One of the greatest myths about real estate investors is that they make the vast majority of their purchases paying all cash as opposed to using borrowed money. Actually, that’s not true. Just as most families buy homes with borrowed money, so do most investors.
Over the past four years two different surveys conducted three years apart found that most investors finance over 50 percent of the transaction; only about one in five investors, 18.5 to 24 percent, use all cash.
Why the Confusion?
Most reports on real estate transactions get their data from public sources, such as county filings of home sales. Mortgages are recorded with deeds in most states because they are liens on the title. However, the forms of financing used by most investors are not. Some use commercial loans like any other business; commercial loans typically have higher interest rates and fees, as well as shorter terms and different qualifying standards. Some prefer to work with portfolio lenders–banks and credit unions that have the ability to lend from their own funds entirely rather than rely upon a secondary lender like Fannie Mae or Freddie Mac. Because the money is their own, they are able to provide more flexible loan terms and qualifying standards.
Hard and Soft Money
Most investors using borrowed money use either “hard money” or “soft money“. Hard money is another financing strategy that can provide needed short term cash for a purchase or rehab. Hard money loans are primarily based on the value of the property. They have shorter terms that mortgages, usually less than three years, and higher than average interest rates. Hard money lenders, often banks or investment companies, can move quickly and usually don’t require a credit report or references.
“Soft money” or private money, comes from individual investors or partnerships that want to participate in your good fortune for rate of return higher than the going rate. Sometimes these are friends or relatives. In recent years, professional soft money investors have played a significant role in the growth of residential real estate investing. Soft money often is used to denote the giving of some item in exchange for something else. For example, let’s say that an investor said that he needed to receive 15% on his funds while you were using them.
Pros and Cons
There are advantages and disadvantages to investing with all cash vs. borrowed money and each investor should decide the best strategy to fit his resources and investment goals.
All cash investors incur less risk should his or her properties run into trouble. Primarily, this is because the risk of vacancies is diminished when the property has been paid for in full. In contrast, the owner of a leveraged property pays a monthly mortgage, which is usually paid for using the rental revenue. If the property is vacant, there is no income, and the investor has to pay for the mortgage out of pocket.
Investors who shy away from borrowing also stand to have a smaller ROI on a percentage basis because their total investment is larger, and they are not taking advantage of the leverage provided by low interest rates. Entry requirements are lower if you can operate on borrowed money at today’s low interest rates, and bolster the potential ROI.
However, when all the money you invest is yours, you don’t have to pay off debt in order to enjoy the full benefits of your investment. Finally, cash investors need to please only themselves. Those who work with borrowed money have creditors to keep happy or they risk their future ability to borrow or even to maintain control of their existing portfolio.
It is important to remember that while it is considered conservative compared to many securities and most commodities, as millions learned during the foreclosure crisis, there is always risk involved in real estate.
As noted above, most investors today utilize borrowed money, since the power of leveraging borrowed money can greatly increase profits, especially in these days of low interest rates. However, paying all cash does have its advantages if you can afford it.