How Much Do I Really Need to Invest in Real Estate?

By: , Contributor

Published on: Oct 21, 2019

Forget the "creative" ways of financing rental properties -- here’s a reality check.

There are several books and websites that suggest "creative" financing methods for real estate investors and claim that you can buy rental properties with little or no money down. These could include trying to obtain seller financing for some or all of the purchase price, borrowing against the equity in your primary residence, and even using a credit card or a personal loan to come up with the down payment.

While these options are certainly possible, they can be difficult (if not impossible) to implement in real-world situations. And even if you can, it’s often financially irresponsible to over-leverage your real estate investments.

So, let’s take a look at how much you really need to buy an investment property in real-world situations and in a responsible manner, as well as some less capital-intensive alternatives you could choose to pursue instead.

How much you’ll really need to buy your first rental property

There was a time, before the housing market meltdown of the late 2000s, where investment property loans with low down payments were rather easy to come by. After the dramatic rise in the housing market throughout the 1990s and early 2000s, most people simply assumed that home values would rise forever. So, in a lender’s eyes, the worst-case scenario was that they’d have to foreclose on the home, which would then be worth more than the loan amount.

Obviously, this didn’t work out too well. Many real estate investors and banks lost tremendous amounts of money when real estate prices started to drop.

These days, lenders are a bit more cautious when it comes to financing investment properties and mortgage insurance companies generally won’t even consider them. As a result, the vast majority of lenders want at least 20% down to finance an investment property. And depending on the case, an even higher down payment (say 25% or 30%) may be required.

If you’re pursuing a conventional loan, the absolute minimum down payment required by Fannie Mae’s underwriting standards is 15%, but that only applies to single-family homes -- and even then, only if the borrower has a good credit score, six months’ of expenses in reserves, and a low debt-to-income (DTI) ratio. For most situations, the most a conventional lender will finance is limited to 75% of the purchase price.

There are specialty lenders that finance investment properties without conforming to Fannie Mae’s standards, but even these will rarely, if ever, accept a down payment of less than 20% of the purchase price.

To cut a long story short, you should expect to need a minimum of 20% down when buying a rental property, and I’d call a 25% down payment a more realistic expectation.

On top of this, it’s important to point out that the origination fees and other lender costs on investment property loans tend to be significantly higher than those of primary residence mortgages. Expect closing costs of 3%–5% of the purchase price on an investment property, including your origination fee.

Crowdfunding

A relatively new form of real estate investing, real estate crowdfunding allows you to pool your money with other investors to fund commercial real estate investments.

Here’s a hypothetical example of how this might work: Let’s say that an experienced real estate developer identifies a run-down apartment complex that it can buy for $5 million, spend $2 million on renovations, and potentially sell for $10 million in a few years.

We’ll say this developer can borrow $5 million from the bank, can contribute $1 million themselves, and needs to raise the other $1 million from investors. They can then list the opportunity on a crowdfunding platform to raise the required capital, and the investors will share in the profits resulting from the deal.

Each crowdfunding deal has its own minimum per-investor contribution as well as minimum income requirements. The most common minimum investment seems to be $25,000, which can be significantly less than the capital required to buy a rental property.Crowdfunding

A relatively new form of real estate investing, real estate crowdfunding allows you to pool your money with other investors to fund commercial real estate investments.

Here’s a hypothetical example of how this might work: Let’s say that an experienced real estate developer identifies a run-down apartment complex that it can buy for $5 million, spend $2 million on renovations, and potentially sell for $10 million in a few years.

We’ll say this developer can borrow $5 million from the bank, can contribute $1 million themselves, and needs to raise the other $1 million from investors. They can then list the opportunity on a crowdfunding platform to raise the required capital, and the investors will share in the profits resulting from the deal.

Each crowdfunding deal has its own minimum per-investor contribution as well as minimum income requirements. The most common minimum investment seems to be $25,000, which can be significantly less than the capital required to buy a rental property.

Real estate investment trusts (REITs)

Another option, and the one that requires the least amount of initial capital, is to invest in real estate through the stock market. A real estate investment trust, or REIT, is a special type of company designed to allow investors to put their money to work in commercial real estate.

I won’t get too deep into the details (we have a REIT homepage for that), but think of REITs as mutual funds, but for properties instead of stocks and bonds. REITs are required to pay out at least 90% of taxable income to shareholders, so these tend to have above-average dividend yields.

Most REITs specialize in a certain type of property, such as shopping malls, apartment buildings, or warehouses. The takeaway for our purposes is that you can invest in a REIT for as little as the cost of a single share.

Can you really afford to buy a rental property?

The bottom line is that in the majority of cases, buying a rental property is a capital-intensive process. In addition to at least 20% down and closing costs, you’ll need significant capital in reserve to cover vacancies and unforeseen maintenance and repairs.

There are ways to buy rental properties with less upfront capital, but these can be extremely difficult to implement. And even if you can find a way to borrow more money to buy a property, it’s often not financially responsible to do so. After all, over-leveraging investment properties was a big contributing factor to the housing market collapse of the late 2000s.

To sum it up, if you have sufficient capital to buy a rental property, it can be a lucrative long-term investment. If you don’t, there are other ways to invest in real estate that are less capital-intensive but also have strong return potential.

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Real Estate Financing | Investing Basics | Real Estate Basics
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