Using High Interest Private Financing is Still Better Than Cash

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With investors battling a tight credit market, the opportunity to obtain financing for investment properties can often times prove more difficult than expected for some investors. Five years ago many of these same investors had no problem walking into their local lender’s office and getting approved for a loan. Nowadays, it seems like underwriters need a blood sample to approve a loan for an investor (even when that investor could pay cash for the house 5 times over).

There are any number of reasons why perfectly good borrowers cannot get approved for conventional financing including:

  • Investors with damaged credit because of a previous investment that went bad (i.e. short sale or foreclosure on credit report)
  • Investors who are self-employed and don’t show adequate income on their tax returns. (likely because they have a good CPA who writes off much of their income)
  • Investors who already have 10 properties with financing (Fannie Mae caps the number of financed properties to 10)
  • Investors who don’t have legal residence in the United States but want to invest in U.S. properties.
  • Investors who have money in self-directed IRAs and want to use this money combined with leverage (financing) to acquire investment property.

For investors that fall into these categories, it can be frustrating to feel like all of the opportunity for financing is out of reach.  I have found however, that rather than simply resigning to an all cash option, these investors are still better off working with private financing, even when the monthly payment is close to break even cash flow (because of high interest and short amortizations).

For example, we work with private financing in Atlanta that requires 50% down at 12% over a 100 month amortization. While this may seem exorbitant, it is interesting to dissect the returns on something like this compared to an all cash purchase.

EXAMPLE:

$80,000 Property

$975.00 Monthly Rent

Assume roughly 4-months of rent to meet property manager, taxes, insurance, vacancy and other expenses. (this is very conservative, but will work for the  simplicity of this example)

Return for cash investor:

$975.00/month x 8-months = $7,800.00 / $80,000 invested = 9.75% (plus rent and property value increases over time).

Return using 100 month financing:

50% down payment

$40,000: 100-month loan has a monthly payment of $634.63 ($7,615 per year)

$975.00/month x 8-months = $7,800.00 – $7,615.00 to pay loan = $185.00 / $40,000.00 = .50%

At first glance, the all cash investment yield of 9.75% is superior to the cash yield of .50% generated from the financed transaction. However, to get a true return calculation on the 100-month financing option, what must also be evaluated is the considerable equity growth from paying the loan.

Year                       Equity Paid into Loan and expressed as a % of the $40,000 down-payment

1st year                 $2,975.69 or 7.43%  + .50% = 7.93%

2nd year                $3,353.08 or 8.38%  +  .50% = 8.88%

3rd year                 $3,778.35 or 9.45%  +  .50% = 9.95% (exceeds all cash return)

4th year                 $4,257.50 or 10.64%  + .50% = 11.14%

5th year                 $4,795.51 or 11.99%  +  .50% = 12.49%

6th year                 $5,405.93 or 13.51%  +  .50% = 14.01%

7th year                 $6,091.54 or 15.23%  +  .50% = 15.73%

8th year                 $6,861.10 or 17.15%  +  .50% = 17.65%

For the investor who can trade cash-flow during the early years for equity build up, the 100-month financing option will generate a greater total return over the life of the loan given the stated assumptions.

For investors attempting to generate maximum benefit on the real estate portion of their portfolio, the 100-month financing option offers a greater return during the life of the loan. However, the greatest benefit of the financed transaction is realized after the loan is retired. Using the same $80,000 required for the cash purchase, an investor that used the leverage would have been able to invest and now own debt-free 2 properties resulting in twice the cash flow, twice the assets and twice the upside potential.

Whereas some investors see 12% interest and scour, the proper usage of even slight leverage can make a huge difference in the long run. For those investors that can’t qualify for conventional financing and assume a cash purchase is the only option, perhaps it’s worth considering shorter term private financing to grow your wealth quicker than you could using only cash.

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About Author

Ken Corsini G+ is the founder of Georgia Residential Partners, LLC - a real estate investing firm based in Atlanta, Ga focused on creating turn-key investments for investors all over the country. He's been investing in real estate since 2005 with hundreds of real estate transactions.

11 Comments

  1. Ken,

    Great article with excellent evaluation. Question. Why not factor in the depreciation on the property as well? That affects the overall ROI too. Your thoughts?

