Is the Investment Insured or Collateralized? (Part 2)
We began on Friday looking at ways to insure or collateralize your investment. This is one of the most important ways to ensure that you will be getting your principle back! Today we’ll look at some concrete examples.
One common example of this is seen in hard money lending. Hard money is used in all sorts of business but is very common in real estate transactions. Often someone developing a project (it could be as simple as renovating a single family residence to flip for a profit, or something more elaborate) either can’t or does not want to deal with a traditional bank loan. They go to a hard money lender who arranges a loan with his investors. To secure the loan, the borrower puts up collateral which is substantially in excess of the amount borrowed. This could be another property, or more usually it is the property that is being built/added to.
For instance, let’s say the borrower can get a great deal on a property and buy for $200,000 a property that should be worth $400,000. He knows he’ll need to put $50,000 worth of materials into it, but should then be able to turn a $150,000 profit. His problem is that he only has $50,000 to put into the deal.
He then goes to a hard money lender. Each has his own requirements, but a common requirement is that they won’t lend more than 70% of the equity value. So in this case, the $200,000 needed is 50% below the $400,000 value and would thus fit most lenders requirements. If the borrower is unable to sell the property or for any other reason cannot pay back the note, the property is foreclosed on. Thus, the collateral insures the investment. This type of collateral makes the high interest that is usually paid on these types of deals very desirable!
Let’s look at one final example of insuring or collateralizing an investment. Let’s say that you are thinking of buying a stock. You think the company has great growth potential and will do well in the changing economic environment, but you are unsure if this is really the place for your money or not.
Upon further investigation, you notice that the company is sitting on a pile of cash! On the balance sheet, the company is carrying $500M of cash and the company stock is only trading at a market capitalization of $500M. This means that the total value the market is currently valuing the company for is the same amount as the cash on the books. All the profits that the company earns are in excess of this amount! This is another form (although not as strong) of insurance on your investment. On one hand, the market price of the stock can always go further down. On the other hand, if your convinced that the management of this company is strong, this cash position should provide stability and/or an additional source of revenues to ensure that the future stock price continues to rise. Again, there is no guarantee with a stock price, but hopefully this helps you to think about the collateral that you have with any investment opportunity.
This is Part 12 in the series Investment Due Diligence. To use this as a growth tool to better understand your own calling, you might start by reading Part 1, Pt 2, Pt 3, Pt 4, Pt 5, Pt 6, Pt 7, Pt 8, Pt 9, Pt 10 and Pt 11.
Photo credit: Grey Wind