financing techniques and sources

MAKERERE UNIVERSITY

COLLEGE OF ENGINEERING, DESIGN, ART AND TECHOLOGY

SCHOOL OF THE BUILT ENVIRONMENT

DEPARTMENT OF CONSTRUCTION ECONOMICS AND MANAGEMENT

BSC. LAND ECONOMICS YEAR 3

LECTURER: Ms. MWANJE NASSIR

COURSE UNIT: REAL ESTATE FINANCE AND TAXATION

ASSIGNMENT#1

NAME MUWONGE RAPHAEL

REGISTRATION NUMBER 12/U/719

STUDENT’S NUMBER 212000124

SIGNATURE

QUESTIONS;

Discuss the different property/ real estate funding techniques or options.

Critically examine the different sources of real estate finance.

March 25, 2015

REAL ESTATE FINANCE AND TAXATION 1

Introduction

One of the most important aspects to investing in real estate is how you finance your property.

Although all other factors may look favourable, having no or little access to good terms could be

a deal breaker. Therefore, before doing anything else, it is important that you begin to line up some

potential sources and explore what options are available for you.

Meaning of the key terms used

Real estate; according to Wikipedia, Real estate is "property consisting of land and the

buildings on it, along with its natural resources such as crops, minerals, or water;

immovable property of this nature; an interest vested in this (also) an item of real property;

(more generally) buildings or housing in general.

Funding; according to Wikipedia, Funding refers to the act of providing

financial resources, usually in the form of money, or other values such as effort or time, to

finance a need, program, and project, usually by an individual, organization or government.

Generally, this word is used when a firm uses its internal reserves to satisfy its necessity

for cash, while the term ‘financing ‘ is used when the firms acquires capital from external

sources.

Techniques; according to businessdictionary.com, a technique is a systematic procedure,

formula, or routine by which a task is accomplished.

Sources; according to dictionary.com, a source is a place, person, or thing from which

something comes, arises or can be obtained.

Real estate finance; real estate finance generally means financial transactions in which

complex techniques are applied to the underlying real estate. Finance and real estate are

intertwined in such practice area.

According to “Real Estate Principles for the New Economy” by Norman G. Miller and

David M. Geltner; Real estate finance is traditionally the process of borrowing or lending,

most often involving a third party that is neither the buyer nor seller of the property in

question.

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Real estate funding techniques or options

When a classic investor thinks about real estate financing, this person must most likely be having

a defined set of techniques, thus whether you are looking to upgrade your current home, buy your

first home or start buying rental properties, you need to be savvy when it comes to financing.

There are mainly two real estate funding techniques or options that’s to say; the traditional and

non-traditional (creative financing). These are explained below;

1. Traditional

This is taken through banks, credit unions and other home mortgage companies and is a great way

right now to finance real estate. If one of your strategies is to buy, hold and rent, then using banks

may be a safe bet for some of your investment properties.

This is a source that can be considered up front when a property is in considerably good condition.

Most traditional lenders or banks have tightened their lending criteria. This way of financing a real

estate investment really is the most traditional, safe and well-known method.

Most banks will not support the financing of a fixer upper until repairs are completed, due to the

amount of risk involved. Therefore, you may need to spend a little extra time searching for those

diamonds in the rough.

Traditional financing is extremely favorable, because you can usually get some of the best interest

rates, terms and closing costs when approved. The process certainly will take longer than using

cash buyers or hard money lending for example, but it can be worth the wait.

Some examples of loans

Construction loans; these are also referred to as interim financing. A construction mortgage

provides the funds necessary for the building or construction of a real estate project. The

project can be a residential subdivision, a shopping center, an industrial park or any other

type of property requiring financing during the time required to complete construction.

Normally, the full amount to be loaned is committed by the lender, but the actual

disbursement of the loan is dependent upon the progress of the construction. Funds are

sometimes distributed to the borrower in a series of draws, depending upon the work

required by the lender.

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Since construction mortgages are considered high risk loans, a lender often requires a

standby or take out commitment from a permanent lender. A standby or take out

commitment means that another lender will provide permanent financing when a certain

event, generally the completion of the project, occurs. This assures the construction lender

that permanent financing will be available to repay the construction loan if the project is

completed and other conditions are met. Sometimes, permanent lenders require a certain

percentage of a project to be rented before the financing is provided.

