The One Real Estate Variable that Can Ruin an Entire Analysis

by on February 22, 2013 · 6 comments

Take a deep breath. Close your eyes. Envision this.

You create or find a deal analysis spreadsheet for your real estate deal that is set up to function perfectly. You absolutely NAIL the after-repair-value (ARV) of the home. You absolutely NAIL the rehab budget. On top of both of these things, you bought the property for the EXACT amount you should have…. however, your end profit is quite a bit below what your spreadsheet was telling you.

What happened? You nailed the most talked about variable: ARV, rehab cost and purchase price.

A very likely diagnosis: you weren’t realistic with the cost of money!

The Real Estate Cost of Money

This is a critical variable that must be accounted for. It usually isn’t harped on as much as the numbers that make up the MAO Formula (Maximum Allowable Offer); however, in my opinion it is just as important.

The “cost of money” is just another way of saying, “interest rate”. The reason this variable can destroy an analysis is due to its seemingly harmless nature.

You might be thinking, “Well, one guy is charging me 8% and this other guy is charging 11%. It really doesn’t matter which one I go with since it is ‘only’ a 3% difference.” – Ahhhh!!! If you find yourself with these thoughts, immediately consult a math textbook! (or just keep on reading)

The Power of Interest Rates

To lay this out. Let’s take a simple number of \$100,000. Let’s also say that from purchase, rehab, to getting to the closing table on the sale it takes 6 months.

With the cost of money being 8%, you would be paying \$21.92 per day in interest. By the time you sell, your total cost of money will be at \$4,005.88 (365 days in year ‘x’ 1/2 = 181.5 days x \$21.92 per day).

With the cost of money being 11%, you would be paying \$30.14 per day in interest. By the time you sell, your total cost of money will be at \$5,469.86 (365 days in year ‘x’ 1/2 = 181.5 days x \$30.14 per day).

That 3% difference just cost you \$1,463.98.

In other words, if you went with 11% you would have paid 36.5% MORE for your cost of money. Eeeeek!

The Importance of Being Realistic

What number did you enter into your spreadsheet for the interest rate? What about the amount of points you’ll need to pay (for hard money)? These are numbers that must be taken extremely serious.

Depending on your strategy will determine what type of numbers you will need to use, so that once again leads back to a Real Estate Investing 101 Rule: know your exit strategy while doing your upfront analysis.

If you are looking to flip, then you won’t need the money for very long, and therefore you’ll be needing to use hard money numbers (including points/fees).

If you are looking to use some sort of “recycle your capital” approach where the loans will be longer term, you’ll be looking at lower interest rates since these sorts of loans will be more than likely made from private lenders.

How do you know what types of numbers to use? You don’t want to be guessing, right? Exactly! Which leads nicely into the next point…

Shop Around and Network in Real Estate Circles

Get out there and talk to people! “There” can be at your local real estate clubs or it can be right here on BiggerPockets. Bottom line is you need to research and network in order to nail down some solid numbers for your analysis.

One way or another, if you’re going to be successful in real estate, you will not only need to learn the ins-and-outs of rehabbing, purchasing and marketing to sell, you need to learn “how” money lending works.

Personally, I underestimated this when I first got started. I was sooooo focused on finding a good deal, fixing it up efficiently and getting it sold that I never started to learn about private money until I needed to. If you are starting out using your own cash, don’t follow in my footsteps. Unless you have a money tree in your background,  you will eventually need to use other people’s money, so start researching, learning and networking right away.

The “Other” Importance of Being Realistic

“Put yourselves in their shoes” is probably the best way to look at this. When you are seeking out private money, remember to be offering worthwhile rates of return.

I was cruising the forums and I saw an exchange where someone was looking for a private mortgage investor. A few people chimed in as possibly being interested and then the poster said they were offering to pay 3.5% on the loan. As you can imagine, the tide quickly turned and there was zero interest in that sort of rate.

If you find yourself entering in numbers and then using 3.5% as your interest rate because you tell yourself you will be able to find someone willing to lend at that rate… STOP NOW! You are NOT being realistic at all! While I can’t say it is impossible, you are going to be on a golden goose egg hunt.

Don’t convince yourself in the spirit of “making your spreadsheet look pretty” to think you can get away with finding lenders who will pay interest rates that low.

For me, I pay 8% to my private money lenders; however, in my spreadsheets I use at least 9% just to be sure I’m NOT being too conservative.

When in doubt, over estimate what you are entering into your spreadsheet.

In Summary…

Don’t let the glitter and glamour of the MAO Formula blind you from the fact that if your cost of money numbers are off, you will be in for a rude awakening when the numbers actually play out.

If needed, brush up on your math so you can see the importance of interest rates and how they influence all the numbers. This will help you to be realistic, both in terms of “what the numbers are” and “what you can get others to pay you”.

What about you? Any practices you use to ensure you don’t get any nasty surprises when it comes to the cost of money?
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Frank Gallinelli February 22, 2013 at 7:54 am

@Clay Huber An excellent exhortation to be realistic!

Let me chime in and take your a advice to re-habbers even further. I often see folks who look at such a project in terms of hard costs only. They buy for \$X, plan to spend a certain amount on nails and 2x4s, and sell for a profit at \$Y. What they often fail to consider are their soft costs, like the interest you discuss here. Missing from their equations may be items like:

–Property taxes and insurance during the rehab period;
–Utilities (I’m a New Englander; we wouldn’t want to see pipes freeze while we’re working);
–Costs of sale: you probably need a lawyer or escrow agent, and possibly a broker; depending on your state, you may have conveyance taxes to pay;

All of these can make that expected profit seem a little less robust. There is one more item that is usually overlooked, and that’s opportunity cost. You are probably laying out some amount of your own cash in the form of down payment, legal fees, title insurance, etc., when you purchase. What you buy with that cash is an asset that provides zero return during the rehab period. Perhaps you could have invested that same cash in an existing property that would provide a return from day one. If so, then the return that you lose by tying up your capital during the re-hab period is really another cost to you.

As you said so well, be realistic.

Clay Huber February 22, 2013 at 7:59 am

Excellent points Frank.

There are lots of other variables, but to me, the cost of money variable can have the biggest impact if not taken seriously.

But yes, no doubt, those other “soft costs” variables must be realistically accounted for too!

Brian Burke February 22, 2013 at 9:55 pm

Very well said, Frank. So many people discount the importance of those items. “Reality” TV shows completely ignore them, and the uninitiated underestimate them. If you are a new investor, take this advice: RE-read what Frank just said.

Clay, great article. People also need to consider ancillary lending costs such as appraisal, doc prep, title, escrow, admin fees, broker fees, tax service, mortgage tax, the long list of garbage fees that are associated with borrowing that all come from the hard working investor’s payday.

Clay February 23, 2013 at 5:57 am

Thanks Brian (you were an awesome podcast guest by the way).

You are right. In all actuality, the interest rate is just the tip of the iceberg when it comes to the world of private lending.

John McCombs February 22, 2013 at 1:28 pm

It is all too easy to skip spopping for the best loan. It is a variable that we often feel like we have very little control over, but we must do our due diligence in this area as well. Great reminder!