real estate include portfolio diversification and favorable tax benefits (Knight, 2007). When the IRA holder decides to retire and take benefits, a choice can be made to take all of the value of the real estate or to take a percentage of it. The remainder will still be owned by the IRA. Although there are benefits to this type of strategy, there are also drawbacks. For example, the investor can't sell a property he owns to his IRA. The investor cannot act as if he owns the property such as providing free repairs to the property owned by the IRA.

Cash Buyers

Garton-Good (1999) noted the benefits of paying for real estate with cash. The cash buyer doesn't have to shop and learn about mortgages nor does this type of buyer have to worry about mortgage payments. The disadvantage of cash-buying is that the investor doesn't get to take advantage of the tax benefits of mortgages which includes deducting mortgage interest on income taxes. Another benefit of mortgages is that they usually require an appraisal, if the cash buyer skips this, they could overpay for a property. Buyers can also receive up to $11,000 per year without tax consequences to use as a down payment for a home (Garton-Good, 1999).

Loans

Much of the success an investor has in getting financing has to do with creditworthiness. If a buyer of real estate has a poor credit score, is self employed or has other issues, the options open to this type of borrower may be limited. Having bad credit is one of the major reasons a mortgage is denied (Garton-Good, 1999). In the 1980's no documentation, low documentation (no doc/low/doc) loans became popular for the self-employed and other borrowers. Because of high default rates, those loans have become less available. No-doc/Low-doc loans usually require a higher down payment of 25% — 30%. A creative alternative for the self-employed is the 75/10/15 financing which involves two mortgage loans where the first mortgage is 75% of the purchase price. In this way, the borrower avoids private mortgage insurance (PMI) — required if an 80% or higher loan is taken, less documentation may be required and a more favorable interest rate may be obtained. Another option for the self-employed might be to take a business loan instead of a personal mortgage loan (Garton-Good, 1999).

Individuals with poor credit can attempt to obtain subprime loans. However, with the increase of defaults on loans of this type, they will vary in supply. Subprime loans are loans available to the borrower with repetitive or extensive damaged credit and who are riskier and less likely to be picked up by the secondary mortgage market. There are three credit problems that would cause a borrower to seek a subprime loan: late payments of mortgages, late payments of credit cards, or a judgment or bankruptcy. The higher the amount that is provided as a down payment, the worse the individual's credit can be (Garton-Good, 1999).

While conventional fixed rate loans are the primary way investors finance mortgages, they can have disadvantages. For example, fixed rate conventional loans have fixed interest rates that remain the same even if interest rates go down. Some loan costs may also be higher than with other types of loans and creative financing may be limited. However, there are advantages to these same types of loans in that the interest rate is guaranteed not to go up and the lender may often choose not to resell this type of loan (Garton-Good, 1999).

Kosnett (2007) tapped into the trend of people wanting to invest in vacation homes in resort type areas. The attraction of these locales is beneficial if the investor wants to enjoy the property personally or if the property will be rented or sold. However, Kosnett cautions investors in vacation property to try to work with local lenders in order to have greater success.

Real Estate Information

Investors can get information on real estate from real estate agents, for sale signs, newspaper ads, placing 'real estate wanted' ads, Internet searches and networking (Galinnelli, 2005). Migdal (2007) suggested maintaining relationships with asset and fund managers who know their markets and are likely to be aware of real estate opportunities that may be unadvertised.

Garton-Good (1999) saw the Internet as a powerful tool for doing real estate research online. Many banks and mortgage companies have their mortgage applications online and provide for the online transmission of important documents even with digital signatures. These changes provide convenience for the borrowers and can also speed up the process. Garton-Good recommended taking care to double check all information since there could be incorrect information online. This can be especially true if working with a lender not located in your local area but available online. There may be tantalizing offers but they may not pan out. Enlisting professionals such as an attorney is still a necessity when dealing with online financing organizations.