Permanent loans; this is used to repay the construction loan. Whereas a construction loan

is typically short term, permanent financing normally covers 10 years or more. Permanent

financing will either be fully or partially amortized through periodic mortgage payments.

Since the payment will be paid from the income generated from the project, the lender can

make the amount borrowed contingent upon a certain amount of the available space being

leased prior to closing the loan transaction. For instance, the developer of a shopping center

might be able to borrow $2,000,000 if 80% of the available space is leased. This could

result in a gap in the capital needed for financing.

Gap financing; Gap financing often covers a shorter period of time than permanent

financing and usually at a substantially higher interest rate. First of all, it is a junior

mortgage, which means the lender does not have the same lien position as the permanent

lender; second, there is more risk involved. Normally, different types of financing are used.

2. Creative funding techniques

In real estate these refer to the non-traditional or uncommon means of buying land or property.

The essence behind creative financing is generally to purchase, or finance a property, with the

buyer/investor using as little of his own money as possible, otherwise known as leveraging, OPM

(Other People's Money). By using these techniques an investor may be able to purchase multiple

properties using little, or none, of his "own money".

Whether you're a first-time homebuyer, a repeat buyer or an investor, you might have reasons why

you don't want to or can't obtain a traditional mortgage. Maybe lenders don't see you as being in

ideal financial health because of a foreclosure or bankruptcy in your credit history or maybe you

have plenty of assets in the bank but can't show sufficient monthly cash flow to convince a lender

that you will be able to make the monthly payments or perhaps you're a small business owner with

irregular income.

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Whatever the reason, there are other ways to finance real estate in case a loan from your bank isn't

going to meet your needs and these include;

Subject-to; a subject-to transaction is a creative financing technique where a buyer is able

to take title to property without obtaining a loan in the traditional manner.

It is a great way to finance a real estate investment quickly, though it will be a short-term

solution.

The name "subject-to" comes from the phrase "subject to existing financing." This means

that you buy the property on the condition that the existing financing stay in place. The

title is transferred, but the loan will stay in the seller's name, and the buyer will make the

payments.

The reason why this is a short-term fix is because sellers aren't going to be very comfortable

leaving the loan in their name for an extended period of time. Savvy buyers will use this

method when they don't want to come up with a down payment, knowing they can

refinance in six months and get the loan put in their name.

This process is similar to assuming a loan, but differs because it usually takes place without

the consent of the original lending institution and violates the terms of the loan. This

technique is useful because it affords the buyer the ability to obtain financing without the

need for transaction costs and does not tie up capital to obtain a new loan.

This technique also allows the buyer to purchase property quickly without going through

the arduous loan origination process. This method is commonly used when buying pre-

foreclosure properties. The buyer gets into the property with zero down, and the seller is

willing because they have to get rid of the property immediately. If you use this method to

finance a real estate investment, just make sure you uphold your end and make the

payments on time.

Lease Option; a lease option is also known a rent-to-own arrangement or lease to own or

lease to buy. It allows a homebuyer to rent a property for a specified initial term with an

option to buy the property at the end of that term. Monthly rent payments are generally

higher than market price, with the surplus going toward a future down payment. If the

buyer opts not to purchase the property, the extra rent is forfeited.

Renting to own can be a good option for homeowners who aren't quite financially ready to

buy but expect to be within the next three years. Perhaps they need time to amass savings

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and/or improve their credit score enough to qualify for a loan. Renting to own can also be

attractive to individuals who are not sure if they will be moving in the next few years and

want to keep their options open.

Seller second mortgages; this way to finance a real estate investment is extremely useful

and used often. The "seller second" means that the seller provides a second mortgage. If

the buyer can obtain a loan, but not for the full price of the property, sometimes a seller

second mortgage is what is needed to make the transaction possible.

In this case, the bank mortgage pays the seller for the bulk of the amount owed (for example

80 percent), and the seller deeds the property to the purchaser in exchange for a promissory

note for the amount of the balance remaining (in this example 20 percent).

