We know that financing of investment property is a very important issue. The decision as to which share of the acquisition costs you are financed by equity and what proportion real estate finance through a loan. This weighting has an impact on your opportunity-risk profile. The highest possible loan ratio had a positive effect on the return on equity and the range of action of the real estate investor. We want to deepen these considerations in this article. I will also give you detailed information about loan financing.
Finance Real Estate From Bank
The bank is a very important partner for you. Because the bank is your source of cash, which allows you to turn a larger wheel and leverage your return on a multiple of the base return. For this reason, it is almost impossible to become a successful real estate investor without a bank. Because that is so, you should try to build up a more intense business relationship with some banks.
If you have already done business successfully with a bank and a banker who is responsible for you, then you have already got to know them. Ideally, the bank clerk has noticed that you are rock solid and understand something about investment property. At the latest with the second deal, which the bank is to finance, then everything will run much faster and smoother.
Not only classic banks are considered as lenders, but also life insurance companies and state development banks and the so-called direct banks without their own branch network. Direct banks operate exclusively via an Internet portal.
Real Estate Finance Through Brokers
In addition, there are financial brokers. They do not offer financing themselves, but they provide financing between the bank and the borrower. In my estimation, it is advisable to contact only independent financial brokers who act as brokers for a large number of banks. For financial brokers who do not work independently, there is a risk that they can only convey a small selection of the offers on the market.
Caution is advised if real estate agents want to provide you in addition to the property loan financing. Such offers are often not based on the most favorable terms and become more expensive through high commissions for the broker, which of course are paid by the borrower at the end of the day.
You should try to establish contact with specialists from the financial brokerage firm who are exclusively involved in arranging loans for an investment property. This way, you can also build valuable contacts with the banks for which the financial agents operate. Check the quotes brokered by brokers just as critically and thoroughly as direct offers from a bank. The involvement of a financial broker does not in any way replace a thorough analysis of the market and does not save you the trouble of critically reviewing the offers made and of finding the optimal financing for you.
Terms of Loan By Banks
For the bank, three aspects are particularly important in deciding whether to provide you with a loan and (if so) on what terms it does:
- Impairment of the property
- Capacity of the property
- Your personal credit rating
As the bank has the property secured in the form of a mortgage, the bank also requires information about the property in order to understand the value of the property. This is one of the reasons why you can not obtain any binding offers from banks before deciding on a certain investment property because the bank makes its loan offer and especially the terms of the loan highly dependent on the value of the property, which must serve as collateral for the loan. In advance, you can only obtain indications for loan conditions that are not binding but can nevertheless provide a rough guide.
In addition, in the financing of investment property, servicing of capital plays a large role in the loan interest rate offered by the bank and in the willingness of the bank to provide a high proportion of the loan for financing.
After all, before a mortgage loan is approved, a financing bank will also require extensive information about your financial circumstances in order to classify your so-called credit rating. The bank does this not out of curiosity, but because it is legally obliged to do so and because the terms of the loan also depend on the economic strength and the financial circumstances of the borrower.
For borrowers with a good credit rating, the interest rate is cheaper because the priced risk premium is lower while the interest rate on borrowers with bad credit is higher.
In this context, databases with information about your payment behavior also play a role. Surely you have heard something from the SCHUFA. It collects a lot of data about you, which is accessed by banks when they screen their potential borrowers. You can query the data stored about you at the SCHUFA to see what has landed there and what the SCHUFA achieved in evaluating this data. The result of the evaluation is summarized in a percentage, which should reflect the probability that you pay your debts on time.
On the basis of random samples, I myself came to the conclusion that the SCHUFA data is very fragmented and that SCHUFA classifications should be treated with caution. Nevertheless, it is interesting to know what you think about them there. Because you have to calculate that your bank bases this data on the SCHUFA as a fixed fact and does not question it further.
If you have now found a suitable investment property and compiled the relevant documents about your creditworthiness and about the real estate, the time has come to ask for special offers instead of just indications. To do this, you must first consider which providers you want to contact and which loan volume you want to ask. Of course, there are also considerations about the correct equity ratio.
