Borrowing To Invest Can Increase Cashflow and Lower Risk – Deploying existing real estate equity owned by you or your friend. Borrowing to invest can be a potentially obvious investment strategy that I would like to put a creative twist on for you. Borrowing to invest in real estate or notes using a cash out mortgage or line of credit against real estate you already own can have very powerful results and can often improve your cashflow and LOWER your risk. Here’s how:
My client owned a primary residence valued at $500,000 and had a $300,000 first mortgage and $200,000 of equity. The client refinanced the property with a new $400,000 first mortgage and pulled out $100,000 of investment capital. His net worth was the same before and after borrowing to invest; he just moved half of his equity into cash. He then took the cash and purchased two $50,000 notes totaling $100,000, secured by $140,000 worth of real estate. The client borrowed the money from his primary residence at 4% and invested it into notes paying 10%.
$100,000 borrowed capital x 4% = $4,000 interest expense $100,000 invested capital x 10% = $10,000 interest income $10,000 interest income – $4,000 interest expense = $6,000 annual profit
On a simplistic basis, we can see borrowing to invest was a profitable move because the fixed cost of funds was lower than the fixed earning rate. Let’s look a little deeper at the cashflow on this deal.
The $100,000 of extra mortgage expense at 4% on a 30 year fully amortized loan is a cashflow outgo of $477/month.
The $100,000 investment notes at 10% interest on a 15 year fully amortized loan is a cashflow income of $1,075/ month.
$1,075 cash in less $477 cash out = $598 positive cashflow
(Albeit, not all of the $598 is profit because we are dealing with principal and interest payments using two different amortization schedules (expense is 30 year and the income is 15 year).
The above is a great example of how being a borrower and using the concept of positive arbitrage can improve cashflow. The investor client is happy because he improved his cashflow position by $598 per month simply by signing his name a few times, but he is also happy because this situation LOWERED his risk. Here’s how:
When your monthly cashflow improves, your risk goes down because you have more liquidity to service your debts and build up cash reserves.
When the investor moved $100,000 of equity from his home into first position debt secured by other real estate, he moved the asset from higher risk “equity” to lower risk “senior debt”. Let me go deeper into this concept. If the investor loses his job or credit in the future, he would be unable to tap the equity in his home without selling his primary residence. However, by moving the equity from his home into first position liens on other property, he has the peace of mind that if he ever loses his job and wants to tap the equity in his home, he can always liquidate the notes for cash.
The investor has also insulated his assets from the potential of real estate price declines. If the investor had not moved his equity from his primary residence and real estate prices decline 40%, his $500,000 property would be worth $300,000, less the $300,000 of original debt, so his net equity would have gone from $200,000 to $0. If he sold his house at this point in the market, he would have zero cash from the sale and he certainly wouldn’t be able to refinance any equity out of her home because there would be no equity.
By borrowing to invest his equity into first position notes, his liquidity is more insulated from loss. His $500,000 property declines to $300,000. Less $400,000 of debt, that means he has a $100,000 negative equity in his primary residence but he doesn’t have to sell his primary residence until the market recovers. Remember, when investing in real estate the value of a property only matters when you are selling or refinancing. The main concern the investor is insulating against is not a change in profitability but a change in access to liquidity. Even if the notes go bad (always a risk), the investor will end up owning the underlying real estate. Ideally, the foreclosed houses would make great rental properties and would produce more rental income than what he was originally receiving in interest income from the previous owner. However, if he decided to sell the foreclosed real estate, even if that real estate had gone down in value, it would not have declined to zero as the equity in his home did. Moving your at risk “junior” equity into positively arbitraged “senior” notes while you have the equity and credit available to you would be the lesser of two evils in the event of large price declines.
Here is another risk mitigating bonus for my investor client: The investor owned a home in a high priced state and was concerned that the state’s economy and home prices might be fragile and unaffordable in the future. He moved his at risk “junior” equity from his high priced state into “senior debt” secured by entry level real estate in Dallas, Texas, which is a more vibrant and diverse economy. The investor felt that moving the equity out of his primary residence into a senior debt allowed him to (1) improve his immediate cashflow, (2) allow him to have access to this equity in the future regardless of his employment or credit position, (3) gave him options for liquidity in the future even if there are massive price declines, and (4) it gave his investments geographic diversity by moving a portion of her equity to Texas.
In addition to borrowing to invest in real estate and cashflow producing notes, I encourage you to watch this free video series where we discuss your “Eight Essential Resources” and how to use them to produce real estate profits: http://www.hasslefreecashflowinvesting.com/video/secrets-of-hassle-free-cashflow-real-estate-investing/
