Before you go out looking for properties, you want to get your financing straightened out. This is probably the most important step in the process, because the way you finance can make or break your investment position.

LEVERAGE
The first thing you want to realize is that there are several ways to finance your purchase. Most people assume you need to put 20% down, and that PMI (mortgage insurance charged when you put less than 20% down) is the devil. On one hand, it is annoying to pay about $100 a month for basically nothing. On the other hand, it is a small cost for increasing your leverage four-fold. Leverage is the key to real estate investment, and is what makes all these real estate millionaires possible. Instead of putting 20% down on one $200,000 house, or $40,000, you can put 5% down on FOUR $200,000 homes, which is the same $40,000. Now instead of seeing appreciation on $200,000 of real estate, you'll see the appreciation on $800,000 of real estate!

It doesn't matter what the rate of appreciation is, this will always increase your real estate portfolio by FOUR TIMES. If appreciation is 10%, you'd see $20,000 appreciation on $200,000, but you'd see $80,000 on $80,000. If appreciation was only 5%, you'd see $10,000 on $200,000, but you'd see $40,000 on $800,000. By leveraging yourself at 5% instead of 20%, you will always increase the appreciation by four times.

There are expenses that go along with each property, so it is not automatically increasing your ROI (Return On Investment) by four. There will be factors such as PMI, tenant placement charges, and possibly HOA fees, but when you total these costs up, your ROI is at least doubled or tripled as compared to putting 20% down.

NEGATIVE CASH FLOW
The next thing to realize is that negative cash flow is not a deal breaker, and in most cases, you will likely have a negative cash flow. This means the rent you collect will be less than your monthly costs, and you will have to come out of pocket with $100-$300 a month. If you put 20% down, your Principal and Interest payment might be low enough so that you don't have negative cash flow, but this benefit is offset considerably by only allowing you to own 1/4 of the property you could own.

Consider this example. It is a true life example of one of the properties I own. I purchased a home for $180,000, and put 5% down on it. I financed the closing costs in with the mortgage, so I came out of pocket with $9,000. My monthly Principal and Interest payments are going to be $1110. I will have about $125 in Taxes and Insurance, $70 in PMI, and $15 in HOA fees. That's a total of $1320. There are already tenants in the property, so no cost in locating them and no lost month, but they are under contract for a payment of $1150 a month rent, which is about $150 lower than the going rate for that area. My negative cash flow is $1320 - $1150= $170 a month.

Now consider what my cash flow situation would be if I put down 20% on that $180,000. My Principal and Interest payment would drop from $1320 to $930, and I lose the PMI of $70, so I would be paying $1070 a month. Since I'm getting $1150 for rent, I'd actually be making $80 a month, so no negative cash flow.

Comparing the two, with 5% down, I'm paying $170 a month, or $2040 a year. With 20% down, I'm actually making $80 a month, or $960 a year. If my $180,000 house appreciates only 5% (a very conservative number, especially in Las Vegas today) I would make $9,000, so a total of $9,960 a year! Isn't that great? Well, yeah, but consider if I had only put 5% down on four properties. I would have to pay $2,040 a year per property, or $8,160 total. Yikes! I have to come up with $8,160 out of my pocket each year? But consider the 5% appreciation on the four houses, which total $720,000. 5% is $36,000. Comparing the two, I can put $36,000 on one house and make $9,000 + 960 = $10,160, or I can put $36,000 total down on four houses and make $36,000 - $8,160 = $27,840. That's greater than 2.7 times the ROI by putting only 5% down! Which sounds better to you?

Realize, you can modify this by buying only three houses, and keeping the extra $9,000 to pay off the negative cash flow. By doing this, you will cut into your ROI, but this means that your TOTAL INVESTMENT IS THE SAME. The numbers for three properties would look like this:

$540,000 property leveraged, $27,000 appreciation realized (assuming 5%), $6,120 annual negative cash flow, and $9,000 held in reserve from the original $36,000. $27,000 - $6,120 + $9,000 = $29,880. On the surface this looks a little better than the four property scenario, but it's only this good the first year, because you held back funds in reserve. Year two (not compounding the appreciation) would look more like $23,760 and year three and on would be $20,880. Still much better than owning one property, but not as good as owning four.

One thing that is constantly forgotten when considering cash flow is the tax benefits. Using our example above, our monthly cash flow situation when only putting 5% down is negative by $170 a month, which adds up to $2040 in a year. We are able to write off all of our expenses (except the principal payment), which adds up to approximately $1200 a month, $14,400 a year. If you are lucky enough to only be paying 35% in taxes, this means you will realize approximately $5,000 in tax credit per house. So even if we are coming out of pocket with $8,160 each year, we are also realizing $20,000 in tax credit a year, so we are actually making almost $12,000 a year.

Real estate investment is a long term (3-5 years) plan, so it requires long term thinking. Even without the tax benefit, you can see how owning more properties considerably offsets the inconvenience of negative cash flow. Hopefully, this example has revealed why negative cash flow is not the demon you thought it was. If it isn't, feel free to contact us and we'll try to explain it in a slightly different way.

FINANCING CLOSING COSTS
Here's a real nugget of information: finance your closing costs into the mortgage. Above you learned about leverage and why it is so good. Here's a way to further increase your leverage. Consider putting $9,000 down on a $180,000. Closing costs will be about $4,500. If you come out of pocket with the $4,500, that's $4,500 more you couldn't put down on a house, and it increases your investment in that property from just $9,000 to $13,500. This decreases your ROI by over 50%! For instance, if you saw $15,000 appreciation on your house and you only invested $9,000, your ROI (again, Return On Investment) would be $15,000 divided by $9,000, or 167%. If your investment of $13,500 is divided into the $15,000 appreciation, you only realize a 111% ROI.

Another way to look at it is by coming out of pocket with $4,500 on two houses, or $9,000, you could have bought another house with that! Instead of two houses, by financing the closing costs, you could buy three houses! I don't think I need to explain why that is a benefit.

So, how do you do this? How do you finance the closing costs into the loan? Basically, you're going to get the Seller to pay them. Let's say you found a house to buy for $175,000. Once the real estate agents negotiate the price, you tell your agent to increase the sales price by the estimated closings costs. So instead of paying $175,000 and the Seller contributing nothing to your closing costs, you adjust the price to $179,500 and have the Seller contribute $4,500 to the Buyer's closing costs.

It doesn't matter when you negotiate these costs into the contract, only that they are negotiated before the acceptance by both sides. In other words, you can bring it up during your negotiations, or you can wait until you verbally get close to a price and then tell them what you want to do. It does not really affect the negotiation process, because the Seller is going to net the same amount of money regardless.

The one thing to consider is that by increasing the Sales Price, you actually increase the cost of selling the home for the Seller. Since real estate commissions are based on Sales Price, by increasing the Sales Price by $4,500, you are increasing the cost for the Seller by approximately $300. A savvy Seller or Seller's agent will catch onto this, and will probably want to negotiate it, but rarely does this come up. If it does, the benefit of leveraging your financing costs is worth it.

WHAT KIND OF LOAN?
There are many different loan programs out there. Click here for a Residential Mortgages 101 summary of the various loan programs.

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