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Six Types of Other People’s Money (OPM) for Real Estate Investing and Four Ways to Profit

How to put OPM to work for you in real estate and four ways to profit from it

In my blog post, "Money Myths and How To Really Get Rich In Real Estate (In 3 Simple Steps)" I talked about the importance of understanding good debt and how to put it to work for you. I call this using OPM, or Other People's Money.

When I discuss the idea of OPM, most people are on board with it—and excited even about the possibilities. But then they become intimidated by how exactly to find and use OPM.

This is normal for people. When we learn new ideas, our mind does its best to create reasons why the idea is wrong or it won't work. Our mind tells us things like:

• "No one would ever give you money."

• "You can't find good enough investments to attract OPM."

• "Using OPM is taking on too much risk. Better off just putting money into your retirement account."

In reality, the hardest part of OPM is knowing how to find the right real estate investment to attract money, but even that isn't difficult if you take the time to learn how to do it.

Here are a couple posts to help you on that front:

• The 4 Essential Steps to Becoming a Successful Real Estate Investor

• How to Get Paid $180 to Buy a New Investment Property

Once you have the right property, securing OPM becomes quite easy—if you know where to look. And when you begin to build your real estate portfolio and a track record of success, it gets even easier.

Below are six solid sources of OPM you can put to work for you and your real estate investments.

OPM for real estate #1: Banks

This one should be obvious. If you own a house, you know what it's like to go to a bank to apply for a mortgage. Most people don't think of it this way, but a mortgage is a form of OPM. Generally, with a single-family home, a bank will cover up to 80% of a home's value. You, as the purchaser, will pony up the other 20%.

This isn't always the case, however. For first-time homebuyers, an FHA loan can cover up to 97% of the purchase price with the buyer only having to contribute the other 3%. Of course, there are stipulations on this, such as you have to live in the home for a certain number of years before you can rent it out.

When it comes to real estate investing, when a property gets to a certain size, it no longer is viewed as a residential property but instead as a commercial property. This means that any bank looking to make a loan will base the loan criteria on the operating income of the property, not on the "market value" like they do for a home.

Often, if you can make the business case for a loan to cover not only a portion of the purchase price but also for the execution of the business plan to grow the property's value, you can fund a lot of your capital costs with the bank's money.

Banks are notoriously conservative, so if you're looking to have little-to-no money in a deal, a bank might not be your best option. But it can be a good place to start.

OPM for real estate #2: Private lenders

While banks are generally public institutions that have high regulatory requirements, you can work with private lenders and equity firms that are willing to invest in real estate. These could be angel funds, investment groups, and more.

You'd be surprised how many institutions are out there with the sole purpose of finding good investments to pour money into. You can find these lenders by either asking other investors you know or by doing some searches on the internet, where you can find things like private lender associations. These loans can be a bit more expensive with higher interest rates, so weigh your options.

OPM for real estate #3: Seller carryback

A seller carryback is where the seller of a property acts as the lender. There are a number of reasons why a seller might do this. Perhaps they are tired of the work required to operate a piece of property, or maybe they are looking for a steady return by collecting set interest on their money rather than rely on rental income ups and downs.

Because a seller carryback is a private transaction, there are many options and it just depends on your negotiating skills. The seller could finance all or part of the property. The rate could be at market, or it could be higher than market depending on risk. The seller could participate in part of the profit in exchange for a lower rate and you doing the work and management to execute the business plan. The options are nearly limitless.

You never know if a seller will be willing to carryback, but as with all things, it never hurts to ask.

OPM for real estate #4: Investors

If you have a good investment property, it will be easy to line up private investors who will want to provide the equity money for the property. This is often how you can raise the money for the percentage of the purchase price that a bank will require you to pay.

So, for instance, if you are buying a four-plex and the bank requires you to put down 25%, you would use private lenders to raise most or all of the equity money needed for that 25%.

This means you need to put together a solid investment prospectus that shows the potential of return for the investors. Ideally, you would have done that for the bank as well, so it should be ready to shop.

This is how Rich Dad Advisor Ken McElroy does his deals, and he has grown his portfolio from one apartment building to thousands of units in multiple states.