Seller carry back; this is a form of owner-financing, the seller of the property agrees to

finance the property outright. They transfer the title to you in exchange for a promissory

note and deed of trust for the full purchase price of the property. This will happen when

you find a seller that owns his/her property free and clear.

That’s they don’t want the property anymore, and don’t mind receiving a monthly payment

on it. Most of the time, however, the seller will place a time limit for when the note must

be paid in full typically, between one and five years. This is a great way to finance a real

estate investment as long as you realize you’ll need to refinance later. Remember: It's easier

to qualify for a refinance loan than a purchase loan.

Contract for deed; this similar to seller carry-back, a contract for deed is another method

of owner- financing. The difference under a contract for deed is that the seller retains title

to the property until the mortgage has been paid in full.

Private mortgages; a private mortgage is a loan secured for real estate that is made by a

private lender, instead of a traditional lender, financial institution, or government

institution. These loans are most commonly short term and last anywhere from 6 months

to three years. These are asset based loans made for the purchase and rehabilitation of real

estate.

Because the loans are asset based, the decision to lend is based on the criteria of the

property and not usually the qualifications, or credit of the borrower thus this creative

mortgage technique allows more borrowers to qualify for a loan.

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Interest rates on these loans are considerably higher than traditional loans. Loans are made

on an LTV (loan to value) of 65% to 70%, to preserve sufficient equity in the property for

the private lender in the event of default.

Short-sale; under this the seller is often several payments behind and may even be close

to foreclosure, the seller can also show significant hardships that have led them to being

unable to continue making payments on this property. The seller will give the short sale

investor a contract to purchase the property, a deed that will probably be placed in escrow,

power of attorney and a number of other documents that will give them full control of the

property. The investor will then present a case to the bank holding the mortgage, that the

seller is no longer able to make payments, is having to relinquish control of the property

and that the loan on the property must be reduced in order for the investor to purchase the

property.

The term "short sale" is a misnomer because it has nothing to do with shorting anything in

the financial sense. These transactions can also take a significant amount of time so it is

not called a "short sale" for that reason either. However, the process is shorter than the

traditional process of going through foreclosure and sale by auction, which is still likely to

take much longer.

Borrowing from a Self-Directed Individual Retirement Accounts (IRA); this is also a

great creative financing option. Most retirement accounts will allow you to borrow from

yourself and repay the funds over time at a low interest rate.

Interest-only loans; if you are an investor looking to purchase, rehab, and sell a property

quickly, an interest-only loan may make sense. This financing allows you to make small

payments at the beginning of the loan, leaving more money for renovations. When you sell

the property for a profit, you can pay off the loan in full, having paid only a small amount

of interest.

Options; an option is defined as the right to buy a property for a specified price (strike

price) during a specified period of time. An owner of a property may sell an option for

someone to buy it on or before a future date at a predetermined price.

The buyer of the option hopes the value of the property will either go up or is already low.

The seller receives a premium called "option consideration". The buyer may then either

REAL ESTATE FINANCE AND TAXATION 7

exercise the option by buying the property or sell the option to someone else to exercise

(or sell).

This is often done to obtain control over a property without much cash. Option premiums

are typically non-refundable. The option represents an equitable interest in the property

and may be recorded at the county recorder’s office. Note- if a Seller won’t let you buy a

property “Subject to their loan”, they often times will have no problem giving you a short

term option on it. I call this “Sub to financing in disguise”.

Borrowing from your whole life policy; a whole life insurance policy is one that

accumulates cash value over time as you make your regular premium payments and earn

dividends and interest. It's possible to borrow against this cash value, and when you borrow

from your own whole life insurance policy, there is no loan qualification process. While

such a strategy increases your borrowing potential, it reduces the face value of the policy

if not paid back.

Peer-to-peer lending; these are loans made between individuals, usually through a third-

party such as an online micro-lender.

Loans from family and friends; friends and family may be willing to invest in your real

estate in the form of personal loans thus you finance your property using funds borrowed

from your friends and relatives.

Assume payments; if you can find a seller who needs to sell a property quickly and has

financing in place, you can assume the seller's payments, often with little or no down

payment.

