It is common for real estate investors to think that profit is generated through cash-flow. We pay $1,000.00 per month for property and collect $1,500 per month in rent. Every month we are “making” $500.00.
While this is somewhat true, it’s not always where “profit” truly lies. This is particularly true in owner financed wraps.
It is actually possible to be paying $1,000 per month, collected $1,000 per month and be reaping HUGE profits.
Profit in a wrap is not equal to the cash-flow, but rather that net interest payment. Sure, there can be profit just in the difference in the two notes. For example, if I take over a note of $100,000.00 and give a new note to an end buyer for $150,000.00, I have immediately created $50,000.00 in profit (equity).
But monthly profit is simply the difference of interest collected and interest paid. In fact, that is 100% of the monthly profit. Always. Every time. It’s never more than that. It’s never than less than that. It is always, forever, equal to the net interest. Always. Did I pound that point home?
As an example. If I pay $1,000.00 in principal and interest to an underlying lender, but collect $1,000.00 in principal and interest from the new buyer (now the new borrower), I have $0.00 per month in cash-flow. But I can still have monthly profits.
If my $1,000.00 payment to the underlying lender breaks down such that $500 is applied to principal and $500 is interest, but the amount I collect is $900 in interest and $100.00 in principal, then my profit is $900.00-$500.00 (the net interest) or exactly $400.00.
But I received $0.00! So how can that be true? Well think of the difference that was just created in equity. Remember, I owed $100,000.00. Now I owe $99,500.00. I was owed $150,000.00. Now I’m owed $149,900.00. Instead of $50,000.00 in equity, I now have $50,400.00 in equity.
Another way to think about it is this: I have put $400.00 into a savings account and $0.00 into my pocket. Sometimes, there is cash-flow. So perhaps I pay $1,000.00 but collect $1,200.00. If my payment is $500.00 to interest and $500.00 to principal, and the payment I receive is $700.00 to interest and $500.00 to principal, I’m actually making less money than in the first scenario, even though I’m collecting more! That’s because there has been no change in the equity, although I get $200.00 cash.
So when evaluating a possible Sub2 to Wrap scenario, it’s important to always look at net interest. While cash-flow seems like profit, it’s not always where the profit lies. Even worse, sometimes, your equity can go down even as you cash-flow. Look at the PI payments, compare and make sure your deal generates a profit, not just a cash-flow.