Recently, a client introduced me to a friend of theirs who is actively flipping 3-5 properties a month. We walked a property together, and she asked what our rate would be for a loan to purchase and rehab the property. I told her our rate was 10% and 2 points. She said it was more expensive than her private investors that only require an 8% return. I asked her to clarify the rate of return she was giving her investors; specifically, was it an annualized rate of return? She said it wasn’t: if she borrowed $100,000, she repaid her investor $108,000. I then asked her how long she usually held her flips – never more than 6 months, and usually only 3.
I didn’t realize it until later, but her cost of capital was higher at 8% than it would have been at 10% plus 2 points. Since the 10% loan is at an annual interest rate, the annual cost of capital is about 12% (adding in the points). This 10% loan, however, if paid back within 6 months, has a cost of capital equal to 7%. The money lent at an 8% rate of return on the other hand, has a consistent 8% cost of capital.
Looking at the graph below, it is easy to see the actual dollar amount paid for each of the two financing options.
While the 8% return ends up being less expensive at the end of 12 months, the 10% loan actually costs less if the holding period is 7 months or less.
For this investor, the actual numbers were the most telling. The property we were looking at was for sale for $250,000 and the rehab was $30,000. She ended up purchasing it that day with funds from her private investor. She sold it 110 days later. This cost her $22,400 to finance the deal. Had she gone with the 10% loan, her total financing expense would have been $14,038 ($8,438 interest + $5,600 points). By going with the lower number, it cost this investor over $8,000 of profit, increasing the total cost of the project by nearly 3%. When it comes to calculating the cost of capital, there are a lot of moving parts – it pays to know your numbers!
In the business of lending to professional real estate investors, we are often told by an investor that they aren't interested in our loan products because they are a 'cash-buyer.' This is how I used to think too. When I started in real estate investing, I used a small amount of money, bought my first house and used the profit I made off of it to buy the second, then third. I continued this process, buying in cash, then using the profits to buy more properties. This strategy worked well, except that it took time. After a few years, I turned a small investment into a small portfolio of rental properties. This was great, however, looking back I realized how much bigger my portfolio could have been had I leveraged my capital in the beginning.
Take, for example, a typical $100,000 single-family house in San Antonio. After $20,000 in rehab and expenses, on a good flip, the house should be worth at least $150,000. That $30,000 in profit equates to a Return on Investment of 20%. Say that the investor in this example had $120,000 in cash at the beginning of this flip. After three months (if all goes to plan), the investor will get their money back and have an extra $30,000 in the bank. If they then put their original investment back into another flip, they could do four houses a year and make a total of $120,000 in profit - an annual ROI of 100%! Not a bad return for an active real estate investment.
But what if in that same year, the investor had decided to leverage his original capital? That $120,000 could have been used as a 20% down-payment on five $100,000 houses that needed $20,000 in rehab. The return on each of those flips would have been slightly lower as the financing would have cost around $4,000, but would have still been a healthy $26,000, or 17.3%. However, since the investor was able to do this five times thanks to leverage, their profits would have been $130,000. If they were able to replicate that three more times in the year, as in the example of the cash buyer, they would net $520,000 for the year. Simply by using leverage to buy more houses, the investor would be able to increase their ROI to 433% annually!
The above examples make an interesting point about how investors should think about ROI. We often see investors that put too much emphasis on the cost of capital and how it affects the ROI of a project - in the previous examples, they would say the cash deal is better because it yields a 20% return instead of a 17.3% return - and they are absolutely right: the cash deal is better. However, what they often times fail to consider is that without unlimited funds at their disposal, it is important for a disciplined investor to look at the Return on Cash, a measurement of how hard your money is working. In the examples above, the cash buyer's ROC is the same as their ROI - 20%. However, for the leveraged buyer, they only invested $24,000 of their own cash, so their ROC on the deal with a slightly lower ROI would be 108.3%. To put it another way, the cash buyer turned $120,000 into a $30,000 profit, whereas the leveraged buyer turned $24,000 into a $26,000 profit.
And the benefits don't stop there. Our clients that use this strategy are able to buy more houses and aren't forced to wait for the 'homerun' deals. Their volumes allow them to take deals that the investor who only has enough capital to do three or four deals a year is forced to pass on. There are so many more of the 15-30% ROI deals out there that if you look in the right places and have the financing in place, you'll never have a gap between deals again. In addition, the leveraged investor who is rehabbing 20 houses a year can demand a lot more from the people on their team than the cash investor doing four houses a year can. These economies of scale can result in contractors giving your jobs priority and increasing their incentive to stick to their bid, realtors that cut their commissions and make sure your paperwork is never forgotten about, and lenders that will bend over backwards to fund a deal in 48 hours. Oftentimes we've found that the savings that are a result of deal volume can actually more than cover the cost of financing.
If you're a cash investor or an investor who has been taking advantage of leverage, we invite you to contact us about your next project, let us give you a financing quote, and see for yourself if using leverage can help you grow your business.