Hard money loans (HML); these are similar to private mortgages except that they are

made through a hard money lender. A hard money lender may get his financing either from

his own contacts with private lenders, or financial institutions with whom he has

established his own lines of credit. Hard money loans are made to real estate investors for

the purpose of investing in and rehabbing real estate. Rates are a little higher than

borrowing directly from a private lender, as the hard money lender may also be collecting

yield spread.

Use a Credit Partner; this means you may have to share the equity that is created in the

property with a Credit partner/investor who will bring in the down payment and/or obtain

a new loan on the property. You will put the deal together and oversee the project. This

REAL ESTATE FINANCE AND TAXATION 8

sometimes may be cheaper than hard money. Someone may let you do this for just a small

fee, which makes this a great source of cheap money. Note: Remember to always pick your

partner(s) carefully and always put everything in writing.

Land trust; this is an agreement whereby one party (the trustee) agrees to hold ownership

of a piece of real property for the benefit of another party (the beneficiary). Land trusts are

used by non-profit organizations to hold conservation easements, by corporations and

investment groups to compile large tracts of land, and by individuals to keep their real

estate ownership private, avoid probate and provide several other benefits.

Sources of real estate finance

Seasoned real estate investors are well versed on the traditional sources of funds available for

buying property. But if you’re new to real estate investing or have only purchased property as your

primary residence, the landscape looks a little different. Unless you’re prepared to pay all cash,

which more and more investors are, and which some properties require, you’ll need a mortgage to

finance your investment, just as you would your own home. Since such a small percentage of the

purchase price of real estate is normally provided from the savings of the purchaser, available

sources of funds need to be known to anyone desiring to purchase real estate. The following are

the sources of real estate finance;

1) Commercial Banks

This is a type of bank that provides services such as accepting deposits, making business loans,

and offering basic investment products.

Usually commercial banks are a good place to start your search to finance an investment property.

Commercial banks issue more mortgage loans than any other source. But don’t assume your bank

is going to give you a special deal simply because you have a debit card from them. Its rates might

in fact be higher.

2) Personal savings

This is also known as owner funding, it applies where an investor has enough money to run the

project through to completion. This is a very rare scenario and mostly happens to projects of

smaller scale that do not require heavy capital outlay and also common among developers who

have been in the industry for a longer time. It is important for the developer to come up with a

REAL ESTATE FINANCE AND TAXATION 9

development budget for the project so as to be certain that he/she has enough capital to complete

the project. Once he has come up with a budget it is also important to develop a cash flow which

allocates the finances to the different activities and phases of the project.

This method has no huge expenses in terms of cost of finances and is therefore very profitable.

3) Life Insurance Companies

Insurance companies play an important role as providers of capital for real estate from an equity

(owner) standpoint. Insurance companies typically do their lending through local correspondents,

either mortgage brokers or mortgage bankers. Insurance companies normally specialize in large-

scale projects and mortgage packages.

Insurance companies receive their money through the payment of premiums by their policyholders

and since both the inflow of premiums and the outflow of claim payments can be predicted with

reasonable accuracy, insurance companies are able to invest in those assets yielding higher returns

but less liquidity than is available to either banks or associations.

4) Credit Unions

These are member-owned financial cooperative, democratically controlled by their members, and

operated for the purpose of promoting thrift, providing credit at competitive rates, and providing

other financial services to their members. These are cooperative financial institutions which are

organized by people who share a common bond, for example employees of a company, labor

union, or religious group.

Some credit unions offer home loans in addition to other financial services. While the majority of

loans made by credit unions are consumer loans, some credit unions provide mortgage money for

both residential and non-residential financing. In addition to permanent loans, credit unions also

make home improvement loans directly to depositors. Credit unions normally use mortgage

brokers to locate real estate investments for their portfolios.

5) Mortgage Bankers

Mortgage banks only do one thing, they originate mortgage loans, using their own funds or funds

borrowed from a warehouse lender. A mortgage banker handles the entire mortgage transaction,

including accepting the initial application, approving the loan and providing the funds for the

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mortgage. This can be advantageous for the investor because the loan doesn’t have to be sent to a

third-party for review.

