As a private money lender, we work with a wide spectrum of clients: from those who are just starting out in the rehab business to borrowers with substantial experience and funds of their own. It’s self-explanatory why someone with only modest savings needs to work with a private mortgage lender. However, why would someone use them if they have enough cash of their own? The answer, my friends, is leverage. This article is a continuation of our series on hard money calculators, so if you need a refresher on the basics, please read our article on Hard Money Calculator Basics.
Financial Leverage Refers to the Use of Debt to Multiply Profits
Leverage is by far my most favorite financial mechanism. To leverage something is to use it to maximum advantage. Financial leverage refers to the use of debt – aka other people’s money – to acquire additional assets and multiply profits. Any mortgage is technically leverage that allows a borrower to purchase an expensive asset without paying 100% of its price with his or her own money. However, working with private money lenders takes such leverage to a different level.
Let’s look at our hard money calculator to illustrate what we are talking about. Take a look at the rows at the very bottom. By using private money, this particular borrower expects to generate around $39,000 in profits by investing approximately $30,000 of their own money in the transaction. All other expenses including 100% of purchase price and some rehab costs are financed by a private money loan. We’ve discussed ROI in our previous blogs, so let’s focus on row forty-eight which shows annualized return on cash.
Working with Private Money Lenders Maximizes Your Return on Cash
Annualized return on cash shows how much profit is generated in twelve months as a percentage of your initial cash investment. For example, let’s assume you put $1,000 into your savings account. At the end of the year you’ve ended up with $1,015. Your profit is $15 and your annualized return on cash is 1.5% ($15 divided by $1,000). The example in our hard money calculator shows that $30,000 invested in the transaction generated $39,000 in profits. This is more than double of the money invested! To be exact your annualized return on cash is 118%!
To the right of this column you see two other scenarios. Unlike the first scenario, none of them assume working with a private money lender. Scenario 2 analyzes working with a partner and sharing both the costs of the transaction and profits equally. Scenario 3 assumes that the borrower can purchase a property outright using his or her own funds and also pay rehab costs out of pocket. Let’s compare these scenarios with using leverage via a private money lender.
Scenario 2 generates approximately the same amount of profit as Scenario 1: around $40,000. However, it requires you to come up with a half of the cash needed to purchase and rehab a property. In our example, it amounts to $125,750. Quite a difference between the out-of-pocket contribution of just $30,000 that was required when working with a private money lender. However, the key difference is in row forty-eight.
Take a look at the annualized rate of return on cash. It just dropped from 118% to 32%! Now you are not doubling your money the way you did in the first scenario. Instead, you are generating a return that is slightly less than a third of your initial cash investment. Don’t get me wrong, these are not shabby profits, but why on earth would you invest $125K to make $40K if you can make these same amount by investing only $30,000?
This is the incredible power of leverage! It allows you to make similar amount in profits by investing a fraction of the cash. Let’s looks at Scenario 3 which uses no leverage whatsoever. Assume you are a wealthy individual that has at least $250,000 to invest in flipping real estate. You can certainly invest it in a single deal and, as the hard money calculator indicates, end up with a sweet profit of $80,000. Because you are paying for your property and its rehab with your own cash, you have no partner to split your profits. You also have no expenses or interest rate associated with your loan. Your annualized return on cash is the same as with Scenario 2 – around 32%.
Alternatively, you can work with private money lenders like us and leverage your $250,000 to purchase not one, but at least seven properties (and have some money left). Your profits from flipping those seven properties will be seven multiplied by $39,175. It’s $274,225!!! The eighty-thousand dollar profit you’ve made by investing your own cash fades in comparison to this number.
Leverage Allows You To Diversify Your Real Estate Investments
Using leverage to buy several properties instead of one has other advantages. If you are an experienced investor with a good head on your shoulders, I certainly hope that most of your flips are profitable. A few of them are home runs and a few – let’s be honest – have probably fell below your expectations. It’s the nature of the business, and some factors that influence the profitability might be beyond your control. What’s within your control though is the ability to hedge your risk by not putting all your eggs in one basket. Just like when investing in the stock market, you want to diversify your assets. The leverage provided by private money allows you to do that.
Working With Private Money Lenders Keeps You Liquid
Of course, you can argue that you would not be able to find seven properties to invest in at the same time. It might be true, but consider another factor. Real estate is not necessarily the most liquid asset. Do you want to invest all your money at once in one property? If you could make the same profit by investing only a fraction of your cash and have plenty of money left for other investment opportunities or life emergencies, wouldn’t you rather do that?
New Funding Resources is a private money lender that helps real estate investors to buy and rehab homes in Maryland, Washington DC and Virginia.