My Money or the Bank’s? | Thursday Thought

In my adventures as a commercial real estate agent and consultant, I frequently come across investors who are new to the game and still haven’t developed a structural procedure for how they go about doing deals.  As such, one of the first common questions is whether or not the investor wants to use their own capital.  Many new investors have put themselves into a position to invest by being conservative, good at saving, wise with credit cards, etc.  Often that mentality couples with a thought process of borrowing as little as possible and paying off any loans as quickly as possible.  It worked to get the investor to where they can afford more than just their own primary residence, so why wouldn’t the same principle apply now?

Here is where I resist the urge to link to the Urban Dictionary’s entry on “OPM.”  More than just a euphemism for “other people’s money,” it’s a solid entrepreneurial precept based on the simplest math.  If it costs you less in interest to borrow than you get on your return on investment, then you should always use OPM.

Okay great, Mark.  How do I know if that’s going to be the case?

A good question, but not as difficult to suss out as one might think.  It really comes down to knowing just two factors:

  1. What is the interest rate on the loan?  That answer isn’t rocket science.  Your lender is going to tell you this is the most certain and simple terms.  Interest rates are still at historic lows (4% is the prime rate at the writing of this article), even though the trend will be upward in the foreseeable future.
  2. What is the rate of return on my real estate investment?  Ahhh, now we have the meat of the question in front of us!  Anyone who has looked into investment real estate has come across an industry term called, “cap rate.”  Quite simply this is a percentage arrived at by dividing the purchase cost of the property into the annual profit it produces.  So as an example, let’s say you buy a building with a couple stores on the first floor and a bunch of apartments above it.  The PROFIT (income after expenses like repairs and maintenance) earned is $120,000 per year and the sale price was $1,000,000.  $120,000 / $1,000,000 =   12%.  It’s a darn good cap rate.

Cap rate is so important in fact, that commercial lenders care far more about this factor than they do about any comparative analysis of the property they are offering the loan for.  Unlike with a residence in which an appraiser comes and looks at the condition of the home and then compares it based on other homes sold in the area; a commercial loan focuses on the income the property produces and if it will be realistic that the borrower will be able to use it to pay the loan back.  This isn’t to say that the building conditions don’t matter at all, but they are not the primary consideration.

Alas, I digress though.  In the most basic of terms, one could look at the items I listed above and apply it to their real world example to make the decision.  If an investor had the $1,000,000 in cash to buy the building outright, yes they would be making 12% return on that investment, but then all of their cash would be tied up in that one investment.

If instead, they got a commercial loan for something in the area of 5%, then they are making a net gain of 7% AND keeping their own money so that it can earn further interest in other investments (be they more real estate or other typical investments like stocks).

Granted, this is an over-simplification because there are costs to acquire the loan (down payment, points, etc.), but when the cap rate on a subject property is so many points in front of a loan interest rate, the devil in the details isn’t big enough to change the efficacy of the concept.  Real estate investing with OPM – when the cap rate makes it feasible – is akin to the power of compound interest in mutual fun investing.  One property can quickly become two, which can become four and so on…

For those who want to see the numbers with loan costs (“debt service”) figured in, the calculation is referred to as “cash on cash.”  A simple calculator for it can be found for free at http://www.proapod.com/calculator/free/o_coc.php

I did a quick example based on the numbers I was generalizing above:

  • $1,000,000 purchase cost.
  • $120,000 per year in rental income (although GROSS income, not profit in my calculation)
  • A loan with 5% rate, 30 year amortization period and 20% down payment/cost to acquire.

It looks something like this:

On this particular property, a smart investor would be in no hurry to pay off the loan.  In fact, they would likely keep borrowing against the property if possible.

Every situation is going to be different.  The main thing to keep in mind, though is that it is just about numbers, plain and simple.  If you do the math, you will have your answer.  Don’t just make any assumptions one way or another, even when based on previous experience.