The Benefits of Using Debt Instead of All Cash Financing for Real Estate

This is the quandary that all real estate investors face: should I use only cash or should I make use of debt financing? Of course, the first impulse is to reject debt financing and go for cash. But such a decision can lead to a quagmire of problems that you must seriously consider.

Here is one scenario.

Suppose Harebrained Harry uses his personal cash, a sum of $130,000, to purchase property worth $100,000, renovate it by investing $30,000 and then sell it for $160,000 within 6 months. He will have earned $30,000 profit in six months for a $130,000 investment.

It might sound impressive but there are potential pitfalls. Harry’s cash is tied up for a full six months; during this time, he will miss any other investment opportunity that presents itself. This means lost earnings.

Now we will look at Wise Guy William who faces precisely the same scenario. His personal cash amounts to $130,000. He wants to buy $100,000 property, and renovate it with $30,000 for a final selling price of $160,000. But since he is the Wise Guy, William does things differently. He gets a $120,000 loan with an annual interest rate of 10%. Due to the loan’s support, he contributes only $10,000 from personal cash. Interest paid during six months is $6000. The profit is therefore $24,000 i.e. the difference of $30,000 and $6000.

At this point, one might think that Harebrained Harry got a better deal by earning $30,000 profit compared to $24,000 earned by Wise Guy William (who lost $6,000 on interest).

But don’t forget that William still has $120000 cash because of the loan. Consequently, he buys property for $90,000, invests $30,000 for renovation and sells the final property for $145,000 to earn a profit of $25,000 on this project. His final profit turns out to be $49,000 i.e. the sum of $24,000 and $25,000.

Put succinctly, Wise Guy William leveraged the power of debt finance to execute MORE projects than Harry. So, in spite of the moderate interest, he earned far more profit.

Before getting excited about debt finance, you should know that not all debt is equal. In fact, commercial real estate finance from banks can be mired with problems.

Banks require long credit history of at least 5 years. SMEs have a much shorter lifespan, so they become ineligible because they are high risk prospects.

Banks also charge high upfront deposits which can amount to 25%. If the development project goes awry, then banks can recuperate losses from the heavy down payment – at your expense.

Banks also offer low Loan-to-Value (LTV) ratios. LTV is the ratio of the loan amount to property price. So if a property’s price is $100,000 and the loan is $80,000, then the LTV is 80%. Banks give low LTVs to mitigate risks. If they offer high LTV, it comes at a high interest rate.  It’s a catch-22 situation: to enjoy low interest rate, you will be subjected to the low LTV ordeal and to obtain high LTVs, you have to suffer high interest rates.

This is just one problem among many. To avoid these pitfalls, you should seek alternative sources of finance.

KLB Business Funding offers up to 90% LTV, no upfront deposits, relatively low interest rates and approval times that can be as small as 24 hours.  

So contact us today for a free consultation.

• 3702 Pratt Avenue Bronx NY 10466
• (347) 755-2257

info@klbbusinessfunding.com