How Should The Real Estate Finance Look Like?
At the beginning of your considerations is the question of what the structure of the financing should look like. You have to decide how much equity is chosen and how high the loan share. Of course, the choice also largely depends on the profitability of the property, and your target to get a maximum return of money. I want to deepen these considerations in the following sections, focusing on two aspects of particular importance to the Bank, the ability to service the capital and the value of the property.
Capacity of The Property
|Total acquisition costs for a rental home:||€ 500.000|
|Net rental income p.a .:||€ 35.000|
|Management costs p.a .:||€ 7.000|
|=> maximum capital service p.a.||€ 28.000|
What is the maximum loan portion if the loan interest rate is 2.5% p.a. and, in addition, repayment of 2.5% per annum is to be made?
We can calculate the maximum eligible loan share as follows:
Maximum capital service p.a / (interest + amortization) = maximum loan amount
In the concrete example, the following calculation results:
€ 28.000 / (2,5 % + 2,5 %) = € 560.000
From this calculation, you can see that the rental income could even finance a higher loan amount than the total investment cost. But that does not mean that you would receive 100% loan financing from the bank without any problems and should strive to do so. It would be too risky if rental income was just enough for running costs and debt service. It is necessary to include a safety buffer so that you do not run into difficulties when major maintenance is required or when there is a vacancy in individual apartments. Your bank will insist on that too. And for good reasons.
Mortgage Lending Value of The Property
The amount of the loan interest rate depends not only on the current situation on the financial markets but also on the recoverability of the property that is to be financed. The exploitation of the so-called mortgage lending value of the property plays a major role.
The mortgage lending value is the value which experience has shown that it is probable that the relevant real estate market will be reliably realized over the entire term of the loan on the relevant real estate market, irrespective of temporary, cyclical fluctuations in value. The mortgage lending value is below the market value and is determined by corresponding deductions from the market value.
A maximum percentage of the fixed mortgage lending value is borrowed from the bank, which is referred to as the lending limit. The lending limit is usually between 60% and 80% of the mortgage lending value, depending on the risk appetite of the bank. The higher the utilization of the mortgage lending value with a credit allocation, the greater the risk for the bank to be unable to fully repatriate the loan from the realization of the property.
Therefore, the loan interest rate becomes higher if the mortgage lending value is increased by a larger amount. For this reason, all banks ask for information on the purchase of a loan offer for a real estate purchase from which the mortgage lending value can be calculated. If the borrower has a particularly good credit rating, the mortgage lending limit can also be exceeded.
Determination of The Financing Structure
From the above considerations, there is again the need to fill a funding gap between the maximum loan share accepted by the bank and the acquisition cost of the property with equity. These relationships determine the relevant criteria for a good financing structure. One could formally summarize that the ratio of loan share to equity ratio must be balanced: as little equity as possible, but as much as necessary. How much equity is now “necessary”?
Ultimately, the calculation of the maximum financing portion of the rental income that can be financed has the insight that it provides a picture of the ratio of available cash flow for the debt service to the maximum amount of loan that can be financed. If this calculation leads to a value that is lower than the acquisition cost, then 100% financing with a loan is not possible purely arithmetically. The missing amount would necessarily have to be covered by equity. When deciding on the amount of the loan and the equity interest, these relationships should therefore first be taken into account. A reasonable compromise should be found that avoids both the risk of financial bottlenecks and over-capitalization.
The best way to approach a well-balanced financing structure is to carry out calculations with different levels of lending. The free cash flow after servicing management costs and debt service and the return on equity should be calculated for each case. Calculate e.g. Simply these two values with an equity ratio of 50% and 80% and look at the results. These calculations can be made using the calculation tool.
Since this figure also depends on the loan interest rate as a significant size, such calculations should be refined after consultation with the bank. Because the bank will make the amount of the loan interest rate also depends on the risk. This means that a very high proportion of loan leads to a higher loan interest rate and vice versa.
When you have finally determined the amount of the loan share, you can get concrete offers for loan financing. Which forms of loans there are and which providers are represented in the market.