“If you’d know the power of money, go and borrow some.” – Benjamin Franklin
The two most important elements to a successful real estate investment are buying right and financing right. In that order. I’ve talked about buying right in these pages many times. Let me talk about borrowing right. The best way to borrow is not always as obvious as you might imagine.
What do you want in a loan? Lowest interest rates? Okay. Longest possible term? Maybe. No points (loan charges upfront) or just a modest amount? Probably. But here’s what you really want: the kind of financing that is going to give you the biggest bang for your buck.
By “bang,” I mean return. And by return on your buck, I mean ROI. That’s French for “king.” In English, we call it “Return On Investment.”
So doesn’t that always mean the cheapest money? In the long run, yes. But in the short run, not always. And that’s today’s lesson. You’re going to learn when to use short-run money – a.k.a. “bridge financing” – to make far greater money in the long run.
To show you what I’m getting at, let’s take a property where you’re buying at a good discount to market value and with plenty of cash flow. (This technique only works when you buy right – but that’s the only way you should ever buy.)
To be specific, we’ll imagine you’re paying $1 million for a property that needs $100,000 in repairs and that will have an After-Repair Value (ARV) of $1.5 million. Not only that, but once it’s fully repaired and leased out, it will have a Net Operating Income (NOI) of $135,000. The NOI is the money that goes to you after vacancies and collection losses and after paying all expenses – taxes, insurance, maintenance, management, utilities, etc. – but before any debt-servicing costs.
Well, how do you get the money for this great deal? There are a couple of ways you could go about it.
Let’s suppose you have good credit (or a qualifying partner has it). So you go to a bank and they say they’ll give you a loan with a high LTV (Loan To Value). Instead of the typical 75 percent or 80 percent LTV for commercial properties, they’ll lend you 85 percent of the purchase price – $850,000.
Great. This means you only have to come up with $325,000 to do the deal. Why $325,000?
Well, you need $150,000 for the down payment (15 percent of $1 million). Then you need the $100,000 for repairs. Then you need $25,000 for closing costs. And let’s set aside $50,000 for reserves to make sure you have enough cash on hand to handle any contingencies that come along until you get the property “performing” (cranking out rents like a Pez dispenser).
If you don’t have the $325,000, don’t fret. You can get together equity investors. Maybe you’ll give away 50 percent to 60 percent of the deal. No harm there. Forty percent of a good deal is better than 100 percent of no deal at all. Plus, you’ll make your investors money and you’ll have a source of capital for future deals.
But let’s say you have a source of ready cash for the entire deal – purchase, repairs, closing costs, and reserves. It could be from a credit line or credit lines. It could be from seller financing. It could be from private lenders. It could be from a combination of these and other sources. The potential sources are many. And once you learn how to utilize them, your ROI could be much, much higher.
Now you might turn just $25,000 into more than $450,000 – or even $0 into more than $400,000. How? As follows…
You take the $850,000 bank loan. And let’s say it was at a competitive seven percent on a 30-year amortization (not unheard of in today’s market). This means your debt payments will total about $68,000 a year. Since your net income is $135,000 a year, your cash flow after debt service should be about $72,000 a year.
But you bought in the right market – one in which values rise a whopping five percent in a year. Now the $1.5 million property is worth $1,625,000 after 12 months. And your $850,000 loan balance has dropped to $841,000. Your equity is now $784,000. Add the net income of $72,000, and you have pretax equity and income of $856,000.
That’s awesome. You turned an investment of $325,000 into $856,000. That works out to a 163 percent return!
Now… how would you like a return on equity of more than 10 times that? That’s what bridge financing can allow you to do. And the counter-intuitive part of it is that you’re initially borrowing more money and at a higher interest rate. Yet you’re ending up with a much greater ROI. Here’s how…
Let’s say you don’t borrow $850,000 at seven percent. Instead, you borrow $1,150,000 at 10 percent. Now you only come $25,000 out of pocket to cover everything. Of course, your payments are higher… but let’s see what happens.
At 10 percent on a 30-year amortization, your payments on a $1,150,000 loan are about $121,000 a year. That only leaves a comparatively slim $14,000 in net cash flow. But you still have the $1,625,000 value after a year. And you got it while only putting a small fraction of the money to work. Your loan balance is now about $1,139,000. So your equity is about $486,000. Add the $14,000 net cash flow and your total pre-tax net is $500,000.
And that’s on an investment of just $25,000. That works out to a 1,900 percent return, vs. “just” 163 percent the “traditional” way!
Better yet, you can now go to an institutional lender and have that high 10 percent money replaced by competitive market rate seven percent money. So now, if you decide to hold onto the property, your net cash flow goes up from $14,000 to about $43,000… even though you got into the deal with only $25,000.
That’s like a 172 percent annual yield on your cash investment – on top of the hundreds of thousands you’re making on your equity.
Not to press the point too hard… but the $25,000 is just to give you a base. In some circumstances, you could do this kind of deal with zero dollars out of your pocket.
A caveat: When using bridge financing, be sure to get your lower-rate, long-term financing in place as soon as possible. That will allow you to use higher LTVs on undervalued properties with strong cash flow (i.e., less money out of your pocket). It will also allow you to act on special situations you couldn’t take advantage of if you had to wait for traditional financing. Especially in the environment of rising foreclosures we’re facing, this can be a very valuable tool.
I’ve done these kinds of deals on the residential side, and I’m now working on them on the commercial side. The key – as you know from my broken-record mantra – is to buy right first. But once you learn how to do that and borrow right to boot, you can regularly turn good investments into great investments returning hundreds of percent for every dollar invested.[Ed. Note:If you want to learn the true secrets to maximizing your return on every dollar you invest in real estate – while still keeping your risk extremely low – check out Main Street Millionaire, Justin Ford’s deep-value real estate investment program.]