Six Keys to Finding the Best Funding for Your Investments
The Effort to Study These Factors Will Be Worthwhile
By Rob Parsley
What is the best source of funding for your real estate investments?
Investors answer this question in different ways. Some prefer the security of working with banks. Some prefer the fast-and-loose style of local hard money lenders. Others prefer the proven processes and asset-based underwriting of private lenders.
But many investors have had to set aside their preferences and find alternative funding sources for their investments because of macroeconomic changes, notably interest rates that have increased nearly 400 basis points in the last 24 months.
The current economic environment has caused some funding sources to dry up and down the market, from large regional banks that made national news to national private lenders that were acquired by competitors to local hard money lenders. No single category of lending completely vanished, but no category was immune either.
That makes the search for funding more important than ever. Here are six primary factors that investors and brokers need to vet when considering a lender:
Rates and Fees
Of course, investors look for the best deal they can find in terms of raw numbers. This is essential in a higher interest rate environment because deals need to pencil out, whether the investor is selling a flipped property or acquiring a cash-flowing rental home.
In today’s market, rates can vary significantly because different lenders have different risk tolerances. And it is important for investors to also check fees—both at closing and throughout the life of the loan—to make sure that the total costs of financing work.
Leverage
In 2022, many lenders pulled back on loan-to-cost and loan-to-value percentages to protect themselves against potential declines in home prices that could turn deals upside down. But in the past 12 months, home prices have proven to be durable in most markets. This has allowed many lenders to stabilize the leverages they offer.
Still, investors need to make their own risk tolerance judgment on how leveraged they want to be, just as lenders have done. An uncertain economic environment may not be the best time for an investor to maximize leverage and take on additional risk.
Deal Structure
Some lenders lead with rate and leverage, while including onerous terms in a deal that limit flexibility. Deal structure is especially important now because higher interest rates and record home prices have increased mortgage payments on investment properties, which challenges cash flow even with rents at all-time highs.
So, investors need to find deal structures that will allow for refinances when the price of owning an investment property decreases. They can find this flexibility by asking questions:
» What is the prepayment penalty structure?
» What are the yield spread maintenance terms?
» Is minimum interest included in the deal?
» What are the adjustable-rate terms?
Investors need to be able to refinance a deal if rates decrease and do so without paying significant penalty fees. Loans that preserve future flexibility—such as interest-only bridge loans or no prepayment penalty loans—are especially valuable now.
Servicing and Draw Process
The closing table is just the beginning of a project, so investors need to know how a lender will service their loans. Are the servicing rights sold, or will the lender service their loans in-house? If there is a rehab or construction budget attached to the loan, the draw process is even more pertinent. Does the lender process draws in-house, or will a third party handle them? How quickly will draws be released? The flow of these funds is vital to a project’s success.
Capital Backing
A lender’s source of funding, and the reliability of that source, are factors that investors did not need to worry about when money was cheap, and lenders could easily find funds to disperse. But as interest rates rose, and as some banks and lenders found themselves overleveraged, it was not as easy for lenders to find capital to continue originating. As a result, lenders of various sizes ceased lending. Investors need to do the research so they know their lender will be ready to offer funds whenever they find their next deal.
Secondary Market Strategy
Where will your loan go after it is closed? This is another factor that many investors did not worry about in the past, because the secondary market set up favorably for loans to be resold. But today’s environment where money supply is tighter has forced investors to know more about the secondary market.
Secondary market requirements around credit quality, leverage, rate, and more impact how lenders structure their deals. Lenders who know which secondary market source will acquire their loans after closing will not change rates or leverages on a whim, because they can operate on the same page as their loan buyers and maintain a consistent loan offering. For example, at Lima One Capital all our loans go to our parent company, NYSE-listed REIT MFA Financial. We work closely with them to develop loan guidelines that help investors succeed while serving as sound investments, and we can stick to those guidelines to give our borrowers confidence.
On the other hand, lenders who must find sellers for most or even all their loans are at the mercy of the secondary market and may be compelled to change loan guidelines on short notice so that they are not stuck holding loans, which would drastically limit their funds for future lending.
Conclusion
The search for the right lender can lead to multiple answers. Investors may find a small hard money lender with plenty of money on hand to finance multiple projects. Builders may find a well-capitalized local bank that is willing to offer highly competitive ground-up construction financing. And investors still have access to strong national private lenders like Lima One with dependable sources of capital that are willing to finance fix and flip, new construction, single-family rental, and multifamily investments.
The hard truth is that it will take more work for investors to find the right lender in this economy, but the effort to study these six factors will be worthwhile in finding reliable financing partners.
