I get asked all the time how to fund real estate investments. There are many ways to fund real estate investments. Most real estate investments are funded the old fashioned way, a mortgage. But there are a lot of other ways too…
Mortgages to Fund Real Estate Investments
When you start looking at mortgages, you will find that there are many different flavors of mortgages; a conventional mortgage, an FHA mortgages, a commercial mortgage, adjustable rate mortgages, home equity line, etc. All of these types of funding can provide the capital required to participate in real estate investing. There are also some very creative ways to do it with seller financing, cash, and partners. These are all advanced topics, and should probably not be used on your first deal. It is possible, but you need to understand the process, inside and out, so you do not get burned on a deal, or burn someone else. In the most extreme case, some creative financing can cause you to serve jail time.
Start Small to Live Large
One thing I would advise someone who is not already living in their own home is to go out and find a duplex, or 4-plex. Make sure you do the due diligence to understand the economics of the deal. Look at potential income, expenses, and cap rate, return on Investment, etc.
After you have decided this is a great deal, buy it and MOVE INTO IT. If you were paying rent somewhere already, you can now skip the rent payment and make a home payment. You can get an FHA, owner occupied loan, with little down. An FHA loan can be used on an owner-occupied 4 unit or less property. The property might not be where you want to live long term, but this is one of the sacrifices that can propel you to your next deal, and possibly many others. After you have lived there two years, you can sell and use the additional equity in your next deal. Remember, there are no income taxes on the gain of a $250K gain on a home sale.
If you do not sell, you will have had the rental property for a couple of years on your taxes, and can use the income to help you qualify for the next mortgage. You have a great rate on the mortgage, and used very little equity to get into it.
Living In Your Own Rental
The advantage of living in your own multifamily property is huge. I already mentioned the mortgage and income advantages. You have all of the write-offs that any other investment property has. You get to fix up the property you live in, and write off the expense. You can even move between units, and rent out your previous one, to make sure that all the units in the property get upgraded. Since you are living in the unit, fixing it does not require longs trips (and motivation) to drive to the rental with your tools.
If you are on site most of the time, you can keep a close eye on your tenants. You can see if they are violating the lease. You can make repairs very quick and keep your tenants happy. This experience will prove valuable in the future when you manage property from a distance, or hire a property manager.
Renting Out a Room
If you are already living in your own home, renting a room out in your existing home can also be a way to do this, without having an extra outlay for a new mortgage. The advantage is you get extra money. The disadvantage is you have someone in your own home, with access to your ‘stuff’ when you are not home. If you do this, you will want to make sure your tenant is a 100% solid tenant. Someone who has a solid job and solid credit score. You want to make sure it is someone whose criminal record is impeccable. You might want to consider a friend or relative, which in itself carries a bit of risk.
Regardless of what way you start to invest in real estate, you need to LIVE BELOW YOUR MEANS (LBYM). If you are spending more that you make before you start to invest, you will spend the money that should be set aside for vacancy, maintenance and tenants deposits. If you are spending all that you make, adjust your lifestyle first.
What have you done to improve your capital position to acquire real estate? Have you ever considered starting as an owner occupied investment property?
Great tips. I think the biggest thing for anyone, like you said, is to live below your means. I’ve considered starting with an owner occupied unit, but I’m not particularly keen on that idea, as we like our current primary residence. Right now, I’m looking for properties in good school districts selling at a considerable discount with no major renovations or repairs needed. The good thing is that we have time to do so, even if it takes us longer to find the right property.
Generally, properties that are all fixed up sell at a premium. If you look for a foreclosure, or a seller that is distressed, you get a better deal. Divorces, deaths, breakups, etc. are all bad situations for sellers, but great news for buyers.
I’m pretty sure you don’t get the income exclusion on rental (investment) properties. See http://www.irs.gov/publications/p523/ar02.html#en_US_2013_publink1000240774 or talk to a CPA. You’re going to need one.
Thank you for the comment!
As always, individuals should consult there tax adviser. In a duplex, you can only exclude the gain from the portion of the property that you lived in. Assuming a 50/50 valuation between units, if you sell, 50% is the gain is attributable to your own exclusion. If the land was the major part of the appreciation, that is also part of your exclusion. In a place with a mother in law apartment, if you allocate 75/25, with the 75 being in the the side you live in, 75% is excluded.
So, the answer is, it depends…
I was already considering this and now that you mentioned it, I am sold on the idea. I really love that you can buy a home, get a residential interest rate instead of an investment rate. Then a few years later move out, rent it out and buy another home. My wife and I have one property, as I have mentioned before, and we are on the lookout for another home to live in now and rent out later.
It will definitely save interest rate expenses. Even if you sell every two years, assuming you have added some value to the property, you get to exclude a lot of capital gains. If you were not married, I would think you could sell to your significant other at a higher basis, take the capital gains, and that person could rent it out.
We never considered an owner occupied property in the beginning and I think it would be very hard to do now. I wish we’d kept our first house as a rental. It would have been perfect, but hindsight is always 20/20. Our good friend who has multiple properties started out that way. I only wish I’d know him back then.
Once you get established, it is much more difficult. You want more privacy. But when you were in College, you probably had people living in the same room, let alone next door. In the early stages, when you do not have much money, it is perfect.
I’m planning on renting out my current house when I choose to move out of it. Hopefully that can be the stepping stone into multiple real estate investments.
That is the way many people start, becoming an ‘accidental landlord’. It is a successful strategy, if you screen properly.
What are your thoughts on sfh vs mfh? Is one strategy superior to the other and why?
I like MFH as the cash flow and returns are better. I have a post about the differences here.
It really matters what you prefer.
Real estate is a great way to protect hard-won capital. Your asset is real, productive and has a use. You certainly can’t print any more of it. Historically, land has been one of the best hedges against inflation and turmoil. People will always need somewhere to live. Price bubbles may come and go… and come again. Meantime, your real estate always retains an intrinsic value.
Brian Linnekens
Absolutely correct!