What is Creative Financing in Real Estate?
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Creative Financing Explained
The most basic definition of creative financing is:
An unusual or innovative way of structuring a loan to buy real estate.
Most successful real estate investors rely on traditional sources of capital as well as creative financing options to help them purchase properties.
Creative financing has been around for as long as people have been buying and selling real estate, but it became more common during the late ‘70s and early ‘80s when the 1973 oil embargo crisis plunged the economy into a period of hyperinflation, and the Federal Reserve attempted to counter the hyperinflation by raising interest rates.
Before the oil embargo, mortgage interest rates hovered around 7%, but as a result of the Fed rate hikes, 30-year mortgage rates jumped to 17%, pricing most homebuyers out of the market. Principal and interest payments on a $100,000 mortgage at 17% are nearly $1,500; the payment would be just $475 at 4% interest.
Without creative financing, the real estate market would have ground to a halt. During this time, buyers and sellers conceived of all kinds of creative arrangements to finance real estate without the need for conventional loans.
Since the introduction of the Dodd-Frank Act of 2010, many of these creative financing options have become less common because of stricter regulation from the federal government.
Creative financing hasn’t disappeared completely as a result of Dodd-Frank, however. Innovative financing solutions are still available to motivated buyers and sellers.
Types of Creative Financing
There are many different ways to finance real estate deals; the credit requirements, cash down, and closing speed vary depending on how the deal is structured.
Below are some of the most common types of creative financing for real estate.
With a seller financing arrangement (also known as “owner financing”), the seller takes the place of the bank and holds the note. Since the seller is acting as the lender, the terms of the note can be customized to suit both parties as needed. Most seller-financed properties are structured to be a short-term financing solution, with the expectation that the buyer will qualify for a conventional loan within a few years and then pay off the remaining balance of the note with a balloon payment.
One common scenario would be a note with a 15-year amortization and a 5-year balloon payment. The monthly principal and interest payments are stretched out over 15 years, but after 60 months (5 years), the entire remaining balance at that point in time must be paid in full. At this time, presumably, the buyer will have been approved for conventional financing.
It’s also worth noting that seller financing is not, technically, a loan. A loan is when an entity or individual gives another individual or entity money to purchase something. In this case, the seller does not give the buyer cash but simply accepts the payment for the property in a series of installments.
Sellers can extend financing on up to three properties a year without worrying about the Dodd-Frank restrictions. Owners who go beyond that number need to work with a licensed mortgage loan originator and comply with other provisions of the law.
Lease Option / Lease Purchase / Rent to Own
A Rent-to-Own arrangement is not exactly “financing”, but they can be structured to help a tenant/buyer purchase a home.
One type of rent-to-own arrangement is a lease option, where the tenant rents the property for a time, usually three years or fewer, with the option (but not the obligation) to buy the property outright at the end of the term.
Another variation is the lease purchase, where the tenant agrees to rent the property for a specified time and commits to buying the property outright at the end of the term.
The creative financing aspect comes into when these agreements stipulate that a portion of the rent payment is credited toward the down payment.
For example, the owner might agree to credit 25% of the monthly rent toward a down payment. If the monthly rent amount is $1,200, the down payment credit would be $7,200 after two years (25% of $1,200 = $300 x 24 months = $7,200).
The buyer usually pays an option fee or “consideration” upfront and the rent is often above-market rent. If the buyer decides not to buy the property at the end of the lease, the owner simply keeps the option money and any down payment credit.
Master Lease Agreement
Commercial real estate often employs this arrangement, but it can also work with residential rentals.
A master lease is a controlling lease that gives the lessee the right to control and sublease the property during the lease.
The property owner gives the lessee equitable title to the property in exchange for a set payment each month. The lessee manages and operates the property and keeps all profits—minus the monthly lease payment.
The master lease gives the lessee the right to control the property for a specified period, usually with little or no money down. A master lease may also have an option for the buyer to purchase the property outright at a certain point, converting equitable title to legal title.
Self Directed IRA
Although most people invest in stocks and bonds with their IRA funds, the IRS allows people to invest in alternative assets such as real estate with a self-directed IRA.
Investors can use funds from self-directed IRAs, either their own or those of friends or non-disqualified family members, to purchase real estate.
There are some important things to keep in mind about financing real estate investments with self-directed IRAs:
- Returns from IRA funds must flow back into the IRA.
- If there is any debt involved, it must be a non-recourse loan.
With a self-directed IRA, it’s up to the individual investor to choose the assets they will buy, however, they need to use a trustee or custodian to ensure that their self-directed individual investment account does not its tax-advantaged status. The custodian’s task is to issue all necessary tax statements and ensure that the account adheres to Internal Revenue Service tax guidelines.
Hard Money Loans / Private Money
Private money and hard money loans are a type of asset-based financing that is generally short-term; and popular for fix-and-flip investors.
Private money lenders are not subject to the strict underwriting standards of conventional lenders. This means they can extend loans to investors who would not qualify for a conventional mortgage due to credit requirements or because the property does not meet lending standards.
Hard money loans are more expensive than other types of financing. They generally require steep origination fees, higher interest rates, and other fees and expenses. However, the loans are not amortized, so monthly payments are typically lower. In addition, borrowers can get their funding faster than the conventional turnaround time, so they can take advantage of time-sensitive deals.
Cash-Out Refi or HELOC
Sometimes investors tap the equity in one property to finance the acquisition of another. This can either be in the form of a cash-out refinance or a home equity line of credit (HELOC).
A conventional lender can be used in both scenarios, but the loan itself originates in a different way than it would for a traditional real estate purchase and the funding is a bit more flexible.
In a cash-out refinance, the investor can take out a new mortgage on an existing property, pay off the existing mortgage, and use the remaining cash to acquire another piece of real estate. Cash-out refis are usually available with terms of up to 30 years.
With a HELOC, the investor does not pay off the original mortgage; they simply borrow against the property’s equity. HELOCs are usually available for up to 80% of a property’s value and have shorter terms (10 years is typical).
Creative financing offers individuals and investors with alternative methods to purchase real estate. As the name suggests, these financing methods are innovative and can usually be customized to suit the needs of the buyer and seller.
Creative financing carries its unique risks, however. It is important to do due diligence and compare options before entering into a non-traditional financing arrangement.
- Rocket Mortgage. (n.d.) Historical Mortgage Rates From The 1970s To 2020: Averages And Trends For 30-Year Fixed Mortgages. Retrieved from https://www.rocketmortgage.com/learn/historical-mortgage-rates-30-year-fixed
- National Association of Realtors. (n.d.) Seller Financing: Impact of the Safe Act and the Dodd-Frank Act. Retrieved from https://www.nar.realtor/reports/seller-financing-impact-of-the-safe-act-and-the-dodd-frank-act
- Internal Revenue Service. Retirement Topics – Prohibited Transactions. Retrieved from https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-prohibited-transactions
- Forbes. (n.d.) Restrictions You Need to Know About Seller Financing. Retrieved from https://www.forbes.com/sites/jordanlulich/2018/07/28/restrictions-you-need-to-know-about-seller-financing/#24521df46594