New Year + Newbies - long enough to be a treatise - Posted by Brent_IL
Posted by Brent_IL on January 01, 2003 at 19:48:37:
This is the time of the year that many hopeful creative real estate investors make a resolution that this year is really going to be the year that they stop procrastinating and start working toward real estate investment success.
I?ve been off line for awhile due to deferred maintenance in the healthy-body department. In the later stages of a recovery period, I decided to write down and attempt to organize some bits and pieces of creative real estate knowledge that are second nature to me, but not always apparent to those around me, so that my wife, who doesn?t have the slightest interest in real estate investment, creative or otherwise, might be able to comprehend how the pieces fit together if I?m not around.
After writing a sketchy outline of 232 pages, I figured out that I?d better live forever because I?m a poor writer and a worse teacher. Ron * Starr was probably being optimistic when he said it takes two years of preparation before one should consider full-time creative real estate investment.
However, this writing process led me to ask what I would do if I were starting out today with no-cash, no-credit, no-collateral, and wanted to make money in real estate. The times, they are a-changing. I?ve spent over twenty-five years refining the hunt for the elusive must-seller. In my sole opinion, those days are slowly sliding away. I believe that in the next five to seven years the number of must-sellers will surge to the point that we, creative real estate investors, will be able to pick-and-choose our real estate projects at leisure.
The difficulty that I anticipate is that quality buyers or renters that can support properties bought at today?s price levels will be sparse. This will be a time of unparalleled profit (my opinion) for those creative real estate investors who have a pile of cash. But what of those who are starting now and are true 3(NC)?s (No-Cash, No-Credit, No-Collateral)?
My objective here is to convey workable concepts and ideas that will create an improved bottom line and provide the cash that will enable new investors to participate in the next cycle. Many of the people that you interact with will say this is impossible; that it?s probably illegal; that these techniques will never work; and that even if they did work, they won?t work in your area or in your location or in your price range; that it is inconceivable that any property owner will accept these kinds of offers; and one that did accept an offer of this design would be declared to be legally incompetent by any sitting judge in the country
I?m here to tell you that your peers, friends, and family are well-meaning, but unenlightened, at best, and utterly wrong if they are merely interested in maintaining the status quo. Misery not only loves company, but it vehemently resents any that strive to remove themselves from its constant companionship.
Every idea that I present here is something that I have done regularly. Some I do every time that I make an offer to purchase real estate. The majority of the offers that I make are accepted, and until about a year ago I made a lot of offers. This isn?t to be construed as me bragging that I?m so good at what I do, but to point out that the folks who will tell you that your investment plans and creative solutions to the challenges of buying residential real estate for investment are nonsense, have never, ever tried it. Most have the uncreative working experience of taking orders from the ?boss.? Someone else has stepped in and reaped monetary benefits by providing viable solutions to the challenges of business while those who doubt continue doing what they are told to do.
I have to fight a tendency to ramble, so my presentations don?t always come off the way that I would wish they did, and I take longer than I really should. It actually doesn?t matter a whole lot. My offers are accepted, not because of what I say, but because I solve the seller?s immediate real estate problems. Take the information I share with you at face value unless you have actual experience that differs. You?ll make more money if doubt isn?t leading you to compete with yourself.
If success is defined as having excessive disposable income, a 3(NC) creative real estate investor can succeed by using the techniques described herein if he or she will devote the time to understand and implement the information given. Failure when using this method stems from haphazard preparation, or from not trying again when one is rebuffed.
This isn?t for everyone. Not all of us enjoy face-to-face negotiations. Steve Cook?s forte is REO rehabs. Ronald * Starr likes doing extensive research on real estate and bidding at tax sales.
This is the best entry-level strategy that I could come up with. I apologize for being long-winded, but I can’t answer e-mails seeking clarification. I believe the numbers are correct, but I cut-and-pasted them from a much longer example that I prepared for my wife. My calculator is gathering dust, but if the figures don?t come out and it is pointed out to me, I?ll fix the post.
