Since financing plays
a large part of real estate sales, it also affects values; the
higher the interest rate, the larger your monthly payment.
Conversely, the lower the interest rate, the lower the monthly
payment. Thus, the lower the interest rate, the larger the mortgage
loan you can afford to pay. Consequently, the larger the mortgage
you can afford, the more the seller can ask for in the sales prices.
Also, people with less cash are usually more concerned with their
payment than the total amount of the purchase price or loan amount.
On the other hand, people with all cash are more concerned with
price. Since most buyers borrow most of the purchase price, the
prices of houses are affected by financing. Thus, when interest
rates are low, housing prices tend to increase, because people can
afford a higher monthly payment. Since the mid 1990’s, the prices of
real estate have dramatically increased in most parts of the
country. The American economy has grown, the job growth during this
period has been good, but most importantly, interest rates have been
low.
How Financing Affects
Particular Transactions
Sales of comparable properties are the general benchmark for
property appraisals. Appraisers look not just at housing sale prices
of comparable houses, but also at the financing associated with the
sales of these houses. If the house was owner-financed, the interest
rate is generally higher than conventional rates and/or the price is
inflated. The inflated price is generally because the seller’s
credit qualifications are looser than that of a bank, which means
the buyer will not generally complain about the price.
SIDE NOTE:
Take a Cue from Other Industries. The explosion of the
electronics market, the automobile market, and other large-ticket
purchases is directly affected by financing. Just thumb through
the Sunday newspapers and you will see headlines such as “no money
down” or “no payments for one year.” These retailers have learned
that financing moves a product because it makes it easier for
people to justify the purchase. Likewise, the price of a house may
be stretched a bit more when it translates to just a few dollars
more per month in mortgage payments.
How Real Estate Investors Use
Financing
As discussed above,
investors use mortgage loans to increase their leverage. The more
money an investor can borrow, the more he can leverage his
investment. Rarely do investors use all cash to purchase properties,
and when they do, it is on a short-term basis. They usually
refinance the property to get their cash back or sell the property
for cash.
The challenge is that loans for investors are treated as high-risk
by lenders, as compared to non-investor (owner-occupied properties)
loans. Lenders often look at leveraged investments as risky, and are
less willing to loan money to investors. Lenders assume that the
less of your own money you have invested, the more likely you will
walk away from a bad property. The goal of the investor thus is to
put forth as little cash as possible, pay the least amount in loan
costs and interest, while keeping personal risk at a minimum.
When Is Cash Better Than
Financing?
Using all cash to
purchase a property may be better than financing in two particular
situations. The first situation is a short-term deal, that is, you
intend to sell the house shortly after you buy it (known as
“flipping”). When you have the cash to close quickly, you can
generally get a tremendous discount on the price a house. In this
case, financing may delay the transaction long enough to lose an
opportunity. Cash also allows you to purchase properties at a larger
discount. You’ve heard the expression, “money talks, BS walks.” This
is particularly true when making an offer to purchase a property
through a real estate agent. The real estate agent is more likely to
recommend to his client a purchase offer that is not contingent upon
the buyer obtaining bank financing.
SIDE NOTE:
Understanding a cash offer vs. paying all cash. If you make a
“cash offer” on a property, it does not necessarily mean you are
using all of your own cash. It means the seller is receiving all
cash, as opposed to the seller financing some part of the purchase
price.
The second case is
one in which you can use your retirement account. You can use the
cash in your IRA or SEP to purchase real estate, and the income is
tax-deferred. In order to do this, you need an aggressive
self-directed IRA custodian (oddly enough, most IRA custodians view
real estate as “risky” and the stock market as “safe”). Two such
custodians are Mid Ohio Securities (www.midoh.com) or Entrust
Administration (www.entrustadmin.com).
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