How Financing affects the Real Estate Market
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).