What if you?re a true newbie, don?t know the first thing about real estate, and don?t have much money to spend on real estate activities?
When you lack tangible assets the only things you have to work with is your knowledge and your integrity. Integrity in an adult is either there, or it isn?t. Knowledge can be acquired.
I?ve seen the basic scenario related below repeated time and time again by wannabe creative real estate investors.
During the first week after exposure to creative real estate, much thought was put into determining if the new RE investor was to be the President, CEO, or simply the ?Chairman of the Board? of his or her investment company. Perhaps, it was considered, being a ?Real Estate Consultant? would be a more favorable approach.
5,000 business cards were ordered.
During the second week, time was spent skimming over the bold print in their new course book, photocopying the out-of-state contracts included with the course, chanting the mantra, ?No money down; Second mortgage crank,? and posting quasi-advertisements on the internet like ?$20 Million Dollars Needed Immediately! Earn 50% interest in Thirty Days. EASY MONEY! ABSOLUTELY NO RISK.?
Once the business cards were picked up, our embryonic investor quit the evil J.O.B. that had been shackling the soaring eagle within.
The third week was more of a challenge.
No slacker, he, the new investor made two offers and contacted three real estate agents.
The first agent, newly-licensed, was polite, but said her broker had poured salt around the perimeter of the agency office to keep real estate investors at bay. She did promise to email everything on the MLS in its entirety after she had learned the computer system and found the time.
The remaining two agents were verbally abusive.
One seller became irrationally angry, and rudely asked him to depart when it was explained that the offer to purchase was for 30% of FMV with the closing to take place in 182 days. She certainly was unreasonable after all the effort the buyer had taken to keep the number of contingencies under ten. She should have known that to cash out our new CRE investor, time was needed to find a note buyer that would pay 99% of face value for an unseasoned, unsecured, 30-year, no-interest note. Mr. Newbie mentally added an extra two days to his standard search time because the future note payee, his intended no-money-down buyer, has been unemployed for quite a while, and, apparently, some note buyers are fussy about things like that, so, he contemplated, he might have to ask two or three of them to buy in order to sell the note. A big price cut in the asking price for the real estate was absolutely necessary because the investor had bills to pay and needed the money. Why couldn?t she understand?
The second seller was laughing too hard to say much, he just sort of shooed Mr. Newbie out of the door. The last thing the CREI did remember hearing between the chortles was, ?There aren?t any stupid people living in this city. Aren?t you aware that this so-called ?creative? garbage doesn?t work here? Don?t you know that creative real estate is illegal in this state? Are you licensed? You can go to jail for making this kind of offer. If you don?t make a cash offer quickly, I?m going to call the police?
Midway through the forth week, which was spent in seclusion, sulking, and wondering what to do with 4,995 business cards, panic suddenly set in when the realization came that without a job, total available funds would last only 6 more days.
Here comes the CREonline.com post headlined URGENT: ?Help, I?m addicted to real estate courses. I spent my last dime buying a course called ?Get Rich in 18 Hours?, I?m broke, too petrified to make an offer, and the unemployment check is late again; what can I do right now to get some money so that I don?t starve to death??
What to do? What can we do? My approach is generalized, but the example given is very detailed.
Here?s a specific example, demonstrated from start to finish, of something that I believe many sincere, but inexperienced creative real estate investor wannabe?s can do that requires little cash, credit, collateral, or real estate knowledge, and even less mathematical skill. The math that I use here is to explain the concept in a way that can be transferred to all rental properties. It isn?t necessary, or recommended that you get this detailed with the folks that you talk to. Don?t let the strings of digits freak you out. Take your time and re-read this until you know where the numbers are coming from so you will own the concept.
This is a No-Cash, No-Credit, No-Collateral, No-Banks, No-Brainer, very little math, cash-flow generator. I conceptualize it as ?renting to eat.? With disaster looming, shyness is not an option. Speaking to people is essential. If you can?t talk to people, you can certainly succeed in creative real estate investment, but you will need cash, or good credit, or collateral, and sufficient time to get it done.
