I was once told by a boss “if you want to understand real estate you must understand finance.” Talk about a scary sentence. “Finance?” This, is not what I had in mind as a neophyte to the real estate industry. After years of working in the real estate field, I agree with my boss. I, of all people, know that numbers can be intimidating, but hopefully focusing on key real estate finance concepts will help to clarify the topic.
Before I get into explaining real estate finance, let me explain why financing is used and why it is often needed.
Have you ever really wanted something, but realized it was out of your price range? You, like most Americans, probably do not save a lot of money. Sure, you may have a 401(k), savings account, and rainy day fund, but you probably do not save up for major purchases. However, in America there is something you can do to buy those items that you want — you can finance them.
First, let me say that I am not an advocate of financing everything under the sun.
However, financing is a key concept that must be understood. Let me use a simple example to explain financing. You go into an electronics store and see it — the most beautiful TV you have ever set your eyes on. The TV is calling your name, like a siren to a sailor.
You are mesmerized. Walking over you look down and notice the price tag. Elation turns to sorrow as reality hits and you know the TV is way outside of your price range.
Just as you begin to walk away from the warm golden glow of the screen, a store employee walks over with a smile and says four magical words “you could finance it.”
Next the employee tells you that you can buy the TV today, take it home and be enjoying movies by tonight.
Unfortunately you slept through finance class and never really grasped the whole finance concept. Looking back at the magnificent TV you ask the store employee to explain the store financing to you.
He explains that the store offers the first 18 months interest free and you do not have to make a payment for the first year and a half either as long as you payoff the balance before the 18th month.
He mentions that interest does accrue over the first year and half and it is added to the principal if the TV is not paid off within the first 18 months. Quickly, he tells you that it is not a big deal and that you should have no problem paying off the TV over 18 months.
You do the math and realize that you can pay the TV off within the needed timeframe and enjoy the TV that night.
About 45 days later, you receive a statement from the financing company regarding your TV. The bill says nothing is due and you decide to put off paying for the TV that month. The next month you have other expenses come up and are not able to make the TV payment. Before long you realize you have two months left to pay the TV off or be hit with close to $1,000 of interest. And this is exactly what the finance company wanted.
The finance company only makes money if you do not make the payments and they get to tack on the extra interest. Regardless of the end result the principals of finance carry across to many fields including real estate.
Just as you can borrow money to buy a TV, you can borrow money to purchase real estate.
Of course, while financing real estate, most lenders today will actually provide a loan that pays down the interest each month over time. Lenders have actually come up with a way to have more interest applied to the payment at the beginning of the loan term.
Years ago, banks realized that individuals who purchased houses often sold or refinanced them within the first five years of ownership.
Now this is a problem for banks, because they make their money on holding loans with individuals paying interest on the loans over time. Ingeniously, banks figured out a way to have borrowers pay more interest at the beginning of the loan.
This is known as an amortization schedule.
The amortization schedule is based off the principal balance with the majority of the payment going toward interest during the first half of the loan term.
For example, if you took out a $1 million real estate loan with a 30 year term, a 30 year amortization, and a rate of 6 percent, the total amount of interest would be $1,158,381.89 over 30 years.
That means you are paying more than the actual principal balance over time.
The amortization schedule in this example has you paying $5,995.50 a month. The first payment has $995.51 going toward principal reduction and $5,000.00 going toward interest. It is not until year 28 where $5010.11 goes toward principal and $985.39 goes towards interest.
Just looking at the example, you would wonder why anyone finances real estate at all if you have to pay so much money for the loan. However, what I did not explain was the concept of leverage.
Financial leverage enables you to make more and lose more than you have actually have invested. If you were to purchase a property for $2 million with a down payment of $200,000 and the property increased in value by 10 percent you would have made a 100 percent return on your initial investment.
Of course, there are other costs such as building expenses, carrying costs and other variables such as inflation. Just like the saying, “what goes up, must come down,” if in the example above the value dropped by 10 percent the investor would lose his initial investment.
If the value drops more than 10 percent, the investor is underwater, which means he owes more than the property is worth.
This is one way you can lose more than you put in with financial leverage.
Real estate financing can be complex. One thing to remember is that financing enables you to obtain a real estate asset today and pay for it over time.
Getting a loan though a bank will cause you to pay more over time, but it will also give you an opportunity to gain tax benefits and possible appreciation over the long haul.
Lastly, financial leverage can benefit or hurt an investor, but it is a concept worth understanding, if you are to succeed in real estate.
Mike Heayn is a Commercial Loan Consultant, specializing in Multi-Family Lending. He can be reached at (310) 428-1342 or emailed at firstname.lastname@example.org.