The Curse of OPM

How many times have you heard that OPM is the key to all the riches in real estate?

Seriously – you can’t turn on a single late-night real estate tv infomercial without some fly-by-night “guru” with a Bentley and a bevy of blonde babes screeching at you about using OPM to make you rich beyond your wildest dreams.

I should know – I’ve watched them all. (For the information only. Not the babes. Really)

The question though, is a serious one. Is access to OPM truly the Holy Grail of real estate investing?

Personally I say both YES and NO, because it can be either a tremendous blessing OR a debilitating curse.

Let’s DEFINE it first though so we’re all clear on the concept.

Other People’s Money (OPM) quite simply is money that’s not your own. It includes everything from unsecured business and personal lines of credit to money that you raise from private investors, and every other source like it under the sun.

On the plus side, OPM is very attractive, especially if you have limited (or zero) money yourself. OPM lets you participate in transactions that you wouldn’t otherwise participate in, and if managed correctly it can help you build wealth.

One of the very favorable aspects of using OPM is that you can often set the interest rate that you’ll pay when you use money loaned by a private individual. Right now I pay my private investors anywhere from a fixed and secured 6.0% to a fixed and secured 14% annual interest, depending on the risk involved. They’re happy every point along that range because the returns that I pay are substantially greater than those in the various markets – and my returns are secured.

The down-side of OPM, though, is significant.

While interest rates on loans from private investors are often done with fixed rates and terms, interest rates on unsecured lines of credit are just about always variable.

This generally isn’t a problem if the money is used for short-term projects, but I know of several investors that have used these types of funds for buy and hold investments. And a few of them even went into foreclosure a year ago when interest rates spiked up.

Another unfavorable aspect of unsecured lines is the fact that they’re callable, which means that at any time the lender can demand repayment in full, and they don’t need a reason and you can’t say no. Think about the likelihood of that happening in this economy when banks are tightening up on their secured loans.

But the most dangerous aspect of OPM doesn’t actually involve OPM at all.

The most dangerous aspect of using someone else’s money is the lack of working capital – or in other words the danger is running out of money. Let me show you what I mean.

Let’s take one of my own houses as an example. I have a rental home in Harper Woods that I bought for $69,250. I received a loan for 100% of the purchase price from a private investor.  And let’s say for the sake of this example that I didn’t have any other money.

So what happens if, say, the basement drain line gets blocked and the full, finished basement experiences a minor flood and that causes some water damage?

Well the house wouldn’t be rentable, and I’d be very worried about mold taking over, so something like this would need IMMEDIATE attention.

And the various costs to address this problem would be significant. The plumber would cost $600-$700 to jet out the roots. The water damage remediation people would cost something in the area of $2000. And the repairs after the fact could cost another $3500 or so.

That could easily be a little over $6000 – or more – for a relatively small problem.

But – if I didn’t have any money, how would I pay for this?

And what happens if I can’t pay for it? The downside would be extreme.

The tenant would move out. I then wouldn’t be able to make the payment to the private investor. Mold would start to take hold and spread, and in a few months the investor would foreclose and get a mold-infested house back.

All because I ran out of money. All because I didn’t understand working capital.

The two points that I’m trying to make are these: 

1. Just because you CAN use OPM on a deal doesn’t mean that you always should, and
2. You need to have a reserve set aside for each property, ESPECIALLY if you’re using OPM.

Lack of working capital is the #1 reason why businesses fail. Don’t be a statistic!