One afternoon recently I tried to cash a check for $7,000 at my bank. Even though it is one of the nation’s leading banks, I was unable to do this because they didn’t have enough cash! They explained that a number of people had made cash withdrawals and the till was empty. Why were they short of cash? Because, while I was content to deposit money in a low-interest checking account, they were lending my funds to bank customers at more than 4 times the rate they were paying me.
I could have lent these funds out myself, but I wanted cash to be there when I needed it. The bank could rely on other branches to shore up their cash reserves; thus, they didn’t need to set aside idle funds to maintain their own liquidity. If they ran out of money, they could borrow from the Federal Reserve Bank so long as they maintained minimum reserves, which could be in the form of U.S. Bonds; so they needed little cash at all. There’s a lesson to be learned here:
First, if you will line up emergency operating lines of credit, you too can live with a lot less liquidity, and keep more of your cash earning high yields instead of lying fallow in bank checking accounts. Second, you can use your money to either buy and sell houses, or to lend to others. Third, if you pick and choose borrowers carefully, and secure your loans adequately, you can lend out a lot of money with very little risk of loss. Fourth, if you can use your money to help other entrepreneurs make more money, you will be able to cultivate a reliable group of borrowers who will be willing, able, and ready to share their profits with you.
It all starts with wholesalers. Wholesalers are people who can find houses that they can buy at around 50% of retail value then sell quickly with a small mark-up. As a rule the house will need some rehab to make it marketable to an owner/occupant. Once a wholesaler contracts to buy such a house, he sells it or his contract as fast as possible to someone else. This may be another wholesaler who marks it up a little more and resells it, or it may be a retailer who does the needed sprucing up to increase the value, and who then sells it to an owner occupant or another investor. At every step along the way, profit and value are added to attract another buyer.
Here’s a pro-forma transaction: Let’s say that a house that would sell for $150,000 after fix up can be bought for $80,000 cash. Wholesaler #1 marks up the property about 10% above his contract price, say $88,000. The next buyer then marks up the original price to $90,000 and makes $2000 selling to the ultimate person who will fix it up to sell in the retail market. That buyer adds about $25,000 in fix-up expenses, bringing his cost up to $115,000. He then retails it to the owner-occupant for $149,900. After paying out another $10,000 in commissions, closing and financing costs, he winds up with a $25,000 profit with 4 months work.
Thus far, all we’ve looked at is the way in which money was made with a house; what about the profit made with the financing? Each of the buyers and sellers will have had to pay for financing in order to make the whole process work. By enhancing the ability of the others to buy and sell by providing funding, the lender may make more money than all the players in the food chain. Let’s see how much a lender who both sold houses and financed them might make:
He buys the contract for $88,000 from the first wholesaler. He by-passes the #2 wholesaler and immediately sells directly to the retailer. By providing financing he is able to increase the cost to the retailer from the foregoing $90,000 to $100,000. He agrees to lend the retailer $125,000 to buy and fix up the house with $5000 down and $4167 interest (10%) callable in 120 days. The retailer can still make $15,000 after selling costs. Making $12,000 in a matter of days on the financier’s $88,000 purchase is great, but the joker in the deck is that he discounts the loan at settlement to an investor for $120,000 and makes a $7,000 profit without using any of his funds. The investor’s profit would be $9167 ($5000 loan discount and $4167 interest). That boils down to a return of 23% per year.