How to use arbitrage effectively

Most people are aware of the concept of financial arbitrage – borrowing money at one rate and then using it to generate income at a higher rate, pocketing the difference between the two rates as profit – as this is what banks do. Banks borrow money (your deposits) at a low interest rate then lend it out to other people at a higher rate, with the difference between the two rates being the profit for the bank (I know banking isn’t actually that simple, but you that’s the high level overview of how banks use arbitrage J).

The most common way to do this yourself is to use leverage on your investment properties. In this case, you are borrowing money to purchase the property by taking out a mortgage and, if the property is cash flow positive, you are making more on the property than you are paying in the loan. It doesn’t seem like it is really arbitrage, since you aren’t getting money directly – the investment and the money are tied together. But it is the same concept of borrowing money at a lower rate than you can get from an investment, applied in a slightly different way.

Consider the following example from a couple of years ago of how arbitrage could be used to take advantage of the equity contained in one of my rental properties.

Obtaining access to the capital works exactly the same way as it does for most investment properties –a mortgage, in this case a cash-out refinance of my property using a 30-year, fixed rate loan at 3.5%. Given the loan includes both a principle and an interest portion, the payments come to about 6% of the loan amount, in other words, for a $200k loan my payment would be around $12k/yr.

In theory, I would be ahead if I could just pay back the interest on the loan, but since I didn’t want to come out of pocket for the principle paydown even though that would just be moving money from one pocket to another, I want whatever I invest that money in to cover the entire payment.

The question was, were do I invest the money so that it will more than pay back the loan. For that, I found a fund that invests in mortgage notes with a fixed rate 9% return paid quarterly [1]. With a 9% return, if I invest $200k I would get $18k/yr in payments, which I could then use to pay off my mortgage and still have $6k/yr in profit to do with whatever I chose. Note that this 9% is not a guaranteed payment – as with any investment there is risk involved. However, in this case, the fund has a 15+ year unbroken streak of making those payments, so I am reasonably confident they will continue.

Alternatively, if I had immediate need for cash, I could have spent $70k and invested just the remaining $130k, and still been able to cover the loan based on the investment.

In the first case, my overall net worth remains constant, with $200k in debt in the property and $200k invested in the fund, but my cash flow has increased by $500/month. In the second case, my net worth drops as I have spent $70k, but my cash flow remains constant since the investment pays off the mortgage.

Getting access to additional cash – either as an ongoing revenue stream or as a lump sum up front – is the magic of arbitrage. You are truly generating money in your pocket using other people’s money to access unproductive equity.

There is risk involved in this strategy, however.

As you know, banks sometimes fail. The primary reason for bank failures is that they invest for the long term, but the cash they owe is redeemable in the short term. A depositor at a bank can request their money back at any time, and if enough of them do it at the same time, the bank fails because they don’t have enough cash on hand. If you are going to try to use arbitrage, you need to avoid this problem. Fortunately, the solution is pretty straightforward. You need to make sure that the debt that you have is stable over the long-term while your investments are liquid in a shorter term. This can be as simple as getting a 30yr, fixed rate mortgage on your property while investing in deals that give you quarterly payments. That way, you will have enough to pay back the loan.

The other source of risk is when the investments don’t work out as planned. No matter how secure it sounds, all investments have some level of risk associated with them. And since you are investing in something with a relatively high return, you need to be aware of the risk in order to have mitigation strategies. For example, if the investment pauses distributions or returns less than expected, you should have an alternative plan for making the debt payments. If you don’t, then you can lose the property that you put up to get the loan. While having this backup plan may require you to take out less debt overall, and thus reduce your theoretical returns, it also reduces the chances of you taking a major loss. As a result, I take a very conservative approach and do not over-leverage myself.

In my case, I had four possible strategies for repaying the loan. The first, and preferred, option was for the rental property to generate enough cash to make the loan payments. This works since the property had significant cash flow even when taking into account the loan. However, if the property went unrented for any length of time, that income stream would be gone. The second was for the investment that I made to cover the loan payments. As long as the investment worked as expected this would also be a good option, but if distributions were paused that income stream could dry up. The third was to use other investments to cover the loan payment since I am just re-investing this cash flow right now. Again, the risk is that the distributions here are paused unexpectedly. And the final one was to use income from my day job to make the payments. This is obvious the least ideal since it could impact my standard of living, but ultimately it is also an option. Of course, my paycheck is not guaranteed and, like any at will employee, I can be fired at any time, so there is even risk here. While each individual stream has some risk associated with it, the likelihood of all 4 streams terminating at the same time is low enough for me to be comfortable with the risk.

It is worth noting that I only had these options because the overall debt payment was low relative to these sources of cash flow. If, for example, my debt payment was $10k/month instead of $1k/month, I wouldn’t be able to cover it using the cash flow from a single family rental and the impact on other cash flow streams would be much higher. In practice, not only would that remove the option of having the rental cover the debt but I would not be able to cover that payment from my base salary alone. If anything didn’t go as planned with the investments, then I would likely lose the property backing the loan since I wouldn’t be able to make those payments.

This is one of those situations where a simple analysis of the numbers is likely insufficient to make a good investment decision. You also need to factor in the risk associated with the investment and ensure that you have appropriate mitigations in place. As Warren Buffet says “Rule No 1: never lose money. Rule No 2: never forget rule No 1.”[2] As a result, the extent to which you pursue this strategy depends heavily on your risk tolerance and what mitigation strategies you put into place.

With interest rates now higher than they have been in 15 years, it is harder to find opportunities to use arbitrage, but it is still a useful tool to have in the right situation.

Have you considered using arbitrage to increase your cash flow?

If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

For additional reading:

This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.