Cost of Capital

Do you know how to calculate your cost of capital?

One of the questions that our customers ask most is.

 

1-What’s my cost of capital?

2-How much money do I need to bring to the table?

3-What fees are involved?

4-Do I need to pay for an appraisal?

 

One thing that new investors don’t know is: When Hard Money Lenders (HMLs) provide terms, that is just the cost of money. As an investor you have to calculate your other costs.

 

What costs?

 

  • Real estate agents commission

  • Holding cost

  • Staging

  • Escrow

  • Title

  • Insurance

  • Inspection

  • Appraisal

  • Advertising

  • Contingency

  • Second lien position

  • Gap funding

  • Etc.

 

Once you have all of the costs that are involved in your Real Estate deal you add the cost of capital, points, interest and second lien to cover the GAP

I will discuss what the GAP is lower down in this discussion.

Your Return on investment (ROI) should be 15% or more to be successful in a Fix and Flip. 

These terms are just the cost of borrowing money.

 

To get your deal funded you will need to calculate your total cost of capital. You need to add all costs that are involved on the deal including all 3rd party costs.

Scenario:

An investor has a deal. The Purchase price is $100,000 

The appraised value is $100,000. 

The renovation cost are $50,000. 

The ARV is $300,000

 

The reality is that most Hard Money Lenders (HML) will lend 70% to 75%  Loan to Value (LTV) on properties. The minimum loan for many HML is $100,000. Meaning that if a property is appraised at $100,000, HML will lend 75% ($75,000) plus 100% of the renovation cost. The total loan would be $125,000 plus doc, processing fees, etc. 

 

The investor would need to bring money to the closing table to pay for the GAP or cost of capital, In the cost of capital or there are cost involved:  origination points, doc fees, broker fees and interest rate. Investors use Private Money Lenders (PML) to cover the difference between the amount approved on the loan, the origination points, interest rate, doc fees, broker fees, and other third party cost that are not covered by the first loan to pay for 100% of the costs. In this case the investor needs to use a PML to pay for the GAP. In this scenario  $46,052.15 (this number is explained below. See calculations at the end of this page) is the cost of capital. One thing to keep in mind is that this is not the only money the investor needs to bring to the closing table because there are other costs involved in the deal that have nothing to do with the cost of capital. I will explain what cost i’m referring to below.

 

What is the Gap? 

The GAP is the difference between what the lender is willing to lend and the amount you need as an investor to buy the property. In the end, the Investor needs to also prove that he has the funds (liquidity) to close the deal but also to cover the GAP (This is called skin in the game). 

 

Just like a traditional bank that lends you 80% of the purchase price you have to put a 20% down payment and pay for the closing costs when you buy a house.

 

One BIG difference between Traditional banks, HMLs and PMLs is that they don’t look at your debt to income ratio LIKE BANKS DO when they lend to you. The HML or PML looks at the Real Estate asset and makes an educated decision using an appraisal.

Note: There are some HMLs and PMLs that do require a credit check, and a certain Fico score It depends on their business model.

 

Why lenders do this? 

Lenders do this because they have to calculate the risk they are willing to take when they are making a loan to an investor and they know that if the project goes south, they will need that 25% to cover all the legal fees to foreclose on the property if you don’t fulfill your end of the bargain.  What is your end of the bargain? To pay him back his money on time with interest.

 

One mistake that Investors make when calculating the closing cost is NOT adding the monthly payments and the interest, not only for the first loan but, for the second one. Another mistake is not calculating all the expenses related to the real estate (RE) deal.

 

What does that mean? 

It means that if you have to pay $46,052.15 (this number is explained below. See calculations at the end of this page)  for the first loan and have a second loan from a PML to cover the GAP on the loan you also need to add his points and interest to your costs. 

 

Going back to the Gap. One way to cover the Gap is to get a second lien position lender a PML to pay for that Gap but that lender will also charge you points and Interest and you need to calculate that and add it to the loan because it is part of the cost of capital.

 

If you get a PML to pay for the 1st loan points and interest, reserves ,doc fees, etc, you will need to add an extra $20,687.84 (this number is explained below. See calculations at the end of this page) to cover the PML points and interest on top of the interest and points to cover the second loan. (The GAP)

 

Another way you can use to cover the GAP is to bring in a JV partner and give them equity on your deal buy you still need to calculate your cost of capital.

 

Let’s do the calculations:

A PML will cover the first lien position to pay for the $46,052.15. You will also need to calculate the points and interest for the PML second lien position thats an additional $20,687.84 for the second loan. This means that your cost of capital for this deal will be $66,739.99. (You need to add this to your deal analyzer) See spreadsheet below.

 

Wait; We are not done.

 

What other costs are involved in your deal? 

The title company is going to have its own set of fees like escrow, Attorney, recording, transfer and conveyance fees, 

 

real estate agent commissions, insurance, home warranty, taxes, title Insurance, HOA, Holding time, Utility costs like water, gas, electricity and miscellaneous selling costs.

 

ONE THING YOU HAVE TO BE CLEAR ON:

 

YOUR ROI HAS TO BE 15% OR MORE. Most lenders won’t lend if you don’t have at least 15% return on investment (ROI).

 

Note: Depending on the lender they will lend up to 90% of the purchase price (PP) to 70% to 75% LTV whichever is lower.

 

Note: Every deal is different. commissions, property taxes, title, home owners association (HOA), etc will vary. You need to do your due diligence.

 

Let’s add the total cost of your deal.  In this scenario prepared to pay a total of $32,000 for the following expenses calculated on the Deal Analyzer below.

 

Your cost of cost of capital $66, 739.99 + the other expenses we mentioned above for this deal deal (Look at the deal analyzer)  $32,000. Total capital needed to close this deal = $98,739.99

 

See pictures below with the deal analyzer and loan calculator

 

First lien position loan

Second lien position loan

Deal Analyzer

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Cost of Capital: (((Coming soon)))

In the following video, I will go into detail explaining how we calculate the cost of capital for a loan. 

 

This is only a scenario:

 
  • Each loan is different

  • Each property is different

  • Each market is different

  • This is how I calculate loans, 

  • There are no guarantees 

  • This is not an offer to sell any securities.

  • Preliminary loan terms are provided to the investors.

  • Terms may vary once all the information is verified. 

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