Today, we’re looking at the six major ways you can find capital to go out and invest in real estate. Joining me is Your Castle Real Estate and Ironton Capital founder Lon Welsh. As an investor for over 20 years, Lon is well-versed in the different ways to get funds to invest.
- Listen to the podcast “#405: Don’t Let Your Equity Just Sit There: 6 Ways to Find Money to Invest in Real Estate” Denver Real Estate Investing Podcast
- Watch the YouTube video (at the bottom).
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
How Do I Make Money Investing in Real Estate?
Before we dive into finding money, we want to take a step back and look at the four ways you make money in real estate. Maximizing your returns in real estate is important for long term wealth, but it’s also a way to keep investing in real estate, too.
To understand these calculations, we’re going to use a long term rental house as an example. This is one of the most common ways people invest. The landlord collects the rents, which forms the Net Operating Income (NOI), then subtract from the NOI the monthly mortgage payments and other expenses to get the cash flow.
But remember, cash flow isn’t the only way to make money in real estate. You also build wealth through: appreciation, or the increase of the home’s value over time; loan paydown, which your tenant chips away at with their monthly rental payments; and depreciation, which is probably the least understood factor.
Depreciation is like an interest free loan from the government. Your CPA can calculate it for you. It’s the portion you’re allowed to write off of the entire property’s value every year. From the IRS’s standpoint, it’s a real expense that reduces taxable income for the year.
You’ll have to give that write off back when you sell the property, but you get to use it for free the entire time you own it. You can even postpone the payment if you use a 1031 exchange. If you own the home when you die, your kids will inherit it at its current value, which reduces their tax liability.
It’s important to understand these factors in-depth so you can see how to maximize those returns and reach your ultimate wealth-building goals.
Six Ways to Find Capital to Invest in Real Estate
There are six major ways that investors get capital to use in real estate. Some of these methods have borrowing costs associated with them, so remember to calculate those costs to see what makes the most sense for you.
1. Use the Cash You Already Have
This can be funds in a bank or money market account, or just cash you have. It’s pretty straightforward, and there aren’t any borrowing costs.
Keep in mind: there’s an opportunity cost when it comes to spending money, and as we likely head into a recession, it’s important to have cash reserves. Lon recommends at least six months of living expenses, or even a year’s worth to be conservative.
2. and 3. Pulling Cash out of Your Primary or Rental Property
There are two ways to pull money out of your properties, so we’re lumping them together. You can either do a cash out refinance or a Home Equity Line of Credit (HELOC). There are a lot of nuances that will make one better than the other for your situation, so make sure to talk to your lender.
When you have equity just sitting in a property, it’s called dead equity. Imagine that you bought a house for $200K, and now it’s worth $500K; that means you have about $350K in equity. It’s great to have that kind of appreciation, but if you’re not using it, then it’s not helping you build wealth.
You can use that equity to invest in another property and start making returns. However, both refinancing and HELOCs have borrowing costs. Before you pull out any money, make sure you understand what the combined mortgage payments of these actions would be. Make sure you have enough money left over to account for vacancy and maintenance issues, and if you’re too close for comfort, you can always pull out less cash.
4. and 5. Self-Directed or Roth IRA
A self-directed retirement account is different from a standard, employer funded 401K or IRA. With a self-directed IRA, you can do anything you want with the money in the account and don’t have to wait to pull out the cash.
One thing to keep in mind is that if you use a self-directed IRA to invest in real estate, you’ll have debt associated with them, known as Unaffiliated Business Taxable Income (UBTI) that you’ll need to pay. While it’s usually not a big deal, it’s something you need to be aware of.
Using these accounts to invest in real estate is a great way to get better returns than the stock market, and they can be used for both active and passive investing.
Again, this is a complex topic, so reach out to Lon or me with any questions.
6. Equity Equalization Loan
This allows you to extract cash while executing a 1031 exchange. When you use a 1031 exchange to buy a new property, it needs to be the same or higher value as the one you’re selling. A common trap Lon sees is that investors will put all of their equity into the new property, which will lessen their overall returns.
To make better use of that money, you can refinance right before selling, or do an equity equalization loan at the time of closing. With this loan, your qualified intermediary will put a second mortgage against the property for the amount you want to receive in cash. Once you close on the old property and purchase the new one, you’ll get back the amount of the loan. This is considered a tax free event, allowing you to keep all of the cash.
Figure Out the Right Move for You
There’s no one size fits all approach to real estate investing or wealth building. Think of it as a big chess game: individual moves will form your overall strategy. If you need help figuring out your next move, reach out to me for a free consultation.