One of the major challenges faced by new real estate investors involves money. Namely, how can you actually pay for a deal? Personally, I’ll argue that even if you have tons of money sitting around, you’re better off financing deals with other people’s money. As such, I’m going to use this article to argue why every investor should use 100% real estate financing.
When you 100% finance a property, you entirely use debt to make that deal happen. This approach has several main advantages, including increased return on investment, keeping your assets liquid, risk reduction, operational control, tax deductions, credit score improvements, and accessibility.
In the rest of the article, I’ll dive into the details of each one of these benefits. Specifically, I’ll cover the following topics:
- What We Mean by 100% Financing
- Benefit 1: Increased ROI
- Benefit 2: Don’t Tie Up Your Liquid Assets
- Benefit 3: Reduce Risk
- Benefit 4: Don’t Give Up Ownership Stakes
- Benefit 5: Tax Deductible Interest Payments
- Benefit 6: Taxes Lower Your Effective Interest Rate
- Benefit 7: Leverage Improves Your Credit Score
- Benefit 8: Anyone Can 100% Finance a Property
- Final Thoughts
What We Mean by 100% Financing
100% Financing Overview
Before discussing the rationale behind using 100% financing in real estate, I want to take a moment to actually define 100% financing. In corporate finance, a company’s capital structure refers to how it blends debt (i.e. loans, notes, and bonds) and equity (i.e. company stock) to fund the company. In real estate, when I refer to 100% financing, I’m specifically referring to debt finance, that is, using loans and other sources of credit to finance an investment.
Using Hard Money to 100% Finance Properties
And, most investors accomplish this 100% financing with a particular type of debt: hard money loans.
When reviewing a loan application, hard money lenders focus solely on the “hard” asset, that is, the property. If they can secure enough equity in the home, they’ll issue the loan. And, most of these lenders base this equity on the after-rehab value, or ARV. That is, they look at market comps to appraise the value following the rehab, and they typically will lend up to 70% LTV on that number. Accordingly, hard money lenders protect themselves with a far higher secured stake in the underlying property.
For example, if a property appraises with an ARV of $300,000, the hard money lender will qualify you for a $210,000 loan ($300,000 ARV x 70% LTV). If you can buy, rehab, and sell this property for $210,000 or less, you both A) qualify for the loan, and B) can entirely finance the deal with hard money.
Traditionally, hard money lending alone often won’t get you to the magical 100% financing number in a real estate deal. But, continuing the above example, you can still reach the 100% financing mark even if your deal budget exceeds the $210,000 hard money loan.
This is actually a fairly typical situation, that is, needing to find funds in excess of your hard money loan. Frankly, it’s extremely difficult to find the sort of awesome deal that a hard money loan will 100% cover. This reality means that most investors have other financing techniques to meet their budget needs above a hard money loan. While not a comprehensive list, investors can do the following to bridge the gap between a hard money loan and deal budget:
- Use a business line of credit.
- Use a home equity line of credit.
- Use a home equity loan.
- Use a credit card loan.
Each of these gap financing techniques provides investors another “tool in the toolbelt” to 100% finance a deal.
What If I Don’t Need to Finance Properties?
I want to make something clear about 100% financing: it’s not just a good strategy for people without a ton of money. Even if you don’t need to finance properties (i.e. you have enough money to pay for a deal in cash), there are still tremendous benefits to this approach. Bottom line, even if you have money to burn, 100% financing a deal often makes sense. And, I’ll use the rest of the article to outline eight major benefits to this financing approach.
Benefit 1: Increased ROI
The concept of leverage (i.e. using debt to purchase a home) significantly increases your return on investment. As the loan-to-value (LTV) increases on a property, the cash-on-cash return increases as well. In other words, with a properly analyzed real estate deal, the greater your leverage, the greater your returns. I’ll demonstrate with a basic example:
Assume you can buy a rental property for $250,000, and it generates $15,000 in net operating income every year. If you paid all-cash for this property, that would translate to a 6% return on investment, or ROI ($15,000 / $250,000). But, what if you instead used a mortgage with a 20% down payment to purchase the property? That would mean you invested $50,000 in cash and a $200,000 loan to buy this property.
