Other People's Money

We got where we are in this real estate mess because everyone was trying to make money in Real Estate. That is not possible. Someone has to lose at some point in the investment life of a property. But for some reason, not only did the investors believe they could, the banks believed the investors could too. The Stock market doesn't work that way, why should the real estate market.

While all investments share the same elements, some issues are only found in Real Estate investments. One is the ability to buy it with OPM. Other People's money.

All investments have risk, and liquidity issues. Some investments require you to actually manage them to get your return. Since there is a basis in the investment and an income stream, hopefully, there will be tax considerations. But, other than perhaps a margin account, you will have to put up all the cash for all other investments except real estate.

Using OPM is called leverage. If you can make more income than the cost of the debt service, then it's called positive leverage and that is a good thing.

Let's crunch some numbers to show the effect of using OPM, rather than your own.

Source of Funds                                    Bank                        Bank Account 
Investment                                      $2,000,000.                    $2,000,000.
Out of Pocket                                      200,000.                      $2,000,000.

Cash Flow Year 1
              Income                                     $175,000                     $175,000
              Interest                                        77,126                                0
              Cost Recovery                              9,828                            9,828
              RE Taxable Income                     88,046                         165,172
              Tax Savings                               $24,653                          $46,248

After Tax Investment Return                       28.36%                         17.61%

You can calculate this with a financial calculator or you can let me use a spreadsheet and run various scenarios for you. As you can see when you have less money at risk, and the investment returns more in income than the cost of the money, then in the term of the investment you will get a better return by using OPM. It has a lot to do with the spread between the Interest Rate and the Cap Rate on the investment. It also has to do with the tax advantage of deducting the interest against the income before calculating the tax. In this case, with the sample numbers shown the return is 11% greater with financing.

Investments can be risky, not everyone can make money. Don't make it worse and risk your own money if you don't have to.