O.K., Joe and Osirus, but this is it. - Posted by Brent_IL
Posted by Brent_IL on August 19, 2003 at 01:58:45:
I?ll give it a try, but no promises.
My challenge is that facts sort of just coalesce in my head, but I have a hard time explaining what I?m doing to others. When I?m unclear with my answers, it generates questions that I answer unclearly that beget more questions. See my problem?
The Monopoly® money terms will have to wait. It?s too late for a cash flow primer.
Here?s some background. Two paragraphs herein are cut-and-paste.
When I say that I try to hypothecate as many deals as I can, all that I mean is that I construct a deal that yields a sufficiently high return, so that if I sell the income from the sandwich position to another investor at a lower yield, I will make a profit. I don?t sell a house because a resident/beneficiary has already purchased the house I bought. What I?m selling is the income stream and balloon payment from the net cash flow of that particular deal. I could be just the balloon. It is due in 18 months to 5 years depending upon my commitment to the sellers. Seven or eight years, tops. I use lease/purchases (NEHTrust-type) to eliminate all of the costs of ownership. What I?m left with is the difference between what I owe and what is owed to me.
This is sold at a discount for whatever lump sum will yield a 12% annualized return for the investor.
Getting the first cash flow buyer is a project. The rest will flow naturally from that one. When you are looking for your first moneyman, remember that some ROI?s have more appeal than others. It isn?t always the highest rate of return. For example, I will get more investor money by promising a 24% annual return that I would if I promised 47% because, while most of the deals could support the interest rate, the ROI will be perceived to be too good to be true. 14% is thought of as an excellent return, but only a crook offers 27%. Investors aren?t familiar with the returns developed by CRE practitioners. To them a 100% annual return is unheard of, and an infinite return is inconceivable. Look at advertisements in the financial press to get an idea and add a point or two.
For me to pay 24% the scenario would have to be:
1 ? Tell me when you want your principal back.
2 - Review the pro forma. I?ll never change the contracts, so I don?t care if you read them or not.
3 - You have one meeting to ask questions. I will answer them. That?s it.
4 ? If you believe what I?m saying, give me money. Wait for the pay-off. No more interaction.
5 ? If you think I?m off in la-la land, put your money back in your pocket and say goodbye. No more interaction.
Then again, 12% has a better image than 13% or 10%. The dealmaker is in complete charge of the rate offered because charges, fees, quasi-contracts, and the like can be put in place to make the income fall into the range that you?ve determined ahead of time. Recall that we aren?t selling the seller?s deal or the R/B?s CFD, but we?re selling a spread position constant.
The 12% investors aren?t all that easy and take more effort on my part. Many have been burned before. Once they?ve been paid, they are easy to get to reinvest from that point onward. I started to pay 12% in 1979 when the prime rate was on its way to 20%. As I learned the art of CREI, the discount rate became less and less important, and turnover became more significant, so the rate didn?t change. Besides, when I talk to people, I like being able to move the decimal point to the left to determine their 1% a month return.
All deals have common elements. Existing financing is taken over subject-to. Always.
Every purchase contract contains redundant verbiage to implement eternal subordination and substitution-of-collateral.
All purchase money mortgages have a payment that is capped at 90% of net income less the payments for the original underlying financing, regardless of the payment schedule. Any underpayments are accumulated and paid with the last scheduled payment.
There is a moratorium on payments for one to how-many-months-can-I-get-away-with.
All but zero interest or less-than-zero interest PMM notes have some percentage of the first scheduled payments going directly to principal.
There are about 30 other pro-buyer clauses in the standard contract to purchase. A few are mutually exclusive, but I can choose the ones that I want to mix-and-match after the contract is signed, but I have to decide what to do before the documentation is drawn up. That way I can optimize the exit. This doesn?t affect the seller unless he asks for something that changes his position.
When you design your deal keep in mind that financial calculators are stingy. They flatly refuse to make any payments for you. When you?re developing the financing package to purchase a property, know the risks; use built-in safeguards; and don?t make promises that are exceedingly difficult to fulfill, or promises that are impossible to keep without flocks of ducks simultaneously lining up in row after row.