Now, your loan payments would cut into your cash flow. But, you’d also increase your ROI. Assuming a 3.5% interest rate and 30-year term on that $200,000 mortgage, you’d have annual debt payments of ~$10,900. As such, your annual cash flow would now be $4,100 ($15,000 NOI – $10,900 in debt service). This translates into an 8.2% ROI, 2.2% higher than an all-cash deal! ($4,100 / $50,000 down payment).
And, in addition to the higher ROI with a leveraged deal, you also gain two other great benefits. First, you gradually build wealth through that loan’s amortization, as outlined in the above profit paths. But, more importantly, you can now use the remaining $200,000 for other deals. Instead of buying one property for $250,000, you can buy five $250,000 properties, each with a $50,000 down payment. With this approach, you’d then own $1.25 million in real estate!
Yes, these are simplified numbers, but the important takeaway is the concept: using debt to buy real estate increases your ROI. And, by extension, this leverage speeds up the process of building long-term wealth. Furthermore, the above example included a down payment. If you can reduce that down payment to zero, you potentially have unlimited returns, as you have no cash into the deal – incredible!
Benefit 2: Don’t Tie Up Your Liquid Assets
Another major benefit to 100% financing involves opportunity cost. When you pour all of your cash into a real estate deal, you lose the ability to use that cash to seize other investment opportunities when they arise (hence the term opportunity cost).
For example, let’s say that you have $100,000 in investable cash (i.e. funds not earmarked for retirement, emergency funds, or other priorities). You want to flip a house, but you’re not sure whether or not to use that cash or seek a hard money loan. With a 70% LTV hard money loan, $100,000 is the loan amount you could receive for a home with a ~$143,000 ARV. And, after analyzing a deal, you confirm that $100,000 will cover all of your costs.
So, at this point, you ask: should I take out a $100,000 hard money loan, paying interest in the process, or should I use my $100,000 in cash to pay for the deal? Yes, using your cash would save you interest payments. But, it would also prevent you from seizing other investment opportunities.
For example, in March 2020, the stock market collapsed at the onset of the COVID-19 pandemic. As Warren Buffett famously said, “Be fearful when others are greedy and greedy when others are fearful.” In other words, when the stock market collapses, buy! At its trough in March 2020, the S&P 500 dropped to around 2,300. By July 2021 – 15 months later – it had rebounded to over 4,300. Accordingly, ignoring dividends, investing that $100,000 in a market-tracking index fund would’ve nearly doubled your investment. And, you would’ve still been able to make this house flip deal happen by 100% financing the $100,000 deal budget.
Sure, you can argue that this is an example of retroactively connecting the dots. But, the important takeaway here is that, if you tie up all of your liquid assets in real estate, you lose the ability to take advantage of other investment opportunities when they arise.
Benefit 3: Reduce Risk
Return per Risk
Traditionally, stocks – or equities – have been considered a higher-risk, higher-reward investment than real estate. Recent studies across the world’s wealthiest economies suggest a different view. While equities do, in fact, remain more volatile – and therefore riskier – than real estate, the returns may not follow that increased risk.
According to the Sharpe Ratio, which measures return over risk, the average return per unit of risk with real estate exceeds that of stocks (as seen in the above chart). In other words, you get far more “bang for your risk buck” when you invest in real estate over stocks. This may seem counterintuitive to many investors, but the numbers support the information.
And, you amplify those returns when you 100% finance an investment property. Say, for instance, you use $40,000 as a down payment on a $200,000 rental property. Even accounting for debt service, your returns revolve around the entire asset – the $200,000 property – not just the cash you put into it, which I discussed in the above section on ROI. But, you don’t need to have those down payment funds to reap the return-per-unit-of-risk benefits outlined in this chart. Rather, 100% financing allows you to generate returns based on the entire asset without needing to clear the significant hurdle of coming up with a large down payment – even accounting for debt service.
But, once again, what if you do have that $40,000 in your bank account to use for a down payment? Should you use those funds, or still pursue a 100% financing route?
