In this post I’m going to cover why you should take into consideration the cost of money (C.O.M.) every time you’re using YOUR cash to buy an investment property (for the purposes of this post we’re focusing on Fixing and Flipping houses) or considering putting your money anywhere that it’s not readily available.
This is a concept that I learned recently from a very smart entrepreneur/investor Garrett Gunderson, he’s the owner of wealth Factory and the author of Killing Sacred Cows and What Would the Rockefellers Do. He did a training in our NYC office about wealth acceleration which is the service his company provides and he started to talk about the cost of money and how successful businesses use this concept to evaluate every financial decision they make when it comes time to use their money..
Why is taking cost of money into consideration important.
I know a lot of investors that use their own cash when it comes to buying their properties but one of the numbers that they don’t consider is how much it is actually costing to use their money. I know you’re probably thinking it’s my money it’s not costing me anything to use my own money or at least that’s what I said to myself.
The basic concept is this, whenever you’re using your own cash and you’re locking it up for
6 – 9 months (or whatever your timeframe is for your fix and flip projects) you can’t use your money to take on other opportunities and what if you missed out on a better investment than the one you’re currently invested in simply because you’re money is tied up. So unless you have more cash available or you leverage your free and clear asset to take out a loan, you’ll miss out.
In this situation being fully invested is costing you money hence the term cost of money C.O.M.
How to calculate cost of money.
Let’s say you have $200,000 in cash and you’re buying a property for $70,000 that needs $70,000 in repair and you’re going to sell it for $200,000 for simplicity sake I’m not getting into all the details about buying and selling cost, taxes, Insurance Etc. Let’s just say you’re making $60,000 in profit and the length of the project is 6 months. If you’re only using your cash you can do two of these in one year for a total profit $120,000.
Now let’s look at this scenario.
You still have $200,000 you’re going to buy the same house for $70,000 needs the same $70,000 in repair and you going to sell it for 200,000 except this time you’re not using $140,000 of your own money in fact you’re actually going to use 20% of the cost of the project so that’s that’s $30,000 (rounded up to make math easier). Now you have a loan from someone for $110,000 at 15% interest. For using their money for 6 months it’s going to cost you
(rounded up) $10,000. Your profit now instead of being $60,000 it’s going to be $50,000.
The difference in these two scenarios is $10,000 in profit to you.
But now it’s only taking you $30,000 to do this transaction instead of the $140,000. That means that what the same $140,000 you can do five transactions conservatively instead of just two in one year. If you’re more aggressive you can potentially do 10 fix and flip projects in one year with the same $140,000 and if each transaction is paying you $50,000 you just increased your potential income to $250,000-$500,000.
So yout cost of money can potentially be anywhere from $130,000 to $380,000.
Let’s look at the ROI perspective you put in $140K and made $60K that’s 43% ROI.
If you put in $30k and made $50K that’s 166% ROI.
Your cost of money is 166 % – 43% = 123% this is what it’s costing you for tying up all your cash in one transaction.
How to use cost of money to exponentially grow your wealth.
This is a difficult concept for a lot of people to understand or should I say be comfortable with. A lot of investors (that have their own cash, this doesn’t apply to those who don’t have their own cash and have no choice but to use lenders.) look at paying interest to a hard money lender, private investors or banks as a negative thing because lenders will charge between 12% -15% interest and to many investors that’s expensive.
What they don’t realize is that “they’re stepping over dollars to pick up pennies”.
I run into a lot of people with this mindset, this is a losing strategy. My advice to you is stop thinking about interest as an expense, debt or a bad cost but instead as cost of business, as investment or as an opportunity to leverage someone else’s money that will help you grow your wealth faster.
Remember my example above? You just doubled your net profit for the year, you did it by using the same amount of money and the best part is you’re even taking less risk. Now I know this seems silly to say because you’re doing more deals but look at it this way your lender is putting up most of the money to fund your deals so they’re taking a bigger risk than you are.
What are the risks of using lenders?
The biggest reason that I hear that people don’t want to use hard money lenders or other lenders to do the real estate deals is because they’re going to put a lien on the house and if something happens throughout the transaction for example the rehab process goes bad, you’re not able to get the estimated sale price because the market turned or the house burns down (there are a lot of things that can happen in a project ) there’s always a solution to the problem you’ll make less money in the deal, you’ll turn it into a rental until the market gets better or you’ll file an insurance claim.
Either way if that happened with your own cash you will have to deal with it anyways and the worst part is because all your money is tied up in one deal (and now that you have a problem in your deal forget about being able to get the money out no lenders will touch it at that point) you really can’t go out and do any other projects making this situation even worse.
On the other hand if you’re working on four other deals and something happens to one of them you can still recover or make up the money in the other deals.
Lenders that work with fix and flippers usually have a balloon payment and will call the loan due after 12-14 months so you need to make sure you’re out of the deal by then or have a plan in place in case you need more time.
They can foreclose on you if you you don’t pay them. This is a the BIG one for people, they feel that because they don’t own it free and clear that they can potentially lose it to the lender. While this is true let me ask you:
Why are you investing in a deal that you’re not sure will sell in 6-9 months?
Do you currently own a home with a mortgage? If so, why would you risk your personal residence being foreclosed on but you need to make sure that your investment property is paid cash?
The cost of money conversation is more of a mindset shift than anything else.
I believe this stems from people’s scarcity mindset, they feel like they have to save as much as possible to make more, but in fact this mentality is preventing them from becoming wealthy.
This can also come from Fear, the fear that they don’t have a good enough deal to overcome any challenges that may come.
Maybe it’s their lack of knowledge about this topic or they just don’t understand the numbers maybe they’ve never seen an example like the one I’m showing you here today.
The one thing that I can tell you is that financial institutions do this all the time and you should do it too, consider making ALL of your investments based on ROI not just how much money you’re going to make at the end of the deal.
This can be a game changer for you in your business and in your life. I know I will never look at another real estate deal without taking this into consideration.