It?s analogous to seeing the building plans for a new house by simultaneously viewing several plastic overlays of the different phases of construction. The people who dig and build the foundation have one set of plans. The tradesmen who frame the house use another set. So it is with the plumbing, electrical, HVAC, carpentry, and finish crews. Although they are interdependent, each of these blueprints are drawn and put in use independently of the other sets of plans. When transferred to transparent overlays, the only way they make sense as a unified whole, to one such as me, who is not familiar with blueprints, is if you pile them from the bottom up and view the entire stack as a completed picture. The plan?s compilation has to be worthwhile for the project to be built.
So it is also with a financing package we design to buy a SFH investment. We look to the house?s existing equity for quick money for closing costs and down payments. Longer-term financing is arranged with the actual carrying capacity of the property and its contract sale value in mind. Individual components can be developed to address specific aspects of the transaction, but when you put everything back together, the combined costs, taken as a whole, must be low enough to warrant buying the property.
Our goal is to keep the overall percentage level of limited-liability semi-secured indebtedness very high while simultaneously keeping our cash payments and real estate secured obligations very low. This is done to keep our return on investment in the upper double digits. When we are convinced that it would take an act of God not to get a high return, we feel confident in passing on a portion of the return to someone else.
Here?s a simple example of a buy-sell-hypothecate transaction. It?s a simple example because I didn?t build in any extra tax advantages to sell to a fifth-party. I?m also going to use a purchase money mortgage interest rate of zero to cut down on the calculations. If you aren?t getting zero-interest seller financing, it?s because the sellers are not must-sellers, or you aren?t asking for it. If I have to pay interest, I?ll get another seller concession that will negate how interest affects the financing. There are many variables to these agreements, but I?ll try to adjust as few terms as I can to make the point.
Asking price - $100,000
Purchase price - $100,000
Existing loan - $50,085 - 8% APR; $410.91 current monthly payment.
CFD sale price to R/B - $110,000 - $1101.92 R/B payment to me. He owns it (kind of) so he pays the expenses. I have a dozen mini-talks that I give people to explain the reasons why I want to do things in a certain way. I don?t have a buy-this-house-with-100% financing talk. All that CFD buyers want to know is how much down and how much a month. No talk necessary.
The seller, a wild and crazy kind of guy, wanted 20% down. Purchase money mortgage note was rounded off to $30,000 with monthly payments of $400 and a five-year balloon. The payment is $400 because I spent 15 minutes by first asking the seller what he felt the place would rent for, and then asking him about the property?s expenses. If he had low expenses, I kept suggesting categories until his estimate was realistically in the ballpark. The net operating income was $400. He was losing money and didn?t even know it. He was lucky I agreed to make the first mortgage payment from another source.
Each month, a third-party bill payer deposits the R/B?s check, sends the seller $400, and sends the rest to the first mortgage holder. If there were junior liens, he would send it to the one that was charging the highest interest rate. There is no monthly income left for me.
In five years hence, the additional payments to principal will have reduced the balance of the first to $23,044. I will owe the seller $6,000. My R/B will owe me $107,248. The difference between what is owed to me and what is owed by me to others is $78,205.
Before closing with the seller I sell my beneficial interest for $44,375 to one who wants a 12% annual return for five years. I decided to pay down the first because guys who write checks for tens of thousands of dollars do not need to pay taxes on additional ordinary income from the cash flow. His LTV cushion increases rapidly. It was great to begin with because I used the SOC to move the purchase money mortgage off of the property. It is a much cleaner deal that way. He sends the check to escrow.
I direct the closing agent (my lawyer) to give the seller $20,000 for the down payment I promised in the purchase contract. After settlement, the lawyer gives me a check for $24,375 plus whatever is leftover from the R/B?s contribution to closing costs.
That?s the extent of my involvement unless something goes amiss with the R/B. It is my responsibility to fix it even though I am technically out of the middle.
This is the basic idea. The more you learn about how the pieces fit together and how everything interacts, the more exotic financing terms you will be able to use the reduce the present value of the contract terms to well below FMV. I try very hard to never go above 81% of true market value.
Seller - $20,000 less about 70% of closing costs.
Investor - 12% ultra-save investment.
R/B ? 100% financing on a new home: 2% to 4% down stroke used for 30% of closing costs and charges I made up. Until recently, 5% to 6% was the average.
CRE practitioner - $24,375 plus.
In real life, it is only one step more than a L/O and the same number of steps as a rehabber using hard money. It takes a lot fewer hours to do this than it does to do a rehab.
Hooray for our side.
This is it; I?m burned out.