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
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."
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
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.
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.
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.
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