Mortgages & Creative Financing

Lending Short and Borrowing Long: It’s a Matter of Principle!

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Who hasn't heard this: "You make your money using other people's money"? This is especially true in real estate! The average investment capital required usually ranges from $10,000 to $1 Billion. As people grow in the real estate investment business they find the only thing holding them back from making more money is usually a lack of capital. Yet, there is a fundamental principle for using other people's money that directly applies to note investing. You, as a note holder or borrower, need to know how to properly lend and borrow money to avoid the pitfalls like the Savings and Loan crisis of the 80's and the recent sub-prime disaster. In both of those cases, people got over confident, and over-leveraged in the wrong direction. Consider these rules of thumb if you are looking to originate a note or buy on terms.

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As a note holder: The first thing you need to ask yourself if you are going to sell a property on contract terms is, "Is this the best return and use of my money?" Sounds like a simple question, but it clearly depends on your current circumstance. If you are continually flipping properties and earning 20+% returns every 6 months, do you really want to sell a property on contract and tie your money up at say 7% for several years? Of course not! You would be leaving profit on the table for yourself, and even worse, someone would be holding your capital ransom (ie. The property), preventing you from doing another deal. If the roles were reversed and say this property was a tough rental property that hasn't done better than a 5% net return for the past several years, then you would look at that seller financing sale, and be very happy with a 7% return, because that was a better use of capital. The length of time you lend money should always be shorter than your borrower is comfortable with. It's your money, no one is going to look out for it, and protect it better than you.

As a borrower: Your goal as a borrower is to get the best possible interest rate and get the best possible term on someone else's money. Say you own a free and clear property that you bought in 2010 for $100,000 and its now a performing rental, giving you a 10% net return year over year. If you could borrow money against that property at a lower interest rate than 10% you would then be able to use that capital for another investment property which would also yield you a nice return. Imagine taking out a $60,000 loan against your $100,000 property as a first position mortgage. The investor is getting a great loan to value 60% so they are heavily protected. What really brings the whole deal home would be a long term note at say 7%. You could then deploy your $60,000 into another property, that say, produces 10% net income and now you have a portfolio of real estate worth $160,000 earning 13% (10%-7% loan+10 new net profit) on your original $100,000. Not too bad!!

So remember whenever you are looking at buying notes, or creating seller financing, or getting financing, it’s always important to ask yourself this questions: Is this the best use of my money? If it’s not, the return is not right or the deal is not right and you should re-evaluate the investment.

    Phil Brown
    Replied over 7 years ago
    Kevin, Your absolutely right in that we should all make conscious decisions in our use of capital, and leverage. However, your “borrower” example is a little off. Under the scenario you describe, the return on your initial $100K would go from 10% to 11.8%, so someone would have to carefully weight the risks and the potential upside to determine if they are willing to take on the debt and another property for “only” at 1.8% increase in yield. The clearest way to show the math is: $10,000 from the original $100,000 home w/ 10% yield…, – $4,200 for the interest on the $60,000 loan at 7% +$6,000 from the 60,000 home w/ 10% yield —————- $11,800 Total return is an 11.8% return on the initial $100,000 invested (Return on equity). There are definitely times when you want to borrow against your assets to gain more leverage, but it’s important to crunch the numbers carefully so that you make well informed decisions. Personally, I’d be willing to borrow at 7% against an asset paying me at least 14% or more, but I wouldn’t take on the situation you described for only a 1.8% increase in yield. If we were talking only paper, maybe, but as a landlord. Not me! -Philip