Use you own money or other people's money in a Fix and Flip?

One of the beautiful truisms about real estate is that it is a highly acceptable form of collateral for lenders.  The question many fix and flippers have is this:  should I fund the project myself or borrow funding?  The answer is determined by your level of risk tolerance and your return on investment (ROI) requirements.

We’ll analyze two examples to illustrate.  Example one has the investor funding the entire project with his own financing.  He has $125k in savings and wants to invest.  Example two has the investor leveraging a private money lender.  He too has $125k in savings and wants to invest.  The basics of the deal are simple:  Purchase price is $75k.  Repair / holding / closing costs are $25k.  ARV is $125k.  Profit margin is $25k.  This transaction should be profitable.  Is it better for the investor to use his own funds or borrow?

Example 1- Investor uses $100k of his own funds to fund the project.  What is the risk level?  If during the project, an unexpected expense, such as foundation problems, electrical problems, HVAC, vandalism, or plumbing arises, where do the additional funds come from?  If the holding costs go over expected timeframe, where do the funds come from?  What if the investor loses his job during the fix and flip and needs to rely on his savings for survival?  The point is that the money is tied up in the deal.  If anything goes wrong with the deal, the investor is out $100k plus.  This type of risk is the worst kind of risk.

The second part of this question is the Return on Investment (ROI) and for the sake of this example,  let’s assume that the simplified transaction goes as planned.  The investor, 4 months later, closes on the property for $125k and receives a check for $125k, and deposits the profit of $25k in his bank account, netting him a 25% ROI ($25k return / $100 investment=25%).  By most measures, this ROI is a success.  But was the risk of $100k worth only a 25% return?

Example 2- investor invests only $10k of his money and leverages a $90k loan at a 12% rate, adding an additional $3600 to his holding costs.  The total investment from the investor in this example is only $13,600 rather than $100,000.  What is the risk level?  If more money is needed, the investor still has $115k in savings from which to draw.  And if the deal goes south, the investor is out only the initial $10k plus holding costs rather than all $100k as in the first example.  Plus, he has significant savings to live off of should any of life’s little emergencies occur.  Leveraging others significantly reduces risk for the investor.

But let’s assume the simplified transaction goes as planned.  The investor, 4 months later, closes on the property for $125k.  After paying the lender back $90k, the investor deposits a profit of $35k.  Subtract the initial investment of $10k and the additional holding costs of $3600, and the investor netted $21,400.  What is the Return on Investment?  The investor invested a total of $13,600 to net a return of $21,400, which is an ROI of 157%!

As if the risk reduction and 600% improvement on ROI weren’t already enough justification for leveraging funds of others, let’s visit the concept of opportunity cost.  Opportunity costs, in economic terms, is the opportunities forgone in the choice of one expenditure over others.    In example 1, an investor used the majority of their life savings and risked $100,000 for a 25% return.  What if another fix and flip opportunity came to this investor?  Due to all funds being tied up, he would have had to pass on the opportunity.  However, the investor in example two had only utilized $13,600 from his savings.  He could perform 8 more fix and flips before using $100k of his own money.  That could be the difference in over $160k of profit!

In summary, the benefits of using other people’s money when performing fix and flips is that you greatly minimize your financial risk, you increase your ROI, and minimize your opportunity costs to perform multiple transactions at one time.    Given that you know what you are doing it is generally optimal to borrow money to minimize the amount of cash you have in the project to increase your returns using whatever set of metrics that you deem as appropriate.