6) Mortgage Brokers

Mortgage brokers usually offer the same programs as a mortgage banker or a commercial bank.

They originate mortgage loans, and then send the application to a wholesale lender for approval.

Brokers don’t approve the loan, nor do they use their own funds to provide financing. A broker

can be approved with multiple wholesale lenders, so he or she can shop around for the best rate or

send the loan to a lender who can approve a loan that another can’t.

Brokers keep lists of lenders with whom they do business; each lender may have unique loan

guidelines when it comes to credit scores or other requirements. Brokers can also send loans to

lenders that are offering better rates or lower closing costs. However, the broker loses control of

the loan application once it’s forwarded to a lender for approval. That’s something to consider if

your loan needs some sort of special attention or waiver.

7) Joint Venture Partnership

A Joint Venture is a partnership in which people decide to pull resources together. In most cases

one person has the land while the other person has money.

A Joint Venture works whereby a land owner does not have the requisite funding enabling him

obtain financing from a bank. In most cases, banks require that the land owner fund approximately

30% of the total cost of the project including land and consultancy fees.

Where the cost of land is less than 30% of the total costs, banks require that the land owner top up

the difference either using cash or construction input till foundation stage. This top up is what lacks

to most land owners. Joint Venture partners come in to assist the land owner reach the required

bank minimum of 30% contribution by the land owner.

Another way a Joint Venture works, the Land owner contributes the land as part of his/her

contribution, then the Financier contributes finances for construction. The profits are then split on

a pre-agreed ratio with the land owner usually getting over 50% of the net profits.

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In the joint venture agreement a Special Purpose Vehicle (SPV) has to be formed. An SPV is a

company owned jointly by the financier and the Land Owner. The land ownership is now

transferred to the SPV.

8) Contractor financed

This is another form of Joint Venture but in this case the joint venture partner is the contractor who

will be given the work of construction. The developer enters into an arrangement with the

contractor such that the contractor agrees to do the works and receive payment at the end of the

project. Just like a Joint Venture a Special Purpose Vehicle is created.

9) Syndications

A group of investors that fund real estate or other projects in return for a percentage of the profits,

or can be paid a set return on their initial loan, etc.

10) Savings and Loan Associations

While savings and loan associations (S&Ls) are not the largest financial intermediary in terms of

total assets, they are the most important source of funds in terms of money made available for

financing real estate. Traditionally, they have been the largest supplier of single-family owner-

occupied residential permanent financing, although S&Ls are not limited solely to this type of

financing. Savings and loan associations also make home-improvement loans and loans to

investors for apartments, industrial property and commercial real estate.

11) Pre-sales/Off-plan sales

This source of financing is common in real estate developments that are fast moving commonly

referred to as ‘hot cake’. In this method the developer seeks to sell the property before actual

construction starts on site. The developer normally gives incentives to early buyers who buy the

property off-plans by giving a discount from the actual cost. The developer can say decide to sell

the property at 15% off the cost it would have cost if buying when complete. Through this way the

developer gets money in advance which uses to finance the construction.

12) Pension Funds

Pension funds are one of the newer sources available for financing real estate. Whereas these funds

historically were invested in stocks and bonds, the recent growth of pension funds has meant new

outlets had to be found for their investments. This growth, plus the favorable yield available

REAL ESTATE FINANCE AND TAXATION 12

through real estate investments, has resulted in active participation in financing real estate projects.

Besides making mortgage loans, pension funds also own real estate. The majority of all their real

estate activity is done through mortgage bankers and mortgage brokers.

13) Mutual Savings Banks

Mutual savings banks are an important supplier of real estate financing. As their name indicates,

these banks are owned by their depositors, who receive interest on their deposits.

All mutual savings banks are state chartered and typically are less regulated than their closest

financing relative, the savings and loan association. Most mutual banks have a relatively larger

percentage of their mortgage. Mutual banks also make personal loans which can result in capital

being moved from surplus areas to deficit areas.

