What Is Other People's Money?
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OPM (Other People's Money) Explained
OPM is a broad term that can denote the use of any source of cash that isn’t coming from the borrower’s pocket.
Conventional bank financing, hard money loans, private loans, and loans from a wealthy family member are all examples of OPM.
The term OPM can also be used by banks and credit unions in reference to the money it lends out to their borrowers because this source of funds is essentially coming from its customer’s deposits.
OPM is what allows a borrower to acquire, control, and improve assets that are valued far beyond their limited cash resources.
The Power of Leverage with OPM
Let’s say there are two investors who have $100,000 to invest in real estate.
A rent-ready duplex (two rental units) just came on the market for $100,000 and generates gross rent of $1,200 per month.
Investor A decides to purchase the property for the full amount of $100,000 in cash. They own the property free and clear, but all of their cash available for other investment opportunities is gone.
Investor B decides to put $20,000 down and take out a conventional mortgage of $80,000 to cover the remainder of the purchase price. As a result of using OPM, they don’t just have the ability to buy this one duplex, they have the ability to buy four more just like it. They can take their $100,000 and break it up into, five different down payments, potentially expanding their rental portfolio from 2 units to 10 units!
The cash investor (Investor A) keeps more of the monthly gross rent for that single duplex, however, the leveraged investor (Investor B) is able to purchase more properties and generate significantly more cash flow, even with the added monthly cost of debt service.
Let’s break down the numbers:
Duplex Bought With Cash:
Cash Investment: $100,000
$1,200 in Gross Rent – $600 in Operating Expenses (based on the 50% Rule) = $600 per month
Remaining capital: $0
Duplex Bought With OPM:
Cash Investment: $20,000
$1,200 in Gross Rent – $600 in Operating Expenses (based on the 50% Rule) – $382 in Debt Service (using 20% down and 4% fixed interest for 30 years) = $218 per month
Remaining capital: $80,000
If the leveraged investor purchases four more duplexes with the same conventional financing at 20% down, they’ll end up with 10 units and their numbers would be as follows (assuming all else is equal):
Cash Investment: $100,000
$6,000 in Gross Rent (5 Duplexes x $1,200) – $3,000 in operating expenses (5 Duplexes x $600) – $1,910 in debt service (5 Duplexes x $382) = $1,090 per month
Even though Investor B has more expenses due to debt service, the property itself is paying down the loan balances with the rental income it generates.
If Investor B does nothing else to pay down the mortgages after the maturity date, then the properties will be owned free and clear, at no extra expense to the investor.
Because Investor B used OPM, they can enjoy their net monthly cash flow and have other people pay down their mortgage(s).
OPM and the Cash On Cash Return
One of the most important metrics to understand in real estate is something called the cash on cash return (CoC).
The cash on cash return considers the relationship between actual cash invested and the total income generated by an investment property.
It’s a ratio between a property’s annual pre-tax income and the actual cash invested:
Essentially, it tells an investor how much return they’re making on the actual cash they put into a deal, not including other people’s money.
All things being equal, the less cash an investor puts into a deal, the higher their cash on cash return will be, thus indicating that their money is working harder for them.
For example, if an investor wants to purchase an apartment complex that costs one million dollars, coming up with that money on their own would take a lot of time and effort and for some, might be nearly impossible.
However, if someone else provides the majority of the cash while allowing the investor to own 100% of the property in exchange for monthly interest on the borrowed money, paid for with the income generated by the property, then it allows the investor to harness the buying (and earning) power that is only possible when using OPM.
Examples of Other People's Money (OPM)
OPM can come in a variety of forms. Here are some common examples:
Conventional Financing. This refers to loan products from banks and credit unions. Conventional loans have some of the lowest interest rates on the market. However, their approval requirements can be much more stringent and may require more money down compared to other options.
Hard Money. Hard money loans are secured by hard assets like real estate and equipment. Hard money lenders are known for charging higher interest rates and origination points compared to conventional lenders, but they are typically less rigid on their approval requirements. They also tend to be more flexible on items such as down payment amounts, term length, and monthly payments.
Private Money. This is a loan product provided by a private party, meaning they are not an established financial institution. These types of lenders can be friends, colleagues, or relatives. These loan products typically charge higher interest rates than conventional loans but are extremely flexible. Each loan is arranged between the investor and the private party, thus creating opportunities that could be extremely advantageous. The biggest hurdle with private money is establishing a relationship and trust between the investor and the private party.
Partnerships. A lot of partnerships are made between two or more parties who have the skill set to get deals done and with the money needed to do the deal. If one person has the skills and they leverage their partner’s capital, this is another way to use OPM. The major drawback is that partnerships normally come with extremely high expectations that both parties have to abide by.
Seller Financing. Seller financing is when an owner of a property provides financing for that property, to a buyer. This can be in the form of a land contract, a deed of trust, a lease purchase, or a private mortgage. Similar to private money, this form of OPM can be as flexible as the seller and the terms can vary depending on the deal. Normally this form of financing charges higher interest rates than conventional financing but may require little to nothing down, and may provide some extremely advantageous opportunities.