In our previous blog, we’ve addressed one of the most frequently asked questions: Is a hard money loan considered cash? Now that we’ve covered when a hard money loan is equivalent to cash and why, it’s time to discuss their differences. In other words, should you pay cash for an investment property or should you borrow money instead? To come up with a strategy that is right for you, let’s discuss the advantages and disadvantages of each way.
Recently I spoke to a brand-new investor who asked us to look at a loan scenario for him. A deal he wanted to discuss was not particularly strong. In fact, my numbers showed him making just over $6,000 in profit. After we talked more, he confessed he was thinking about purchasing the property all-cash, to “test the waters” and “eliminate additional expenses.” Were he to bypass a lender and pay his way with his own cash, his profits would increase substantially.
Paying cash for an investment property offers maximum control over the costs and the rehab process.
You cannot argue with math. If you were to use our hard money calculator, you would see that using your own cash appears to be the best way to maximize your short-term profits. And for obvious reasons: you would greatly minimize the carrying costs of your loan. The carrying costs are all the cost that you incur during the time you own a property. They include property insurance, property taxes, maintenance, and if you are using financing, an interest charged by a lender. The longer it takes to rehab and sell a property, the more in carrying costs you incur.
By using his own cash, our borrowers would not have to borrow money and, consequently, would not have to pay interest. Over the twelve month’s period (his estimate of how long it would take to rehab and sell the property), his savings would amount to upwards of $20K. From this borrower’s perspective, if he pays cash for an investment property, it eliminates both expenses and risk of dealing with a lender. As a first-time flipper, he was frustrated with being outbid and concerned with making mistakes or being taken advantage of. Paying with his own cash was his attempt to exert maximum control over the costs and the rehab process itself.
However, being successful in real estate is not necessarily about exerting maximum control. It’s about making money.
If you were to use the same logic as this borrower, why not skip hiring a construction crew as well? Investing your own sweat equity instead of paying a crew is bound to save money and drive your profits up. If your ultimate goal is to eliminate any depency on the third parties, there is a good argument that your constructon crew should be the first to go. After all, you rarely hear about a rehab faltering because of a lender. More often the issues arise because of an unreliable crew and incompetent management of the renovation process. So off with your construction team as well!
Not so fast. Many of our borrowers, no matter how “handy” they are, will outsource the rehab process because they don’t have time. For them, “having no time” means that they choose to spend their time somewhere else. The majority have full-time jobs and family obligations. In other words, their time is finite and they are looking to make the most of it. They choose to pay someone else to do their renovations so they can spend their time wisely. So is with cash: you might choose to borrowe because your money is finate and you already doing something else with it.
Folks rely on private loans because they choose to spend or invest their own money somewhere else.
An important aspect to consider when deciding whether to pay for an investment property with cash is the opportunity cost. Unless you are stashing your money under your mattress, I assume it’s invested somewhere else and is generating some kind of return. If you were to invest in real estate, your goal would be to generate a higher return on your money than it’s already producing. So when the borrower we discussed above calculated that his profits increased by $20K by using cash, he forgot to subtract the return that money will be generating for him over the course of twelve months if it were left wherever it was before. Assuming a mediocre stock market return of 6% a year, his cash investment of $240K would have generated over $14K!
Another issue with using your own money is timing. Let’s assume you have some stock market investments you’re willing to pour into your real estate empire. When exactly do you sell it to time the things right? You can attempt to sell it when the market is riding high and transfer it to your savings account. There it would sit – earning almost nothing – until a suitable real estate opportunity will present itself. Alternatively, you can leave your money in the stock market until you find a property and only then sell your investments. But what if the market crashes right around the time you need the money? Do you still liquidate at the bottom potentially losing an opportunity for a rebound?
Cash tends to run out. Buying property with private loans provides you with ulimited leverage.
This is how time and cash are similar: they both tend to eventually run out. Many folks don’t have cash, to begin with. For them a question of whether to pay cash for an investment property is rhetorical. A hard money loan helps them to compete with borrowers that have pockets way deeper than them. But even the folks with deep pockets, if they’re active in investing and juggling multiple properties, would sooner or later be in need of a cash infusion from an external source. Typically, this infusion comes in two forms. They can borrow funds from a hard money lender and incur expenses associated with it. Alternatively, they can bring in an equity partner and split their profits. You can use our hard money calculator to figure out which way is cheaper.
Whether to pay cash for an investment property or not, depends on your long-term strategy.
Ultimately, the decision of whether to pay cash for an investment property or to borrower from a private lender, depends on your financial goals. However, if you want to be an all-cash buyer make sure that you have enough money to meet life’s unexpected expenses, pursue other business opportunities and diversify your overall portfolio. Also, make sure the money you earmark for real estate is easily accessible and is not dependent on the stock market fluctuations. Always consider the opportunity cost of investing your money somewhere else. Paying cash for an investment property will offer you more control over a particular transaction. Using borrowed funds will increase your costs but provide financial leverage to diversify your investments, expand your business, and make more money in the long run.
New Funding Resources is a private money lender that funds promising real estate opportunities in Maryland, Virginia, and Washingon, DC. We work hand-in-hand with our borrowers to help them grow their profits and minimize their risk.