First and foremost, most investors should make an effort to build relationships with smaller, local banks. These banks generally only loan 15 or 20-year money and offer:
- Quicker turnaround
- Flexibility on credit score based on personal relationships
- Knowledge of local markets
- Networks of local attorneys, real estate agents, contractors, insurance agents, and other professionals
- The option of cross pledging
- Ability to keep money local
Private money and hard money sound great, but aren’t all they are cracked up to be. We aren’t talking about friends-and-family money, but companies like CoreVest, LendingOne, Visio, or a brokered loan. Based on my recent experience, some of the challenges for this these loans include:
- Funding can take as long as 60-90 days
- Rigid processes
- High expenses and/or broker fees
- No cross pledging
- Extensive documentation requirements
- Requirement for excellent financial records
Every single item I list for small bank relationships has been a competitive advantage at some point. Quick loan turnarounds let me ink deals that others ponder on. Having a loan officer who knows how to get things done in town is invaluable. That might be getting a repair made or knowing the best agent for flood insurance.
If an investor chooses—or maybe more accurately has to choose private money—the disadvantages can be significant. A partner and I are trying to buy a 6-plex right now and are over 90 days trying to get the deal closed. The private money processes have been arduous. We have had an appraiser back out, a requirement for a property manager’s policies and procedures book, lease reviews by third party legal specialists, and other issues. Not saying that these are necessarily bad—just that local banks don’t have these burdens and are easier for the new or intermediate investor.
Lack of reinvestment profit is the basis for most objections to using 15 or 20-year loans. An investor doing a basic analysis might rationally opt for 10-15% real estate returns with a 30-year loan over the alternative 5% mortgage interest savings or 8% stock market gains. But there is a fallacy in this logic—it implies that the cash flow disappears. That cash flow is not available for reinvestment. False news!
That investor has another option. They can use the equity in one property to buy another. This is called cross-collateralization and is possibly the most valuable advantage to using a small, local bank. Cross-collateralizing has two main benefits:
- Additional investments can be made without any money out of pocket as long as you meet the bank’s loan-to-value requirements. These are typically 75-80%.
- Reinvestment of both appreciation and loan principal reductions can be made in short turnaround times. New properties can be bought as often as a buyer likes.
Shorter amortizations have additional benefits. The first is that it is an automatic savings plan. It is difficult to go out and buy a new Jeep with money that is not in an operating account somewhere. This will help significantly when I am ready to retire. My plan is to sell a portion of my portfolio, pay down debt, and create the cash flow I will need.
The second benefit of this equity-build method is to provide a buffer in the event of an economic downturn. If any of the local economies in which I am invested swoon, I can refinance properties to longer amortizations, lowering my monthly payments.
Lastly, financing with shorter amortization loans imposes financial discipline. Buying only properties that cash flow to your personal target with a higher monthly payment ensures that an investor is not “reaching” for marginally profitable properties.
An Important Exception
This is advice to my 25-year-old self: If possible, a new investor’s first purchase(s) should be a house hack using agency (FHA, VA, etc.) money. Buy as many units as you can this way, up to a 4-plex at a time, up to the loan limits. Low down payment, 30-year amortization. Lather, rinse, repeat every two years.