For all of the benefits of real estate, it is not a liquid asset class. That is, quickly converting a rental property portfolio to cash is not easy. Yes, you can certainly sell or refinance properties to turn your equity to cash, but it’s not a quick process. As a result, tying your cash up in real estate exposes you to liquidity risk, that is, the risk of not being able to access cash when we need it.
I like to think of having cash on hand as a personal insurance policy. Unfortunately, none of us can predict the future. We don’t know when some sort of financial emergency will arise. I would rather use leverage in real estate and keep cash and cash equivalents readily available than tie all my liquid assets up in real estate. What happens if a family member or I experience a health emergency? Yes, health insurance will cover some expenses – but not all. Rather than go into massive amounts of debt to cover emergency expenses like that, I’d prefer to have some cash available. If I pour all of my liquidity into real estate, I won’t have that same peace of mind.
A Counter-argument Regarding Risk
I’d be remiss to not briefly discuss a common counter-argument regarding risk, which is the idea that real estate proves too risky.
During the Great Recession, property values in many parts of the country seemed to collapse overnight. As a result, contrarians have argued that investing in real estate – particularly flipping houses – poses too much valuation risk. In other words, the value of a property can change too quickly, setting house flippers up with the massive risk of final values not aligning with projected ARVs.
While yes, property values can and do change, real estate as an asset class remains remarkably stable. And, even in a worst case scenario, investors can mitigate the effects of volatility in two ways.
- Speed: It may have seemed that property values during the Great Recession collapsed overnight, but this took time for the market to react. By completing flips quickly – ideally in six months or less – investors limit their exposure to valuation risk. The market just doesn’t generally react quickly enough to see a catastrophic collapse in property values in less than a six-month period.
- Conversion to rental: But, let’s play devil’s advocate and assume, for the sake of argument, that property values do collapse during a flip rehab period. When you look at historical valuation trends, real estate appreciates over time. Dips in the market inevitably happen, but if you hold a property long enough, it should appreciate. This provides house flippers a contingency plan. If the market drops during a hold period, you simply embrace the BRRR strategy and convert your flip into a rental property. Eventually, values will recover.
Benefit 4: Don’t Give Up Ownership Stakes
Maintain Control of Major Decisions
In this section, I’m going to speak towards the idea of using debt-based financing rather than equity. In other words, when you finance a property, not bringing on business partners who invest money in return for an ownership interest in that property.
Unfortunately, when people invest with you, there are always strings attached. If someone gives you money to make a deal happen, that person will want to have a say in how you manage the deal. This can become a day-to-day nightmare, with someone nitpicking every decision you make, from what outlet covers to use to how you should price the renovated property.
Additionally, when you give up an ownership stake in a property, that investor will inevitably have a unique personal and financial situation. I’ve seen it happen countless times: someone invests money in a deal, experiences a financial hardship, and demands the invested money be returned. As I said above, real estate just isn’t a liquid investment, and you can’t quickly return funds once they’ve been poured into a property.
When you 100% finance a property with debt – as opposed to bringing on equity partners – you don’t have to deal with either of the above situations. Instead, you maintain complete control of a deal’s major decisions. Yes, you’ll need to abide by debt covenants related to your loan, but those covenants likely won’t dictate operational decisions. Simply put, complete debt financing gives you more control over a deal.
Reap the Rewards
When you give up ownership stakes in a deal, you also sacrifice a portion of the deal’s returns. For instance, say you bring on a business partner to finance a house flip. You offer 50% of the deal’s profits in return for a $10,000 cash investment. If you net $50,000 on the deal, that means you have to forfeit $25,000 of that profit.
Yes, you can certainly make the argument that it’s better to take a smaller cut of the profits than not make a deal happen. But, this line of reasoning ignores the fact that you can 100% finance deals. As outlined above, even if a hard money loan won’t cover your entire budget, additional gap financing techniques exist that A) enable a deal, but B) don’t force you to give up an ownership stake.
Benefit 5: Tax Deductible Interest Payments
100% real estate financing also has the major benefit of tax deductible interest payments. According to the IRS, real estate investors can “generally deduct as a business expense all interest you pay or accrue during the tax year on debts related to your trade or business.” While restrictions exist, investors can generally deduct all interest on debt secured by a property (e.g. traditional mortgages, hard money loans, and certain HELOCs).