    Jeff

    • Jeff – great point. You could factor in depreciation into this equation as well (although not sure it would make any difference between the cash and financed example)

      • Ken,

        Well, one way depreciation makes sense is when you accelerate it. By applying cost segregation to your $80,000 house, here’s how much more $ you get using MACRS method of accelerated depreciation vs. the incorrect 27.5 year straight-line method:

        MACRS Cash Flow Add’l Equity Paid into loan Total Equity Gain
        1st year $522 + $2,975.69 = $3,497.69

        2nd year $958 + $3,353.08 = $4,311.08

        3rd year $573 + $3,778.35 = $4,351.35

        4th year $335 + $4,257.50 = $4,592.50

        5th year $313 + $4,795.51 = $5,108.51

        6th year $132 + $5,405.93 = $5,537.93

        MACRS (Modified Accelerated Cost Recovery System) segregates personal property (e.g., cabinetry, molding, ceiling fans, & carpeting) as 5-year depreciable assets, and land improvements (e.g., landscaping, paved/concrete driveway, sidewalk, and fencing) as 15-year depreciable assets. This creates the accelerated depreciation I mentioned earlier.

        In your scenario, the gain from cost segregation is an additional $2,833 in available cash flow from the accelerated depreciation over years 1 – 6. At the discretion of the investor, this can be applied to the loan which, of course, further increases the ROI well beyond your original calculation. Plus, you can now petition the local taxing authority to reduce the property taxes as a result of the new property class assessment. It wouldn’t be a huge sum, but every dollar in your pocket as an investor is one less to Uncle Sam and your banker.

        I am pretty confident most investors will vote to take that money…and btw, from a banker’s perspective, cost segregation increases debt service coverage by 15% or more in most cases.

        Ken…what say you?

  2. Jeff Brown

    Hey Ken — Funny how doing a thorough analysis, and letting the chips fall how they may, often shows surprising results.

    In this excellent example, what would the operating expenses be for the 100 months it takes to eliminate the debt? Thanks again, Ken.

  3. Ken- This is great! I flip a lot of houses to landlords. But in my area, an $80k property only rents for $800 a month. Your leverage analysis still applies, even with lousy gross rent multipliers. But our leveraged landlord ends up with negative monthly cash flow. That’s been a REALLY tough sell.

    Thanks for providing me the missing analytical piece in my puzzle– this will make it easier to explain to reluctant landlords why they should at least consider private financing, from a long-term return perspective!

  4. For someone who needs current income from their properties, this is obviously not the way to go (I know, duh!), since there will be no cash flow until the note is paid off. The IRR on paying cash vs using this loan is slightly better, due to the negative spread on the loan. This leveraged deal is more like a zero coupon bond, that has no income currently but will pay off in the future.

    The ideal investor for this would be someone who doesn’t need current income, but it will create a nice annuity in the future for their retirement. For this investor, buying cash creates monthly cash flow that can’t be reinvested in small increments. This leveraged approach eliminates that reinvestment problem.

    Good perspective to share, thanks, Ken!

  5. Are there no closing costs and points for this loan or is it 12% period all in??

    If the market was 975 you would probably want a rent of 900 to 925 so you get the most apps and land the strongest tenant.

    So let’s say taxes are 1,200,management is 10% so let’s say 98 a month is 1,176 annually,10% vacancy is another 1,176 that is 3,552 annually.975 X 4 = 3,900 in your projected costs minus 3,552 equals 348.00 annual reserves or 29.00 monthly.

    The first year of lease up the property manager takes half of first months rent 975-487.50 minus the 348.00 = 139.50 negative cash flow.

    I don’t know if I am missing something but it seems the annual costs would be higher than in your evaluation.I am not even including if a major repair is needed in any of those years.

  6. Well articulated. It is unfortunate that with the lowest interest rates in 50 years it is so difficult to get financing on income property. If you can get it use it.

  7. Great article, I find myself using cash as I am in the same situation. What is the best way to find high interest private funding for real estate rental deals? An internet search will list you hard money lenders, but they tend to only be interested in those who can flip, or refinance, and those arent the goals for renters. Do you know the best way to find these opportunities?

    lisa

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