OPM for real estate #5: Government Tax Credits

If you are interested in investing in properties that the government subsidies, like affordable housing, you can utilize a slew of tax credits to help fund your real estate investment. Here are two explained by PocketSense:

Rehabilitation Credit

Investors who choose properties related to gentrification may get some relief from the Rehabilitation Tax Credit. This one is designed to encourage developers to renovate, restore and reconstruct older buildings. It applies to structures initially put into service before 1936, offering a ​10 percent​ credit. If a building is classified as historic in the tax year in question, it may qualify for a ​20 percent​ tax credit.

Freddie Mac Tax-Exempt Loan

The government offers tax exemptions in order to encourage certain behaviors. Municipal bonds can be exempt from taxes on interest earned, as can some loans issued by the federal government. The government allows certain loans to be exempted through Freddie Mac.

The government kicked off a Freddie Mac tax-exempt loan program designed to help multifamily property owners. This program applies specifically to those purchasing, refinancing or renovating an affordable housing property. It provides financing with ​4 percent​ Low-Income Housing Tax Credits, referred to as LIHTCs.

These types of investments require a high-level of financial intelligence, so you don't want to just jump in. But if you do the work to become a pro, you can make a very good living.

Additionally, you can find tax credits for building or retrofitting properties with environmentally friendly enhancements. It varies from marketing to market, so do your homework and see what you can get.

OPM for real estate #6: Cash flow on operations

This is where things get very fun and why I believe real estate is one of the best ways to accelerate the velocity of your money. Once you have a good real estate investment property and a plan for growing its value, you can utilize that property itself as a means to generate cash out of thin air for other real estate deals.

I hit on this in “Money Myths and How To Really Get Rich In Real Estate (In 3 Simple Steps)” when I talked about how to improve a property for greater cash flow and value:

As an example, let's talk about Rich Dad investor Ken McElroy. Ken, as you may know, is a real estate mogul specializing in apartments-a real estate class called multi-family housing.

What Ken and his partners do is find apartment buildings that underperform. Because the value of a commercial real estate asset like an apartment is based off the Net Operating Income (income after expenses), any opportunity to increase NOI is an opportunity to see a healthy return.

For Ken and his team, a variety of factors could help with this. For instance, the current landlord could be renting units well-below market rates. Turning those units and raising the rent could dramatically increase NOI. Or perhaps retrofitting units with washers and dryers, as well as a cosmetic facelift could increase rents by anywhere from $25 to $50 a month. Multiply that by hundreds of units and you'll see a lot of lift in income.

Since the bank values a property on the Net Operating Income, not on "market value", a lift in income is a sizable lift in value. You can use this higher value to do a refinance, pull money out of a property tax-free, and then redeploy it into another real estate investment. Continuing the cycle over and over again over many years exponentially grows your portfolio-and your wealth. And it's all done with OPM.

But that's not the end of your real estate profit story. Let's move on to the next profit center: Amortization.

Four ways to profit from real estate

Of course, the whole point of securing OPM for real estate is so that you can then eventually profit from real estate. So, for the rest of this post, I’m going to give you four ways to profit from real estate once you buy it with OPM.

When I travel the world and speak, I often get the same question: how can I profit from real estate?

The reality is that there are four ways to profit from real estate that, when added up together, make for considerably higher returns than the stock market (and most other investments for that matter). These profit centers are the reason that real estate is one of my favorite investment vehicles.

A word of clarification: as you read about these profit centers, realize that I'm talking about investment real estate—that is property bought specifically to be run like a business rather than your personal residence. As I've said before, your house is not an asset. It takes money out of your pocket. But your investment real estate is, if you invest properly, because it puts money in your pocket, and it does it in two ways: direct cash flow and phantom income.

Cash flow and phantom income

Before I dive into the four ways you can profit from real estate, I want to quickly touch on the difference between direct cash flow and phantom income, because real estate provides both types of income.

Cash flow is money that flows directly into your pockets on a regular basis. This can be monthly, quarter, annually, etc., but it is realized income that is passive in nature. By passive income, I mean income that you do not have to work for. It comes automatically because your asset itself creates the income. This is one of the lowest taxed incomes, and extremely powerful for building wealth.