14) Real Estate Investment Trust (REIT)

REITs pool the money of many investors for the purchase of real estate, much as mutual funds do

with stocks and bonds. There are three types of REITs. An equity trust invests their assets in

acquiring ownership in real estate. Their income is mainly derived from rental on the property. A

mortgage trust invests in acquiring short term or long term mortgages. Their income is derived

from the interest they obtain from their investment portfolio. A combination trust combines the

features of both the equity trust and the mortgage trust. Their income comes from rentals, interest,

and loan placement fees.

15) Finance Companies

Traditionally, finance companies have provided consumer loans for the purchase of both durable

and non-durable goods. However, as commercial banks have become more and more involved in

personal loans, finance companies have turned to other forms of investment including real estate

mortgages. In residential real estate, finance companies are actively engaged in second mortgages.

This type of mortgage is usually made at an interest rate four or more percentage points above the

rate on first mortgages and is amortized over a much shorter time period. Some of the larger finance

companies such as those owned by the automobile manufacturers finance land development,

provide commercial gap financing, acquire land leaseback and enter into joint ventures with real

estate developers.

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16) Individual Investors

There are a number of large investors located throughout the United States who constantly lend

money on real estate. These investors include individuals with available funds, groups of investors

seeking mortgage ownership and large investment companies desiring to hold a diversified

portfolio. They deal both direct and through mortgage brokers. Additionally, many of these

investors seek to take an equity position in real estate. It is thus possible to raise equity capital

through syndication instead of relying solely on mortgage funds.

17) Foreign Funds

This refers to the foreign capital that is invested in the real estate sector thereby taken as the form

of real estate equity capital.

Other sources mainly in the United States include;

Federal National Mortgage Association (Fannie Mae)

Off Shore funding

Farmers Home Administration (FMHA)

Government National Mortgage Association (Ginnie Mae)

Federal Home Loan Mortgage Corporation (Freddie Mac)

Common real estate finance sources in Uganda

According to Shelter and Settlement Alternative: Uganda Human Settlements Network, the sources

of housing finance in Uganda include;

Commercial Banks such as DFCU Bank, Post Bank, Housing Finance Bank, Centenary

Bank among others

Housing micro-finance; this is through Micro Finance Deposit taking Institutions (MDIs),

Micro Finance Institutions (MFIs), Savings and Credit Cooperatives (SACCOs) and other

support programs.

The Cash Loans Approach; Uganda Micro Finance Limited (UML) is the only Micro-

finance Deposit Taking institutions (MDI) directly offering loans to the housing industry.

Other initiatives in the pipeline include the introduction of housing micro-finance products

in Micro Finance Institutions (MFIs) by two Non-Governmental Organizations

(NGOs).These are Stromme Foundation and Habitat for Humanity Uganda (HFHU).

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Community Self-Help Projects; Four self-help projects have been undertaken in Uganda

to provide low-cost housing for the poor. They have all had a Public-Private approach and

donor support.

Non-Conventional Housing Finance; this is through rotating credit societies, saving clubs

and Savings and Credit Cooperatives (SACCOs) which are under the Ugandan

Government’s program of “Prosperity for All”, the poor (who are unable to access the

above means of housing finance) have been able to finance small scale businesses and in

some cases they have enabled the construction of houses.

Personal financing; this includes three components that is to say; self-financing from

personal savings, contributions from family and remittances and finance from extended

from social security sources (such as pension, gratuity, medical benefits) and contributions

from saving groups/ Savings and Credit Cooperatives (SACCOs).

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References

Finance in Real estate slide share by Manish Nagori

Megan Dorsey, David Rockwell; Finance Residential Real Estate, 18th Edition; Rockwell

Publishing.

Real Estate principles for the new economy by Norman G. Miller and David M. Geltner

Financing Basics for first time home buyers by Robert Stammers

Real Estate Development: The future of funding; Berwin Leighton Paisner

www.investopedia.com/articles/mortgages-real-estate/08/homebuyer-financing-

option.asp

en.wikipedia.org/wiki/Real_estate_economics

http://financial-dictionary.thefreedictionary.com/real+estate

http://creativerealestateinvestingguide.com/2013/03/12/ten-no-money-down-techniques-

to-buy-real-estate/

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finance-uganda&catid=83&Itemid=296#cb

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