How Much Down Payment is Needed in a Real Estate Transaction?
By Cliff Hockley, President
Bluestone and Hockley Real Estate Services
Executive Director, SVN | Bluestone and Hockley
How does an investor decide how much down payment is needed? There are many answers to this question – but most importantly a real estate investor needs to balance their investment strategies, risk management, financial institution lending requirements, and cash in the bank to decide on the appropriate amount of leverage in a deal.
Investment Strategies and Risk management
Individual real estate investors typically want to use the least amount of their cash to buy an asset (20 – 30 %) and borrow the rest from a financial institution like a bank, savings and loan, credit union, insurance company or a hard money lender.
Experienced investors with significant cash and real estate holdings may put 40 – 50 % down on a deal to ensure that they can resist future economic downturns. Often as investors mature and reach their financial goals, they typically become more risk adverse and will tend to invest in deals that may require a higher down payment to protect them from potential risk.
Some investors buy with 100 % cash, (like REIT Pension funds or insurance companies) because they have the cash and they don’t want to deal with paying interest to a financial institution. This may seem a very conservative stance, yet if you have the money and want to reduce your risk, it’s a strategy that works and increases your return.
Investors must understand the local market they are buying in before they make the decision to purchase an investment – bearing in mind that some markets enjoy sustained economic growth, and some do not. In some states, counties, or cities there is no economic momentum, and the value of the real estate may not grow exponentially over time -like a town with one factory that drives 50% of the local economy. In that case, financial institutions may require a higher down payment, a faster amortization, or possibly a higher interest rate to account for the risk they are taking. Even though there might be a greater risk, , an investor may choose a risky third or fourth tier market, because the CAP rates (return) in those markets may be higher, and therefore drive a greater cash flow to their pockets.
Cash Down Payment
The vast majority of real estate investors in the United States are limited by the amount of cash they have to bring to the table to close a deal.
They look for help in raising money to buy a real estate asset in a variety of ways:
- They save money until they have enough for a down payment
- They invest with partners that bring money to the table
- They are selling an asset and using the funds from the deal (with or without a 1031 exchange) as down payment
- They refinance an existing asset (business or real estate) to raise the money
- Mom, Dad, or the grandparents lend the investor money for the down payment
- Other: You fill in x, y, z, or see a list of possible options on this website
The amount of cash an investor can raise typically will equal the down payment, reserves, due diligence and closing costs that will be necessary to close a deal. The benefit of sharing a deal with other investors is that you do not have to bring as much money to the deal up front, and when the time comes to sell you can either trade up to another investment together, or you can exit in your own LLC to buy your next property (call your CPA and Attorney at least one year ahead to structure potential exit options.)
Financial institutions tend to set standards ranging from 20 – 30 percent down with debt coverage ratios in the 1.20 to 1.35 range. They also set standards for investor global net worth and stress test deals at higher interest and debt coverage rates to insure they aren’t at risk as interest rates increase. It is not unusual for a financial institution to quote one rate to get you to the table and adjust the deal to increase the amount of down payment you must pay from say 30% to 35%-40%.
As a sophisticated real estate investor, you will want to align yourself with a Mortgage Banker that brings you multiple financing offers and gives you a chance to review and choose the best deal for your particular situation. In a recent transaction one bank offered the following terms:
Up to 70% LTV of Appraised Value (Opus Bank ordered 3rd party appraisal)
|30 years (with a 30/360 day payment calculation)|
|10 years (PPP terms for each product below)|
4.90% fixed for 3 years and then would adjust on a 6 month LIBOR thereafter with a margin of 2.45% for the remainder of the loan term; so a fully indexed rate today of about 5.00%.
4.95% fixed for 5 years and then would adjust on a 6 month LIBOR thereafter with a margin of 2.45% for the remainder of the loan term; so a fully indexed rate today of about 5.00%.
5.00% fixed for 5 years and then would adjust on a 6 month LIBOR thereafter with a margin of 2.45% for the remainder of the loan term; so a fully indexed rate today of about 5.00%.
5.15% fixed for 7 years and then would adjust on a 6 month LIBOR thereafter with a margin of 2.45% for the remainder of the loan term; so a fully indexed rate today of about 5.00%.
2 yrs. I/O is allowed with a 12.5bp increase to the rates quoted above, so long as we are at or under 65% LTV, if 66-70% LTV; then just 1 yr. I/O is allowed with just a 7.5bp increase to the rates above.
Start rate is the floor and ceiling is 9.50%.
There is a stress rate of 5.45% at 1.30 DS on most loan types.
This is recourse pricing quoted above; for non-recourse you can add 10bp to all pricing above, as well the reset margin after fixed period goes from 2.45% to 2.60%.
|3 Yr. fixed||3-2-1%|
|4 Yr. fixed||3-2-1-1%|
|7 yr. fixed||3-2-2-1-0%
|Rate Locks:||60 day available for a 1% refundable deposit
|Processing Fee:||.10% of the loan amount (Min. $1,500/ Max. $5,000) + appraisal and enviro—no other 3rd party reports generally are needed.
|Tax Returns:||$2,500,000 need 2015 and 2016 personal tax returns for all sponsors + K-1’s-no LLC/Partnership returns.
|Documentation:||The following are not required in most cases: legal opinion, tax/insurance impounds, reserves for capital improvement, engineering report, and seismic/PML report; earthquake insurance.
As you can see from this summary they start at 70% loan to value rate and stress test at a debt coverage rate of 1.30. This demonstrates the desire for the Bank to reduce their risk. This bank also limits itself to closing deals in metropolitan areas of at least 250,000 inhabitants – no small-town loans for this bank.
There is no one answer to how much down payment is needed to buy real estate. Every deal is
different and every investor has different needs. A good place to start though is to investigate what
market terms are being offered by financial institutions and use that as a starting place. Then you need
to work backward to include the banking and due diligence costs, and finally have them clarify if they
use a stress test and how they would apply it to your deal.
Typically, you also will want to include some cash reserves in your deal, because not all real estate deals
turn out the way you expect. The roof could be leaking, the foundation has slipped, your property is
in a tsunami zone, or the tenants might not be credit worthy – or ultimately everything could work out perfectly. Bottom line – plan ahead so you will be ready with your down payment when the right deal comes along.