How do aspiring real estate developers get started and then stay successful? There’s more to it than you might think. While finding great deals on properties, moving quickly, and understanding construction costs are all important, true success really comes down to a thorough understanding of financing and leverage. Over the past 10 years, the percentage of financed flips in the real estate industry has been as high as 68.5 percent. Without leverage, far, far fewer flips would get done in the real estate industry.
Leverage, or buying properties by taking on some debt, has many benefits. Leverage can:
• Enable developers and other investors to get deals when they don’t have enough cash on hand for the full purchase price
• Provide higher returns on investment (ROI) than when investors use only their own cash
• Allow real estate investors to expand their businesses at a faster rate than would be possible if all their capital was tied up in deals
Using Leverage Effectively on Fix-and-Flip Deals
Flippers use leverage to make flipping more affordable and potentially more profitable. Without it, a flipper must provide 100 percent of a property’s purchase price in order to buy a property. Suppose an investor pays $100,000 in cash for a property and is able to quickly resell it for $110,000.
If the investor uses their own funds to purchase the deal, the result is a 10-percent ROI: ($110,000 – $100,000) / $100,000) = 0.10.
10 percent is not a bad return, but an investor might do much better using leverage. The amount a flipper can borrow is determined by the lender’s loan-to-value (LTV) standards. A hard money lender will typically set an LTV ratio in the range of 70 to 80 percent. In other words, the lender would put in up to $80,000 on a property appraised at $100,000, with the buyer supplying the remainder.
Suppose the investor with $100,000 of capital receives 80 percent financing for five $100,000 houses. The investor uses the $100,000 cash to put down $20,000 on each of the five houses. Assume quick resale of all five for $110,000 each, a gain of $50,000.
Ignoring financing costs, the gross return rises to a whopping 50 percent ($100,000 – $50,000) / $100,000) = 0.50. Leverage allowed the investor to earn a five-times-larger return on the same initial capital.
Note: For the sake of simplicity, this example assumes quick turnover on the five properties, thereby minimizing interest costs on the borrowed money. But even if you factor in $2,000 in expenditures for interests and fees for each of the properties, the return of $50,000 – $10,000 = $40,000, a four-times-larger increase over the non-leveraged case.
Of course, a new flipper might not be ready to tackle five properties at once. However, the advantage of leverage still pertains. If a flipper with only $20,000 borrows $80,000 to flip a $100,000 house for $110,000, the return is $10,000, or 50 percent (($30,000 – $20,000) / $20,000) = 0.50. The flipper receives $110,000 for the home, pays off the loan of $80,000, and walks away with $30,000 (minus fees and interest).
Do Not Overlook the Dark Side
The dark side of leverage is risk. Leverage works well when prices rise, but can wipe out much of the investor’s original investment capital if prices fall. For example, suppose the five houses in the previous example lose $10,000 each. The investor’s loss is $50,000, destroying half of the original capital. The same is true for the second example, in which the investor puts up $20,000, a $10,000 loss is a 50 percent loss.
Finding the Right Private Lender
Rookie mistakes happen everywhere, including in the rehab sector. One such mistake involves choosing a private lender based only on lowest interest rate offered rather than taking a more holistic approach. Rate shopping is great, but a savvy developer will look beyond annual percentage rates (APRs) and to other less tangible factors when evaluating a private lender.
The most important feature a private lender can offer is expertise born of experience. For rehabbers, the best lenders have development experience. These lenders can help flippers navigate the obstacles bound to arise during a rehab or flip. A lender that has worked all stages of a redevelopment project knows what to do and who to contact in the event of unforeseen complications with the project. That often spells the difference between success and failure for a deal. Rehabbers should also look for a lender with a local presence. It’s important to have access to a lender who can provide insight on zoning laws, building codes, inspection processes and many other local issues.
Finally, a good private lender will offer creative ways to finance your deals. For example, a project can be sectioned into two phases – purchase and rehab – with separate funding for each phase. Structuring loans in this way means a rehabber doesn’t have to pay unnecessary interest on the entire cost of the project for the duration of the project, but rather can wait on the second phase until permits are obtained and work is ready to begin.
Leverage Pays Off When Investors Use Debt Wisely
Whether an investor is buying their first property or looking to grow an existing portfolio, utilizing leverage can create a distinct advantage. However, real estate investors must have some of their own “skin in the game” in each deal, to show lenders they are:
- Personally invested
- Believe in the project
- Understand the need to push the project forward every day
Investors should use debt wisely, understand the cost of debt, and fully understand the concept of the time value of money (i.e. the longer the project takes, the less money you make.) Debt used wisely is a powerful tool in growing your business and bottom line.
Finding Capital: Private Lenders vs Traditional Banks
Private money lenders specialize in lending to borrowers for fix-and-flip and renovation projects. They provide capital to borrowers who are just getting started in the business, those who may have credit dings, and those who do not have enough experience to get bank financing or simply lack access to personal capital to finance the deal.
Traditional banks do some things well, but lending to flippers is not one of them. They are not set up for these types of loans, because they make lending decisions based primarily on the creditworthiness of the borrower rather than the value of the property. Simply put: flip loans are outside the comfort zone of traditional banks.
Private lenders, however, are not shackled to the paradigm used by banks. Rather, they can evaluate a property’s current and future value, and then lend up to 80 percent of the value of the property notwithstanding the credit score of the borrower. That’s important, because an entrepreneur borrower’s credit often doesn’t match a bank’s credit requirements.
Banks also have other deficiencies. They do not move quickly, and speed is something that flippers cannot live without. Rehabbers must seize the moment when a property becomes available because competition is often keen. Flippers turn to private lenders because only they can respond with the speed necessary. Furthermore, many banks can’t fund renovation projects, which makes traditional lenders a non-factor for an investor seeking hard-money loans or bridge loans.
How Private Money is Cheaper Than Cash: A Case Study
On one of our recent projects, the loan amount was $230,000. That sum included the following items:
• $132,800 toward purchase price
• $6,000 towards closing costs
• $6,900 points
• $70,000 for renovation
• $13,800 six months interest
The interest clock starts ticking on the full loan amount including the construction reserve from day one. This borrower started paying 12 percent on $230,000 immediately. That rate might sound high at first, but he had a short renovation schedule and planned to use the construction budget within 60 days.
This borrower put up $35,000 of his own capital. Everything else was financed into the loan. Assuming that he closes the sale at the predicted price of $330,000 and pays five percent in sales costs, he will net $313,500. After paying off the loan and getting his investment back, his net profit after all costs will be $48,500. That is a 138-percent return on his original investment and, if annualized (assuming the project takes six months from start to finish), it is 276-percent return.
If he had paid cash for the property and all improvements, his costs would be reduced by $19,800 in points and interest. His return would have been 27.8 percent (55 percent annualized). Those returns are also excellent, but his return is actually five times better using financing and getting leverage then it would have been using his own cash.
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