New investors frequently ask why a real estate investor with sufficient capital to buy an investment property (rather fix-and-flip or buy-and-hold), borrow if they have sufficient capital on hand to fund the purchase and renovation of the investment property. When I explain that investors do this so that they can make more money there is always a puzzled look on their face, so I thought it appropriate to explain this.
To begin I would like to share that all of the most successful capitalist in America (including real estate investors) have used debt to amass their fortune. Likewise Corridor Funding’s most active and successful clients maintain around $200,000 to $1,000,000 in their account but still use debt, and while also seeking to maximize the amount we will finance thus minimizing the outlay of capital they will have to pay at closing.
New investors will ask, “if you’ve added cost of interest expense and lending closing costs how does borrowing make you more money?” and “why would you continue to borrow when you have enough money to fund your own investments?” These are very logical questions and I will attempt to explain the most common reasons that leverage (borrowed funds) are used by investors with large cash reserves, and how using leverage can amplify returns while also allowing cash on hand to serve other purposes.
Maximizing Hard Money Return on Investment
Investor 1 Uses Debt to Finance Purchase and Renovation: We will analyze an example where Investor 1 does a fix-and-flip that is purchased for $150,000 and it will require another $50,000 in renovation costs to bring the home to its most marketable value, or (ARV) of $260,000.
Investor 1 intends to borrow to finance most of the $200,000 required to purchase and renovate the fix-and-flip, so he borrows 90% of the $200,000 and puts 10%, or $20,000 towards the purchase when the property is purchased.
We will also assume the following:
In the above scenario Investor 1 will receive $64,400 in sales proceeds at closing when the property is sold ($260,000 less loan of $180,000 less sales commissions of $15,600).
Investor 1 put a total of $34,400 of his own capital to receive $64,400 in proceeds at closing, for a net profit of $30,000 and a return his capital of 87% in 4 months!
($30,000 net profit / $34,000 of Investor 1’s Capital Used = 87% Return on Investor 1’s Capital Used)
Example 2 where Investor 2 uses 100% of personal Capital to Fund Project Investor 2 used his own capital to fund the $200,000 purchase and renovation, while also incurring the assumed $4,000 in closing costs and $15,600 in realtor sales commissions. When the property is sold, Investor 2 will receive $240,400 after realtor commissions are deducted and a net profit of $40,400, or $10,400 more than Investor 1. However, Investor 2 used $204,000 of his capital to achieve the $40,400 Return on $204,000, or 19.8% return on the capital Investor 2 put into the same 4 month fix-and-flip project.
($40,400 net profit / $204,000 of out of pocket expenses =19.8% Return on Investor 2’s Capital Used)
These two examples are basic and there are more complex metrics like IRR that actually take into account when the investor parted with their cash (example: At closing, month 1 payment, month 2 payment, etc.; but we will save this for another post). This example was meant to show you the power of using a lender’s money to boost, or lever your return on the capital that you actually put into a given project. Using debt responsibly can vastly increase a real estate investors returns, but debt should be used responsibly. Corridor Funding uses licensed appraisers to help make sure the investor has not over projected their returns. However, it should be noted that the investor must manage their project efficiently and be conservative in estimating the time to complete the project, and the financing costs that the investor will incur.
Opportunity Costs An opportunity cost is defined as the loss of potential gain from other alternatives when one alternative is chosen. With this said, the REAL rule to real estate investing is that “the money is made when you buy”, so if all of your capital is tied up in one project and you have to forego other deals that arise you are incurring opportunity costs. An example of opportunity cost can be seen with Jared Kushner’s 2006 acquisition of one of New York’s most prestigious buildings. In 2006, the Kushner Real Estate Group purchased 666 Fifth Avenue for $1.8 billion and although this prestigious building passed the “location, location, location” test, it turned out to be a terrible investment that cost the Kushner companies tens of millions over the last 12 years. Jared Kushner simply way over estimated the building’s potential for generating rental income. The building has not been able to cover the interest only loan and the other expenses like maintenance, taxes, tenant improvements, and other marketing related costs. So with respect to opportunity costs the question becomes; how many projects could the Kushner Real Estate Group have done over the last 12 years had they not been stretched in subsidizing a poor investment. Likewise, if our Investor 2 had all of his capital tied up in the example fix-and-flip discussed earlier and he had to forego two opportunities that would have generated the same Return on Capital that Investor 1 had used, Investor 2’s opportunity costs would have been $60,000 because of the projects he no longer had capital to pursue. This is the reason that Corridor Funding’s most active investors like to stay liquid, or keep cash on hand because the money is made when you buy. If you are not liquid when deals arise you will be on the sideline missing out on potential profits.
Staying Alive / Cash Reserves for the Unforeseen It is critical that investors maintain sufficient cash reserves on hand to address unforeseen expenses, even if they do not plan to pursue other opportunities that become available. Clearly the 49 year-old prestigious Kushner Real Estate Group would have gone under had they not had sufficient cash on hand, and other revenue generating projects in their portfolio to subsidize the 2006 carrying costs of 666 Fifth Avenue. Again bringing the example back to main street; “you never REALLY know what you’re going to spend until you put the hammer into the wall”. In other words there will be surprise expenses when you pursue a real estate value add project, and it is important to have cash reserves on hand so you can absorb these if and when they occur.
Conclusion Like America’s most successful entrepreneurs, our most successful clients deploy debt towards most if not all of the real estate investments they pursue. They do this to magnify the returns on their own capital and to keep cash on hand for new opportunities, and also for the unforeseen surprise expenses that every active investor has run into on a project.