Phantom income is a new concept to many new investors, but it is a powerful way to build wealth. Phantom income is not direct cash flow, but it is savings that come to you through tax savings, time savings, etc., as well as the potential gains you might have in the future. I’ll explain more because in real estate there is one profit center that is cash flow based and three that are phantom income based.

Now, here are the four profit centers of real estate.

Real estate profit center #1: Cash flow on operations

As the name implies, this is the cash flow profit center of real estate.

If you're holding real estate as an investment, you will have tenants. Each month they will pay you rent. Let's say that you own a rental house and get $1,000 per month in rent. Over a year, that is $12,000 in income.

Now, subtract out your expenses, which include things like your taxes, insurance, your property management, vacancies, turnover expense, allowances for repairs, etc. (This doesn't include your debt—more on that later).

For purposes of this example, let's assume that your monthly average expenses are $100 a month. Your cash flow on operations then would be $900 per month. That is what is referred to as your Net Operating Income (NOI).

Out of your NOI you pay your debt service. Let's assume for this example that you have a $200,000 property with an $180,000 loan at a rate of 3.7%. That's a debt payment of about $830 a month.

So, that would be rental income of $1,000 minus $100 in operating expenses minus $830 in debt service, equaling $70 in cash flow. That times 12 equals $840 in cash flow per year. That $840 divided by your $20,000 equity stake would equal a 4.2% cash-on-cash return.

Real estate profit center #2: Amortization

Amortization is the concept of paying down your debt service. It is phantom income because you don’t get the money in your pocket each month, but your equity grows with each payment you make—and because your rental income covers the debt payment, it is income to you. Let me explain further.

Each month, when you make your debt payment (or rather your tenant makes your debt payment) out of your NOI, a portion of that goes towards paying down your principal on the loan. When you hear somebody talk about a 30-year fixed fully amortized loan, it means that when you make all 360 of those monthly payments at the end, the loan is 100% paid off.

Because your tenant is paying rent, and that rent is covering the debt payment, the principal pay down included in that debt payment is actually profit for you. Let's take a look at how this plays out with our $180,000 loan from above.

In the first year of the loan, you'd be paying $6,604 in interest and $3,338 in principle. As the loan matures, the interest amount goes down each month and the principal amount goes up. But we'll use these numbers for now.

That $3,338 is profit to you. It's true equity in your property.

If we add this $3,338 to the $840 in operating income, we now have $4,178 in income for the year, a 20% return on our $20,000 invested into the property. Plus, your interest payment is often tax deductible, so added bonus, but check with your tax advisor to be sure for your specific case.

Already, you're crushing average stock market returns and there are still two more real estate profit centers to look at.

Real estate profit center #3: Depreciation

Depreciation is another form of phantom income, but it is also often referred to as a phantom return. The basic concept of depreciation is that your investment property is made up of two parts, the land and the improvements on the land, i.e., your house.

Appraisers will assign percentage values to your property based on these two parts. For this example, 20% of the value is the land and 80% of the value is the improvement. Over time, the house will deteriorate, so the government in the US (check with your tax advisor to make sure you qualify), lets you write down that 80% value over a certain number of years depending on the type of real estate. For residential homes it's 27.5 years.

So, your $200,000 property has $160,000 that can be depreciated over 27.5 years, which equals $5,818 per year. This amount is listed as a loss of income, even though no money is coming out of your pocket. Now, let's see why this is called phantom income.

Let's assume you are in a 30% tax bracket. That means that, applying 30% to your depreciation of $5,818, nets you $1,745 in annual tax savings.

Adding that $1,745 to our existing income of $4,178, we now have $5,923, a 29.6% return on your cash of $20,000.

Let's take a look at the last profit center, appreciation.

Real estate profit center #4: Appreciation

Appreciation is the phantom income frosting on your cake. I don't invest in real estate for appreciation. I'm a cash flow investor. But I do appreciate my appreciation, pun intended.

Let's assume you have a conservative appreciation rate of 3% a year on average for your $200,000 property. That equals $6,000 per year in value added to your house.

Add that to your $5,923 and you have $11,923. That's a 59% return on your $20,000 capital investment in your $200,000 property. And that blows investing in the stock market for the long term out of the water.

These types of returns are achievable by anyone, as long as they understand how to find the right deal and run the numbers correctly. And it takes a high financial IQ.