To borrow or not to borrow, that is the question. Real estate investors have long sought hard money loans to fund their projects, but what is the impact of using hard money loans on profit? Unlike most of the articles on the site, this one is going to have us doing a lot of math together. My apologies in advance for bringing back bad memories from your high school Algebra I class.
Let’s say that an investor purchases a home for $120,000 and puts $30,000 into the rehab of the project. Let’s look at the impact on profitability if the investor obtains an 80% hard money loan at 9% interest with 2 points. For the $120,000 loan, the investor would automatically owe $2400 as soon as they sing the loan papers due to the 2 points. They would also be paying $900 per month in interest on the project. For illustration purposes, let’s also not take into account any closing or other costs to compare apples to apples.
The deal looks pretty good if the investor is able to sell the home for $200,000. If they were to simply pay cash for the deal, they would make $50,000…a very respectable 25% return on investment. Let’s say, however, they use the above-mentioned financing scenario and it takes them 6 months to buy, rehab, and sell the property. They would pay a grand total of $7800 to the lender in interest on their $30,000 cash injection ($150,000 purchase price and rehab budget minus the $120,000 loan). The profit drops to $42,200, but you make a whopping 140% because you only injected $30,000 of your own money into the deal. So far so good with using hard money, but what happens if the profit margin is much thinner or if it takes a much longer time that you expect to sell the property?
Let’s start with examining a scenario where we only sell the property for $165,000. If we paid cash, our profit is $15,000, or a somewhat respectable 10% return. If we borrow, however, our profit drops to $7200 (due to the $7800 we had to pay the lender) for a return of 24%. The percentage return is quite strong, but margins are getting quite tight when it comes to dollars and cents. Let’s use that same $165,000 sales scenario, but let’s imagine that it takes 12 months to sell the property instead of six. Our lending costs eat up almost all of our profit.
Borrowing money to finance projects is a risk…a risk that should be analyzed for every deal that you do. Be sure you have built a great model and you’ve built in enough to handle the unexpected if you are borrowing.