Real estate investing has long been popular with self-directed investors. The only trouble is that real estate investing often involves a large outlay of cash. Perhaps you don’t have enough cash in your retirement to complete a deal. Or maybe you want to spread your funds among a few deals instead of sinking all your cash into one property. Fortunately, the Solo 401k plan allow you to use leverage via a non-recourse loan. This means you can get a mortgage or financing to make your dollars go father with your investments.
You’re probably familiar with traditional mortgage financing. You find a property you like, you go to the bank, you apply for a loan. You have to produce income stubs, credit checks and sign a personal guarantee that you’ll make the loan payments.
Retirement accounts use a different type of mortgage financing called a non-recourse loan. Non-recourse loans collateralize the property, not you.This type of deal typically involves more risk for the lender. Therefore, the down payment on a non-recourse loan is usually higher. Typically, the lender will want 40-50% down and will lend the remaining 50-60% to the borrower. If there’s a default on the loan, the property is taken but the other assets in the Solo 401k, and assets outside the retirement account are not affected.
Non-recourse lenders can be a traditional bank or private lender. The property is owned by the Solo 401k trust and there is no personal guarantee signed by you (no credit check, no income stubs).
Because you’re only using retirement funds, you cannot supplement the deal with any personal money.
In a non-recourse loan, the underwriter is underwriting the property, not the borrower. The underwriter wants to see a good deal, with strong cash flow. This lessens the risk for the lender. Using non-recourse loans to leverage a property can be very advantageous to the investor.
Let’s compare a deal with and without non-recourse leverage.
Example 1: All Cash, No Leverage
If you are doing an all-cash deal, that means you must pay for the entirety of the property out of pocket. If you’re doing a cash deal with retirement funds, you cannot add any personal funds to the deal. That means you must have enough money in your Solo 401k before you buy the property. Here’s a review of the pros and cons of a cash deal with no leverage:
- No mortgage paperwork or processing delays
- Very little chance of negative cash flow
- Never worry about the property being underwater in a real estate downturn
- Put more money into less deals
If you have $200,000 in your Solo 401k and you want to buy a cash deal, you are limited to using that $200,000. That might mean you buy one property for $200k, or perhaps two properties at $100,000 each.
Example 2: Solo 401k Deal with Leverage
If you decided to use a Solo 401k non-recourse loan, you can often get more property for your dollar and maybe even build a bigger portfolio faster. Let’s review the pros and cons of using leverage with your retirement account to buy real estate:
- Higher quality property when using leverage
- Higher ROI over the long-term because quality of property is better
- Cash-flowing with rental income
- Ability to purchase more properties with same amount of cash
- You have to find deals worth leveraging
- You have to find a non-recourse lender
- Non-recourse lender should know how to title mortgage in the name of the 401k trust
Now let’s examine the same scenario we looked at with the cash deal. Your Solo 401k portfolio has about $200,000 in cash.
You can either buy one deal at $200k, or maybe two smaller deals at $100k each.
With leverage, you could invest $100k into two different houses, but instead of the house being worth $100,000 when buying cash, this house could be worth $250,000 when using leverage.That’s half a million dollars worth of property vs. $200k worth of houses when buying using only cash.
While the amount of equity starts out the same, the leveraged scenario can potentially offer more opportunities for greater profit. This is largely due to the value and quality of the property being higher in the Solo 401k non-recourse loan deal.