In the blog post on leverage, we talk about using financing in general. In this article we compare three different methods and discuss the power of each. To remind our readers, we discuss the specifics of owning and operating residential real estate in the Dallas, Denton, Fort Worth area in this blog. If you have been reading but haven’t started investing yet, Get a Mentor and get started.
Which method will you use to make “$500K in 5 years”?
Take a look at this table below representing a sample deal. It is broken into three Phases: Entry, Operating and Exit and shows three different financing methods: Normal, Bridge and Cash. The Entry phase comprises purchasing, rehabbing and getting the property on the market for rent. The Operating phase is managing the rental property and the Exit phase is the eventual sale. We show an exit phase simply to show the results in conclusion. This does not imply that you should exit the deal. We’ll discuss the financing methods and the rows below, after the table.
|Cost at Service||113,500||117,000||111,500|
|Cash Out of Pocket||33,500||5,000||111,500|
|Home Owners Dues||20||20||20|
|Monthly Cash Flow||693||524||1,075|
|Cash on Cash Return||24.83%||125.77%||11.57%|
|Income from Cash Flow||41,584||31,442||64,500|
|Cost at Point of Sale||92,864||95,727||91,227|
|Property Refresh Cost||5,250||5,250||5,250|
|Capital Gain from Sale||55,011||52,148||56,648|
|Total Gain from Ownership||96,595||83,589||121,148|
|Total Return on Investment||85%||71%||109%|
|Annual Rate of Return||17%||14%||22%|
The financing methods are the columns: Normal, Bridge and Cash. Normal is a typical real estate purchase loan method where the buyer puts 20% down and gets a loan for 80% of value. This falls under the category of what’s called a conventional loan. Cash is self-explanatory where no loan is involved and buyer brings cash for the purchase and closing costs. Bridge is where a lender provides a short term loan (a few months perhaps) for a buyer to purchase and rehab the property. The lender may also include closing costs. After the property is fixed, the buyer refinances into a long term mortgage and pays back the short term lender.
The sample we are using here is a property that’s worth $140,000 that you buy for $100,00. It is 1,750 sq ft and needs about $10,000 in repairs. This would be a very typical single family rental property deal in the north Texas area including Collin, Dallas, Denton and Tarrant counties. Let’s look at these rows in particular:
1. Closing Costs: For the Cash deal this is going to be the lowest as you only pay title fees and government charges but no loan costs. The next highest would be the Normal deal with the loan costs addition. The highest is the Bridge loan. This is primarily because this cell includes two closing costs. The first at purchase of property and the second when you refinance to secure the long term mortgage. Bridge loan costs by way of closing costs and interest rates are higher than Normal loans as it is a short term loan and the lender is at a higher risk given the property condition. At the time of purchase the lender is loaning you money that’s more than what the property is worth. Someone’s got to pay for that!
2. Mortgage Payment and Cash Flow: For the Cash method, there is no mortgage payment – of course. Bridge loans are usually 75 to 80% of market value. In this sample deal it is 80% of $140,000 which is $112,000. Compared to the Normal loan which would also be 80%, but 80% of purchase price, not market value, which is 80% of $100,000 or $80,000. So the monthly mortgage payment for the Bridge method would be the highest at $551, compared to $382 for the Normal method. With all other operating costs being the same in the Operating phase, the mortgage difference would make the cash flow smallest for the Bridge deal. Cash method would be the highest and Normal, second.
3. Out of Pocket Cost and Cash on Cash Return: Though the cash flow is smallest with the Bridge method, the Cash on Cash Return would be highest. Often many orders of magnitude higher than other methods. This is because the Out of Pocket Cost is the lowest in the Bridge method. Bridge method is the perfect implementation of the goal: “Use other people’s money.” As purchase, rehab and both closing costs are leveraged, your out of pocket cost is close to non existent. In this case it is $5,000. For $5,000 you get to control a $140,000 asset and you get the benefits of the cash flow that an asset of that size produces among other benefits of that asset (read about the different ways real estate makes you money). That is the power of the Bridge method.
4. Cost at Point of Sale: Though this is not tied to the different financing options, it is important to mention. This row includes depreciation. We assume that you own this asset for 5 years. After depreciating each year, using simple straight line 27.5 year depreciation this would be your cost basis. This is deducted from the sale price to calculate your gain. In this deal, regardless of the method used, the gain is about $100,000. With Cash method it is usually better, as you don’t share that much of your profits, but you take all the risk and you are setting aside quite a significant sum of money.
So now, as we have discussed the significant differences of the three methods, which is better? To answer the question, let’s run through this scenario: If you have about $100,000 to invest, how many properties can you own and operate and make that gain of $100,000 each with that money? If you use the Cash method the answer is probably one (if that). Then it takes 5 years to get that money back and for it to give you another $100,000. Doubling your money in 5 years – in normal investments that’s considered pretty good. But not in real estate. If you used the Normal method with the same $100,000 how many can you do? Five or almost Five? If each property makes you a gain of $100,000 in 5 years, using the same amount of money invested, you made half a million dollars. That’s $400,000 more than what you did with the Cash approach or a 400% return ($500,000-$100,000)/$100,000.
Finally, let’s ask the same question for the Bridge method: How many properties can you do with $100,000 if your out of pocket cost for each property is $5,000? Twenty? So how much did you make in 5 years? 20 times $100,000 = $2,000,000. That’s two million dollars. What is the return? ($2,000,000 – $100,000)/$100,000 = 1,900%. Okay, may be you don’t believe you can do that. May be you are coming up with objections in your mind right now. May be you can’t buy 20 properties at a time, may be you can’t operate 20 properties at time, may be you can’t rent out 20 properties at a time, may be this, may be that. But ask yourself this: Can you do half that? Can you do 1/4th that? Are you at least 25% capable in what you do right now? If so, that’s a $500,000 net-worth growth (realized gain) in 5 years, using only $5,000 of your own money per deal. 5 years goes in flash. Are you ready to change your life? Get a Mentor and get started.