Have you or someone you know recently had an offer rejected in favor of a cash offer? Its common enough now that its making the news. Given the historical highs in real estate paired with increasing proportion of student, auto, and credit card debt people carry against the lagging growth of wages, you should expect the opposite. Why is that?
For the remainder of this article let's assume that you are trying to finance the purchase of a distressed property.
Side note: if you are reading this because you have a deal you need financing for right now, call with me at 484-706-9601 or visit www.wingspreadlending.com/borrowers!
Conventional Financing
Let's start with a look at conventional loans. They fall into two categories: conforming which are those that meet Fannie Mae and Freddie Mac guidelines, and non conforming which do not. The majority of conventional loans are conforming. Loans are available with as little as 3% down, though the standard is 5%. Expect to pay private mortgage insurance (PMI) if you put less than 20% down. With this type of loan, investors get the lowest interest rates and longest terms for the lowest possible monthly payment. They generally take at least 30 days to close at a minimum. When dealing with a distressed seller, your offer may not be accepted due to the longer closing period. The closing period lasts even longer for government backed mortgages such as FHA, VA, and USDA loans.
Cash Offer (from accumulated capital)
When a buyer has accumulated enough capital that they can pay the purchase price, renovations, and closing costs without a loan, they are making an all cash offer. Because there is no underwriting and approval required from a lender, cash buyers can close on any timeline. A distressed seller views this as the ideal scenario and offer. For flippers, a cash offer equates to the the lowest holding costs of the three methods, and returns a good amount on investment. For rental property investors, cash offers represent the greatest possible cashflow for one property. Saving this kind of capital can take decades making it very difficult to achieve the ability to make this kind of offer.
Same As Cash Offer (Private / Hard Money Lending)
If the ability to make cash offers is so hard to achieve, why do we keep hearing about the rise in cash offers? It comes down to a third type of financing using a hard money or private money lender. This type of financing leads to a buyer making a "same as" cash offer, and many people just call it a cash offer. The two have become synonymous because these financiers close in nearly the same timeline as cash buyers do, making them highly desirable to distressed sellers.
Are You Making Your Best Offer? A Comparison Example
Let’s look the following example to compare the best offer. For clarification, best means the offer that yields the best return or ROI.
Assume you found a distressed seller who's home, after repairs, you estimate will appraisal for $300,000 (ARV). The repairs to achieve this appraisal cost $20,000 and the closing costs at the title company equal $10,000. Suppose you are able to negotiate a purchase price of $170,000 using the common formula for maximum allowable offer (MAO). To calculate MAO, multiply the ARV by 70% ($210,000) and subtract $40,000 for repairs and closing costs. Here's a comparison of what you would need bring to the closing table and how much you would need to borrow.
3 Ways to Buy an Investment Property
Some assumptions on the numbers:
Conventional: 20% Down, 5% Interest Rate, Paying Cash for Renovations and Closing Costs
Cash Offer (Traditional): 100% Cash for Purchase, Renovations, and Closing.
Cash Offer (Private/Hard Money Lender): 10% of Purchase Price Down, 90% of Purchase and 100% of Repairs and Closing costs financed, 2 Points to close, and a 12% Interest Rate.
Example Comparison for a Flip
Now that we know how much we are financing and how much we have in the deal, let's calculate our ROI if we flip this house. Assuming 10% of the purchase price will cover your closing costs and broker commissions, we expect the settlement to equal $270,000.
The settlement refers to the cash paid out to you after closing costs and paying off the mortgager. The total investment tracks how much cash we have in the deal. Profit is the remainder of the settlement after returning the capital invested in this deal. Return on sale is the percentage of the sale that we made in profit. Return on investment calculates what percentage of the capital contributed was returned in profit.
The clear winning strategy for flipping is the private/hard money loan. While the conventional loan returned the largest profit in pure dollars, it required twice the out of pocket investment as the PML/HML cash offer which returned 150% of the invested cash in profit. Very nice!
Example Comparison of Rental Property
How do the strategies compare for rental properties? Just straight up, the hard money loan loses because the financing costs are too great. But these loans aren't supposed to be long term loans. So let's compare the investments assuming that we refinanced the hard money loan into a conventional loan (same terms as the other conventional loan).
The calculation error for the PML/ HML offer jumps out immediately. It should, just not for the reason you're thinking. But first, notice the cashflows for each offer type. Conventional and cash both offer great straight up cashflow. But when you compare that to the amount of money invested in the deal, your return is less than 10%.
Contrast those against the PML/HML that we refinanced. Since the ARV of the property is $300,000, we can borrow up to 80% of that which is $240,000. You can either pocket the difference ($57,000!!!) of what you owe ($183,000), or just refinance what the remaining balance. In order to maximize cashflow, we only borrowed enough to pay off our debt. So now we have $0 invested in the deal, and still making $345.95 per month, or $4,151,40 per year. So when calculate our Cash on Cash, its infinite because $0 divided by any number is incalculable.
The Winner is....A Same As Cash Offer Using a Private or Hard Money Lender!
There you have it. A winner regardless of investing style. More and more investors are buying deals, and the increasing amount of "same as cash" loans being used explain why "cash offers" are becoming more common in real estate transactions.
If the example above excited you, reach out to me about funding your next project either by calling 484-706-9601 or visit www.wingspreadlending.com/borrowers to learn more.
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