What is the Most Expensive Way to Finance Your Real Estate Deals?

Question

During a presentation given at a local real estate investor’s club last week, a very successful real estate investor wrote a list on the white board. The list he gave was 15 different ways to finance your real estate deals. Some of these included:

1.	Your own cash
2.	Your partner’s cash
3.	Your SEP IRA
4.	Your family or friend’s cash
5.	Hard money lenders
6.	Bank line of credit

After writing out the list of 15 ways to finance your real estate deal, the investor then asked the group, “What is the most expensive way to finance your real estate deals?”

Of course everyone in the group said ‘hard money lenders,’ but this was the wrong answer. The correct answer to the question is actually #1, followed by #2.

But why is your own cash the most expensive way to finance your real estate deals? Consider the opportunity cost of locking up all of your own cash in one deal at a time. What if the deal goes south? By using hard money lenders to finance your real estate deals, you can do more than one deal at a time, spreading out your own precious cash across more deals.

The second most expensive way to finance your real estate deals? Number two, your partner’s cash. Unlike a hard money lender that will only take interest payments and a loan fee, a partner will take 50% or more of your profits.

If you want to be a full-time real estate investor and quit your day job, you can’t do just one deal at a time. This means you’re only getting paid every 4 months. By using hard money lenders to finance your real estate deals, you can do 4 deals at a time, which would allow you to get a paycheck every month.

Instead of using your own cash, the most expensive method to finance your real estate deals, consider using hard money lenders and spread your cash out over multiple deals.

J Scott · Answer

I knew as soon as I started reading what the question and answer were going to be.  As with most things in real estate and investing in general, the answer to almost all questions will be "it depends."  And if you spin the circumstances in the right way, you can justify almost any answer.

In this case, the guy obviously wanted to be provocative and/or controversial, so he gave a question and some circumstances where the "right" answer would have that effect.

That said, for me and my situation, I agree with Jon.  If I were to use loans for all my deals, my cost of capital would be much, much, much higher than what I was earning on my cash sitting in the bank.  That doesn't make any sense unless there were some other advantages to holding that cash in the bank.

If the thought is that I'll want to do more deals than I have cash, then it makes sense for any successful investor to finance (your returns will generally be higher than your cost of capital), but it wouldn't be financially prudent to finance the first set of properties and then use your cash on the later ones -- it would make more fiscal sense to use your cash first and finance later.  This reduces your overall cost of capital by ensuring your only paying for money when you absolutely need it.

Of course, there are situations where cash might be more "expensive" than financing.  But, these are generally situations where there's an opportunity cost to using cash now versus later.  The most common situation would be where you would finance a deal now in order to preserve cash for a later deal that couldn't be financed -- and if you didn't have the cash, you couldn't do the later deal.

But, my assessment above presumes that all deals are essentially the same, and any of them could be cash or could be financed, so this situation doesn't apply.

Again, everyone will be in a different situation, but for me, I prefer to use about 70% of my cash before I consider financing, saving the 30% in case any cash-only deals come along...

Jon Klaus · Answer

Corey, what should you do with your own cash?  I for one like my cash to work hard and not just sit in the bank or be consumed with lifestyle.

I'm not against OPM, but it seems like some say it's the only way to go.  What do you do with your cash if it you don't put it to work?

Rob K. · Answer

A lot of investors are very short-sighted. They don't see the finish line that one day, you're going to want to have everything paid off and not owe a dime to anyone. Obviously, most of us started by borrowing money. The goal should be to have so much money that you no longer need to borrow. It's much better to pay cash and not have to pay for appraisals, the mountain of fees that banks charge, or even worse, the fees that HMS's (hard money sharks)charge, and especially all of the compoiund interest that adds up.

It's amazing how fast time flies by. Often, when you buy a house, you don't think you will keep it for a long time. I own houses that I've had for 10+ years. It has flown by. Look how fast your kids grow up.

I would never tell someone not to borrow money to buy a house. (I tell everyoine never to borrow to buy a car) I just think that using your own cash is the best way to go if you can. Then, you don't have that debt weighing down on you and you're not on the treadmill every month to make the payments.

Personally, I would rather own ten houses that are paid off than 20 or 30 that are mortgaged.

Dale Osborn · Answer

When you first start investing your own cash is limited so you want to try to spread it around into more properties. In this scenario borrowing would make more sense and your limited cash is the reserves.

Later as you build up your reserves - you can start to increase the amount you contribute towards a property and still maintain a solid reserve amount. Initially perhaps you put in 20% and financed 80%. Later you might move to 40% down and only finance 60%. As your cash amount builds, you can make several choices for it:

1. Pay off the mortgage and just use the income to live on. This may result in paying some higher income taxes without the mortgage deduction.

2. Decide you want to just be the bank and use your cash to finance other investors or buyers. A very passive form of investing for the retirement years.

3. Invest your excess cash into writing books and putting on boot camps to train the entrepreneurs of tomorrow. Not for profit like the so called gurus do - just because you feel the need to give back.

4. Take your excess cash and enjoy all of those consumer spending deals you passed on to get where you are today. Take a cruise, tour Europe, Asia, Australia, etc. Enjoy life!

At some point you reach saturation and simply say - I have made enough and you fade into the woodwork??

Corey Dutton · Answer

Yes you're right Glenn Espinosa, most people start out doing one at a time, which means they are starving to death in between pay checks. Hard money is a good way to do several at a time so you get a paycheck more often.

Glenn Espinosa · Answer

A lot of this depends on your goals as well as what stage of your rehabbing career you're in. To get to the next level and to grow exponentially, you'll definitely need to start leveraging the use of other people's money.

I'm currently struggling with this issue myself. I've only ever done 1 flip at a time but I would like to break into 2 or maybe even 3 simultaneous flips during the upcoming year. While I've put up about 60-75% of the cost required to do my previous flips, I'll definitely need to decrease that ratio and finance more of my flips in order to reach my goal of doing multiple flips at a time. There just isn't enough cash in my bank account to grow my business exponentially.

Callum K. · Answer

Thanks for the response.  I didn't notice this thread was directed towards flipping and certainly understand the differences in how one operates under each others circumstances.  Your approach intrigues me because I was hoping for some magical way to not have to deal with all the red tape with banks.  Perhaps your approach may work for my situation as well...  Regardless, different perspectives will give me something to think about in my endeavors.  Thanks again!

J Scott · Answer

This is the rehabbing/flipping forum, so I assumed that is what we were discussing.

If we're talking about rentals, that's a completely different conversation and then there would be a lot of other factors that would play into what the right decision would be in different situations.

Corey Dutton · Answer

The problem with cash out refinances is they are harder to get from a bank and hard money lenders usually won't do them and if they do they won't go longer than 12 months which isn't enough time for an exit unless you're flipping it. Plus cash out refinances from a hard money lender usually cost more than a rehab loan from one. Just sayin...

J Scott · Answer

Maybe.  Or maybe we're in different situations, have different goals or have different access to financing.

Personally, it's just as easy for me to do a cash-out refinance on a property I own outright than it is to purchase it originally with financing.  In fact, it's actually cheaper and much easier for me to do a cash-out refi than to purchase with financing upfront.

I'd rather buy 10 houses for cash and then do cash-out refis to buy more if necessary, as opposed to getting loans on each of them upfront.  That way, the loan durations are shorter, I don't get loans that I don't need and the whole process is a lot simpler (for me, at least).

But again, that's based on my situation, my goals, my strategy, my opportunity costs, my financing options, etc.

What is the Most Expensive Way to Finance Your Real Estate Deals?

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