For example, say you have a $100,000 hard money loan to rehab a property into a rental. Assuming you’ve drawn the entire amount, that translates to $10,000 in annual interest expense, all of which is tax deductible. Eventually, you’ll refinance that hard money loan with a takeout mortgage, and the interest expense on that loan will also be tax deductible.
On the other hand, say an investor provides you $100,000 for a 50% stake in the property. In the terms of the agreement, you’ll owe the investor $10,000 in preferred returns following the refinance, and then 50% of the annual cash flow once you’ve converted the property into a rehab. In this situation, you save on interest payments, but you’re actually worse off. The $10,000 you pay the investor as a preferred return is not tax deductible, and nor are the subsequent annual returns.
Simply put, you can deduct interest expense, but you can’t deduct owner/investor distributions, another reason to embrace 100% financing.
Benefit 6: Taxes Lower Your Effective Interest Rate
Related to the above, taxes also lower the effective interest rate you pay on debt. Accordingly, when you compare debt financing a real estate deal with other financing options (e.g. bringing on a business partner), you must account for this reality.
Here’s how it works. Say you have the option to finance a deal with a hard money loan at 15%. At first glance, this may seem like a high rate (NOTE: for a variety of reasons, from risk to time horizon, hard money lenders charge higher rates than you’ll receive on a traditional mortgage). But, when you factor in the tax savings, the effective interest rate is reduced. Assuming you have an effective tax rate of 25%, you’d calculate your effective interest rate as follows:
Effective Interest Rate = (Interest Rate * (1 – Effective Tax Rate))
Effective Interest Rate = (15% * (1 – 25%)) = 11.25%
In other words, when you factor in the tax deduction provided by interest payments, that 15% hard money loan rate effectively lowers to 11.25%. When considering the other benefits of 100% financing a real estate deal, this effective reduction in interest rates makes debt even more appealing.
Benefit 7: Leverage Improves Your Credit Score
One of the major benefits to using hard money is that credit score largely doesn’t matter. As long as you don’t have any judgments or bankruptcies on your report, your credit score won’t affect your ability to qualify for a loan.
However, as you expand from house flipping into other real estate investing strategies, you will eventually need to secure traditional financing. For example, buying a pure rental property or doing a BRRR deal both require long-term mortgages. And, the lenders who issue these loans will absolutely require minimum credit scores.
Fortunately, the most effective way to improve your credit score is by making regular, timely payments on your outstanding debt. Therefore, if you start small with a 100% financed property, those payments you make on that debt will gradually improve your credit score. And, as you improve your credit score by making these timely payments, you’ll gain two major benefits:
- Larger loans: Generally speaking, the better your credit score, the larger the loan for which you’ll qualify. So, if you begin with a $100,000 mortgage on a BRRR property, you’ll eventually qualify for a $150,000 loan, then a $200,000 one, and so on. In this fashion, 100% financing a deal – even a small one – will allow you to gradually improve your credit score, which in turn will allow you to scale your portfolio into larger properties.
- Better rates: Additionally, improving your credit score provides you with better interest rates. Lenders save their best rates for the most reliable borrowers, typically those individuals with excellent credit scores. And, lowering your interest rate just a little can save you tens of thousands of dollars. For example, a $200,000, 30-year mortgage at 3.5% will cost $42,000 less in total interest payments than the same loan at 4.5%.
Benefit 8: Anyone Can 100% Finance a Property
Lastly, the accessibility of debt provides investors a tremendous advantage. When you think of raising capital for an investment, convincing investors to fund a deal can be a major challenge – especially for new investors. Realistically, most of us just don’t know a ton of people sitting around and looking for places to invest hundreds of thousands of dollars.
But, anyone can find a bank or hard money lender. If you have a solid deal lined up, a hard money lender will likely support it. And, you don’t have to be a member of a country club close with extremely wealthy individuals to connect with a hard money lender. Instead, you simply need to reach out to a hard money lender, meet the lender’s requirements, and you’ll receive your funding.
100% financing a property democratizes investing. It doesn’t matter who you are or who you know. If you find a good deal, you can use debt to finance it. You don’t need to rely on connections with high-net-worth potential investors.
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