Interest Rate Arbitrage

Usually when we discuss arbitrage we are dealing with the simultaneous purchase and sale of the same securities, commodities, or foreign exchange in different markets to profit from unequal prices. However, in the real estate business a different form of arbitrage frequently comes into play. In this case, interest rate arbitrage. Unlike a purchase/sale arbitrage, in real estate we often use a borrow/invest arbitrage.

Common to real estate transactions might be the borrowing using one property or asset and the simultaneous investment of the borrowed funds into another property. This happens in many “no money down” deals where money is borrowed using a second mortgage, a credit card, a home equity line, a title loan or an unsecured line of credit. Although this is an oft used technique, it is commonly brought into play without recognizing a critical fact. One that can either make the deal profitable, or put a huge nail in its coffin.

So here’s the simple truth. If you are not making a higher percentage yield on the investment than the percentage you are paying on the newly borrowed funds: DON’T DO IT! I know it sounds crazy, but people do this all the time. For example, they borrow on a credit card for a down payment. The credit card may charge 18% to 22%, but the new deal only produce a total return of 10%. So do the math. On the borrowed portion of the investment alone you would suffer an 8% to 15% outright annual loss. This means that you would be depleting one asset for the sake of another. This may not be the right thing to do. On the other hand, if you can borrow at 8% and make 12% you have a pure 4% arbitrage yield.

This simple fact is lost on most people when they buy property. On a larger scale, many transactions are done, and with alarming frequency, where a property is purchased, an initial investment (down payment) made and money borrowed for the balance when the property yield is less than the interest on the debt. People just don’t run the numbers. Then they just keep feeding the problem until it gets too big to handle and they take the hit. Unfortunately, all alligators aren’t in zoos.

So remember, never borrow unless the yield on the asset you’re purchasing will cover both the cost of borrowing and make you a reasonable profit. These are words to life by. Good luck. Make good decisions and your life will be great.