Distressed and vacant properties frequently provide the best return on investment relative to other, more stabilized, properties. Instead of making your money through slowly increasing rents and net operating incomes, you earn profit by buying at a good price, rehabilitating it and selling it at a higher price. Leverage, like that provided by hard money loans, increases your returns and makes these potentially lucrative investments even more valuable.
For example, consider the purchase of a $150,000 house that needs $50,000 in work to bring it up to a market value of $275,000. It will cost you about $3,000 to hold onto the house for a year while you work on it and find a buyer, and about $20,000 in commissions and fees to sell it. In other words, you’d spend $203,000 to make $255,000, and end up with a healthy 25.6 percent return. This is a relatively conservative analysis — projecting a property with only a minor discount.
If you could borrow $110,000 of your $203,000 in costs, the economics would work out differently. On one hand, you’d have about $15,000 in additional costs for loan origination fees and interest, but, you’d end up with $155,000 at the sale, having only spent $108,000. The $108,000 includes the $15,000 in loan costs and the remaining $93,000 you put down. This is a 43.5 percent return — almost twice what you make on buying the same deal without using hard money. Furthermore, since you’re using less of your own money, you can buy two properties at the same time.
REASON INVESTORS USE HARD MONEY LOANS
The reason that using a hard money loan gives you the best return on investment is that you get to put less money in the deal but get to keep all of the upside. The hard money lender makes their money on the loan fees and interest, but doesn’t get to participate in the value that you create. Since they don’t do the work, they don’t make the money. This is the magic of leverage — it inflates the proportion of your investment that is subject to upside.
For many of the best investments, hard money lenders are the only option, since they do not require the same strict qualifying standards as a bank. While these loans may seem expensive to source, they clearly offer the best return on investment. This is why they are so popular with upside-seeking property investors.