There are a several types of information that the real estate investor should keep in mind. These include mortgage trends and refinancing options. Investors must become avid consumers of real estate information to identify and follow mortgage trends and refinancing options. Garton-Good (1999) defined "housing bubble" as a period of rapid and high appreciation of property. The housing bubble period may be a happy one for the investor as they see the property they've purchased appreciate in value rapidly. However, when the housing bubble bursts, the investor can't sell the property at the higher prices and may lose money when selling. If the investor has refinanced the property and taken cash out or otherwise obtained a loan against the higher value, there may be negative consequences if the property must be sold to pay the loans off. Refinancing offers are rampant and often attractive, but careful planning is needed when considering these options. Refinancing has to make financial sense and the timing has to be right to provide the investor with value. Investors should also be aware that credit is checked again during refinancing and credit problems or errors can block refinancing. Lenders may tout "no-cost" refinancing but the hidden costs may add up quickly (Garton-Good, 1999).

Terms & Concepts

Debt Financing: Paying for a property with credit.

Equity Financing: Financing based on the equity of a business.

Lease Agreement: The formal legal document entered into between a landlord and a tenant to reflect the terms of the negotiations between them; that is, the lease terms have been negotiated and agreed on, and the agreement has been reduced to writing. It constitutes the entire agreement between the parties and sets for the their basic legal rights.

Loan: Temporary use of a sum of money.

Mortgage: A security instrument in which real property is pledged as collateral for the payment of a mortgage note.

Mortgage Banker: A company or individual that originates mortgage loans and sells them to investors, while taking care of borrowers' loan payments, records, taxes and insurance.

Mortgage Servicing: The collection of monthly payments and penalties, record keeping, payment of insurance and taxes, and possible settlement of default involved with a mortgage loan.

Real Estate: A piece of land and the physical property on it.

Realtor: A designation given to members of real estate firms affiliated with the National Association of Realtors (NA), who are trained and license to assist clients in buying and selling real estate.

Bibliography

Anderson, S. J. (2007). Real estate pros learn lessons from tough clients. Mississippi Business Journal, 29, 6.

Benke, W. & Fowler, J. M. (2001). All about real estate investing: the easy way to get started. New York: Mc Graw-Hill.

Bogoslaw, D. (2007, July 7). Real estate bets in shaky times. Business Week Online, 29. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26003782&site=ehost-live

Bromiley, J. K. (2007). House flipping pitfalls could eat into profits. Wenatchee Business Journal, 21, C10.

Gallinelli, F. (2005). Insider secrets to financing your real estate investments: what every real estate investor needs to know about finding & financing your next deal. New York: McGraw-Hill.

Garton-Good, J. (1999). All about mortgages: insider tips to finance or refinance your home. Chicago: Dearborn Trade Publishing.

Jiawei, Z., Tony, T., & Joy, Z. (2013). Impact of home affordable refinance program on mortgage credit performance. Real Estate Finance (Aspen Publishers Inc.), 30, 47-53. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90069129&site=ehost-live

Knight, J. (2007). Using an IRA to buy real estate. Real Estate Finance (Aspen Publishers Inc.), 23, 19-20. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25752313&site=ehost-live

Kosnett, J. R. (2007). Own your piece of paradise. Kiplinger's Personal Finance, 61, 42-45. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25639434&site=ehost-live

Migdal, N. (2007). Faster than a speeding bullet. Real Estate Finance (Aspen Publishers Inc.), 23, 21-23. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25752314&site=ehost-live

Morgenson, G. & Harvey, C. R. (2002). The New York Times Dictionary of Money Investing. New York: Times Books.

Pattap, S. (2013). U.S. equity REITs and industrials — An exercise in contrasts. Real Estate Finance & Investment, 8. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=88301306&site=ehost-live

Sabatini, G. (2013). Sale-leaseback — Corporate real estate as a long-term source of financing. Site Selection, 58, 190-196. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87813826&site=ehost-live

Teger, L. (2007). Thinking about investment in real estate? Have a plan — first! Hudson Valley Business Journal, 18, 24.

Warr, G. D. (2005). Make more money investing in multiunits; a step-by-step guide to profiting from apartment buildings. Chicago: Dearborn Trade Publishing.

Suggested Reading

Dahl, J. (2007). Great minds don't think alike. Smart Money, 16, 19. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25763900&site=ehost-live

Kosnett, J. R. (2007). Own your piece of paradise. Kiplinger's Personal Finance, 61, 42-45. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25639434&site=ehost-live

Taylor, M. (2004). A small world. Mortgage Banking, 65, 80-85. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=14831469&site=ehost-live