“There’s no such thing as a free lunch.” Ultimately, you’ll pay a price for almost everything you acquire. This can be as obvious as the number on a price tag, or as subtle as unconventional credit terms that can affect value; as has been demonstrated. Calculation of profit can be equally obvious or obscure depending upon the timing of receipt of payment. When everything is bought and sold for cash, estimating profit can be pretty simple; but when the cash is borrowed or loaned over time, time greatly impacts cost and profitability. What you pay, and when and how you pay it versus what you get back – and when and how you get it – control profit.
Suppose you had $100,000 that could be used to buy a house, or to lend to someone to buy a house: There are two costs to consider: One is the price being paid, including payment terms, versus the value of the house. The total price, transaction costs, length of time the house will be held, net costs or profits incurred during the holding period, and net gain upon sale after taxes all determine profit. The other cost is the loss of alternative opportunities that might have yielded more profit if the $100,000 had been invested in them. Without making an effort to calculate potential cost, income, gain, and yield, almost every financial decision boils down to pure speculation where luck plays the most critical role.
Today’s world is chock full of poor people who boast of the fortunes they have lost in much the same way as Marlin fishermen brag about the one that got away. Molly Brown said it best, “It’s not how you start, it’s how you finish.” You could simply trust your future to blind luck. Many millionaires have made fortunes without realizing that they’ve been gambling; and you can too. On the other hand, those who base wealth on luck are like lottery winners; neither stay rich very long.
In the near future, institutional loan costs and terms will prevent a lot of people from using conventional financing to buy or sell. It is during this kind of credit market that being able to manipulate numbers pays off whether carrying back financing when you invest, or when buying and selling houses. To illustrate; which of the following choices would you select when buying or lending money on a free and clear house with a current retail gross fair market value of $150,000?
1. $100,000 cash that you have to borrow with 10% down payment on a private, fully amortizing 60 month, full recourse loan at 10% interest? How would holding costs compare with net rents? Would this make more sense if you intended to move in?
2. Nothing down and nothing a month on a $150,000 Note with 5% compounding interest that would be due and payable at the end of 5 years? In 5 years, would the net house sale proceeds plus the net rents add up to more than the debt you’d owe?
3. Full price of $125,000 with $5000 down and $2000 per month at zero interest over the next 5 years? Would paying off the house be worth all the negative cash flow?
4. Full price of $165,000, non-recourse loan with zero down, zero interest, and zero payments; plus 50% of the total gross rents and net gain at the end of 5 years? If the loan isn’t paid off at the end of 5 years, the house must be given back to the seller along with all of the collected rents. Even with “safe” leverage and the use of all the cash flow, will future appreciation exceed $165,000 plus half the rents?
5. Lending a buyer $100,000 at 12%, interest-only, with balloon Note due in 5 years? Would $12,000 per year without any work be better for you than the other choices?
More than math is involved here. Doesn’t your choice depend upon your skills and your financial needs and capacities? If you were willing to trade future gain for cash flow, #2, #4 and $5 might seem best. If you needed tax shelter, all of them would work. If you were willing to sacrifice cash flow to build equity, #3 would do that. If you wanted rental income, you could buy with #4, or simply master lease under any of the financing schemes. If you wanted to speculate on gain, you could Lease/Option for a large share of future profit in lieu of earning a fee.
