Leverage, which in this context means buying properties by taking on debt, can be used to grow your wealth. The reason leverage is used is that it can boost your return on investment (ROI). The debt portion of a leveraged real-estate deal is funded with borrowed money.
Leverage makes flipping more profitable. Without it, a flipper would need to provide 100 percent of a property’s purchase price plus renovation costs. Suppose a flipper pays $200,000 in cash. The flipper might be able to quickly renovate the property, say over three months, for $30,000 and resell the property for $260,000. That’s a 13 percent ROI (($260,000 – $230,000) / $230,000).
That return is not a bad, but a flipper will do much better using leverage. The amount a flipper can borrow is determined by the lender’s loan-to-value(LTV) standards. A hard money lender will typically set an LTV ratio in the 70 to 80 percent range. This applies to the projected value of the property afterrenovation. In other words, if the lender puts up 80 percent of the $260,000 property, the loan amount would be $208,000. The flipper would be responsible for the remaining $52,000. If the flipper sells the property for $260,000, the ROI would be 400 percent (($260,000 – $52,000) / $52,000). That’s right, in this example you get a 4X return on your money by using leverage. That’s a lot better than 13 percent.
For the sake of simplicity, this example assumes a three-month turnover on the property, thereby minimizing interest costs on the borrowed money. But even if you factor in interest of $5,000, the return is (($260,000 – $57,000) / $57,000), or 356 percent. Don’t forget, the interest is deductible, which improves your return even more.
Finding the Right Private Lender
Rookie mistakes happen everywhere, including the rehab sector. Rate shopping is great, but a savvy developer is going to look beyond APRs. The most important feature a private lender can offer is expertise born of experience. For rehabbers, the best lenders have years of experience, because these lenders can help flippers navigate the obstacles bound to arise. A lender that has funded all kinds of project knows what to do and who to contact. That often spells the difference between success and failure.
Rehabbers should also look to a lender with a local presence. It’s important to have help with zoning laws, building codes, inspection customs and many other local issues.
One last point – a good private lender will offer creative ways to finance. For example, a project can be sectioned into two phases – purchase and rehab – with separate funding for each phase. Structuring loans in this way means a rehabber doesn’t have to pay unnecessary interest, but rather can wait on the second phase until permits are obtained and work is ready to begin. If you live in the Washington D.C. region and want more information about using leverage, contact Specialty Lending Group today!