If you'd like to really explode interest rate yields, let me explain a technique called a 'split wrap' loan. It is the quintessential technique for multiplying yield.
Once upon a time I happened to hit it lucky and found an entire neighborhood eager to sell their homes because a major employer was rumored to be shutting down. If we recast the deal in current terms, a typical one of these houses would have been worth $100,000 with an assumable 8% loan in the amount of $60,000. It could be bought for $80,000 with $20,000 down. A private mortgage lender offered to lend the down payment under the following circumstances:
To fund the $20,000 cash down payment, he created two mortgages. First, the existing $60,000 fully assumable FHA loan with monthly payments of $417.45 was 'wrapped' with a fully amortizing, non-recourse, level pay 25 year $64,000 ($4000 plus $60,000) second mortgage that carried a 10% interest rate overall. This wrap around loan required Principal and Interest payments of $580.29. A third mortgage in the amount of $16,000 was created that required 12% interest-only payments of $160 per month; with a single $16,000 balloon payment of principal in 3 years.
These financial terms were perfectly acceptable to me. With this financing, I was able to buy a 100% leveraged $100,000 house that rented for $850 per month, with 'nothing down', for only $80,000. Until market rents increased, after paying management, taxes, insurance and maintenance cash flow difference between the rents and the payments I estimated that this house would wind up costing me about $1000 per year. But much of this would be offset by tax shelter and loan amortization. I proceeded to buy 21 houses on approximately these same terms in a single day. Here's why:
Forecasting only 3% appreciation per house per year, I figured that my net worth would be rising at the rate of $250 per month on each house that I bought this way. At a fair market value of $100,000 per house, buying 21 houses jumped my assets by $2,100,000. With $20,000 in 'negotiated equity' on each house, I was increasing my net worth by $420,000 'going in'. Not bad for a weekend's work. In any kind of business, that's a fantastic yield when you consider that it cost me nothing down and very little each month. After all, I was more interested in building my net worth than in generating income per se.
Why did the lender not buy some of these houses himself? He didn't like the hassle of rental ownership. Furthermore, he was focused on generating income rather than portfolio growth. Let's see how he fared. While I was feeling pretty chipper about my portion of this deal, he wasn't doing too badly himself.
First of all, each $4,000 'wrap-around' 2nd mortgage investment earned him 2% over the original 8% on the $60,000 existing loan balance. That generated $1,200 per year profit. Next, he also earned 10% on the $4,000 he'd loaned. That came to $400 per year. Thus, the total $1,600 per year interest spread yield on each $4,000 wrap around second mortgage investment calculated out to about 40% yield which would extend over the next 25 years. That's more than Warren Buffet has been able to achieve on his stock portfolio. But his yield was a lot higher than this. Read on.
There's a lot more to this little story. With its 12% interest-only payments of $160, in the prevailing 8% first mortgage market, he was able to readily sell the $16,000 third mortgage to other private investors at face value simultaneously with the closing. Thus, he only needed to fund his $4000 wrap around loans. The joker in the deck is that he wasn't using his own money.
Using other property as collateral, he'd borrowed the $4000 he'd loaned from his banker at 11%. So, at an annual cost to him of only $440, he was generating a cash flow yield of $1600. Using 100% leverage, his $1600 annual cash flow per house less his loan costs of $440 was generating $1,160 net net per year, per house times 21 houses.
With 21 of these loans, merely with the stroke of a pen, he was able to increase his yearly pre-tax net income to $24,360. There are a lot of people in the world who work pretty hard to come up with over $2000 per month in income. All that remains for him to do is to sit back and watch the interest come in year after year until these loans are refinanced. If all loans paid to term, without regard to present value discounting, his total gross profit would come to $609,000. If you compute his yield as a percentage return on his invested cash, it comes to 263.64% per year!
