One of the main goals of investing in real estate is to achieve a return on investment (ROI). And while there are plenty of ways to do that when purchasing a property with cash or traditional financing, the ability to use other people's money, or OPM finance, can increase your return on investment tremendously. The concept of using other people's money to finance real estate deals may seem far-fetched, but it's actually quite popular in real estate investing. Learn how OPM works, including common types of OPM finance, and pros and cons of this alternative method of financing.
Why use other people's money to invest in real estate?
There are benefits to investing with cash. Less debt means less liability if the investment or economy were to go south, but the less capital you have invested in a given asset means the greater the opportunity for increased return. For example, let's look at a fix-and-flip in two scenarios: The first works with a hard money lender putting $20,000 into the investment, netting $30,000 as profit when all is said and done. Looks great on paper, earning a cash-on-cash return (CoC) of 150%. Now let's look at an all-cash scenario. Instead of working with a lender, you put $180,000 cash up front. You save on the cost of financing, earning a net profit of $40,000, but the return is much less at 22%.
Even though you earned more, you had to spend more, meaning your money has to work harder for you to achieve the same return. Tapping into other people's money means you can use less of your own money and, hopefully, earn more with it. You can also leverage your money, spreading it across multiple assets rather than investing all of your money into one investment property.
Common types of OPM finance
Hard money loans are by far the most common type of OPM finance. A third-party lender, which can be a private institution or individual, provides a loan up to a portion of the property's value, oftentimes including things like renovation costs. It's not uncommon for hard money loans to include points or other financing costs offered for shorter periods of time such as a year or less. You can also secure financing outside of a formal hard money loan, for example from a friend or family member, which usually will offer a lower interest rate.
Pros and cons of using OPM
Outside of having the ability to leverage your own money and increase your return on investment, a major advantage of using OPM is the ease of obtaining financing. Because these loans are handled in the private market, you don't have to jump through a lot of the hoops of traditional financing, such as underwriting the property, inspections and appraisals, and qualifying as a borrower.
However, one of the biggest disadvantages of using other people's money is the cost of financing. Private-money lenders are notorious for charging high interest rates, sometimes in the double digits, meaning your profitability ratio is dependent on the specific deal as it relates to finance cost and cash flow or expected revenue.
Right now, mortgage rates are some of the lowest they've ever been. For many it doesn't make sense to obtain a loan at 10% interest or more when rates are hovering around 4%. But there is a lot of work that goes into traditional financing and securing a lower long-term rate.
The lower the interest rate, the less risk you carry in your financing and the greater the return you will achieve, but the ease of getting the loan may outweigh the higher cost for financing and for some properties may be the only option. OPM is great for investment properties that need renovations, because the lender will likely include renovation costs into their financing terms, allowing you to fix the property up and get it rented before refinancing it at a lower interest rate.
Using other people's money can be a valuable tool in your real estate investment tool kit, but it's important to remember it's still debt. Just because you have less money into the investment doesn't mean you're free from risk. It's always important to make sure you're not overleveraged in any one investment property and to have a firm grasp on the property's income and expenses. I am a big proponent of using other people's money. Out of the over 50+ deals I've completed to this point, 90% have used OPM. Knowing the cost for financing before you analyze an investment allows you to consider the cost for financing and determine how much, if any of your own money will be needed up front and ultimately determine if using OPM is the right move or if another financing option is better suited for you or this particular investment.