What I am illustrating is not real estate investing; not long-term buy-and-hold, not short-term flips, nor is it intermediate L/O?s. This is not a true lease/option in the traditional sense, but is a hybrid of numbers 2, 6, and 13 in Jim Kennedy?s list of 22 real estate investment niches, i.e., retail flipping (purchase and quick resale); buying and reselling properties using (trusts,) wraps, contracts for deed and land contracts; and using notes to (lease,) buy, sell and trade property. I think of things like this as real estate derivatives. This is a way to quickly acquire the cash to survive, or for quick in-and-out reinvestment activity until one has the real estate knowledge and contacts to do something else. Or, one may continue doing this, but at that point it will be a choice.
This variation is a simplification of something similar that I do now, so I know, unequivocally, that it works. If you disagree with me, and feel that it won?t work for you, don?t bother with it. Try something better suited to you
The plan is two-fold; to find those with a comparatively modest amount of extra money, and those with apartments or houses to rent. A fundamental premise is that it is much quicker and much easier to become knowledgeable about the lease rates and amenities in your local rental market than it is to gain expertise in the intricacies and complexities of real estate deal-making and purchase contracts. Go back and read that last sentence again.
This activity requires:
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Simple residential leases which include the right to sub-lease (hand-written in if attorney approved, or take a local form to a real estate lawyer as a sample so it can be adjusted to specific state laws before use);
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Assignment pledge forms with a release clause to be used as a security agreement (same real estate lawyer); and
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Promissory notes.
Review ?Caveats, cautions, and concerns? below.
The needs of a renter are more basic than those of a home buyer.
Everyone wants to live safely in a well-maintained space. Renters, however, are not overly concerned with property appreciation or a possible change in character of the neighborhood over a longer period of time. Future appreciation doesn?t belong to them, and if, at some point in the future, the neighborhood changes in ways that are not to their liking, they can move.
All unsubsidized rentals lease at, or below, the going market rate. If a unit is over-priced, it will not rent until either the asking rate is reduced or local rents catch up. A tenant who can read the newspaper and looks at housing for three or four days will quickly become an expert in judging price vs. amenities in a given location and marketplace.
You need to become an expert, too.
Memorize one sentence and two questions.
The statement, and the answer to most generalized questions about the nature of your employment is, ?I?m a manager for a company (sole proprietorship) that rents housing, and also provides monthly income to folks who want to earn 12% annually.?
The first question is to be asked of every person who has any type of residence for rent. Talk to them all.
The first question is:
?Mr. Landlord, I?m in the rental housing business. If I pay five months rent up-front, in advance, will you give me credit for the sixth month?s rent and the opportunity to possibly repeat our arrangement for another six month period??
N.B. What you are not asking, and never will ask, is if he or she will lease/option their property. You will also never ask a landlord if he or she will sub-lease the unit. You implied the sub-lease when you said that you were in the rental business; that?s enough verbalization.
An immediate ?Yes? is infrequent, but the question will stimulate questions by the landlord that will act as a springboard for profit. Right now, assume the landlord says, ?All right, I?ll do that if I approve of your renter.? In contrast to traditional L/O?s, if he or she doesn?t bring up the topic of acceptable renters, make it a point to tell the landlord that all tenants will be submitted for his or her approval.
You begin to search intensely for a quality tenant with good credit to sub-lease your rental. How is it even possible for you to get sub-tenants that have better credit and better credentials than you have to rent the place, and to do so quickly, when the landlord could not? The answer is simple.
Rent 10% below the going rate for similar units in the area.
We?ll come back to this aspect shortly. Suspend disbelief for a moment. It will all come together by the end of this post.
The second question is asked of every adult you meet except the landlords.
Ask:
?You seem to come in contact with many people, Ms. Acquaintance. Who do you know that?s unhappy with the rate of return that their certificates-of-deposit or IRA?s are earning that you think might want to benefit by doubling their interest income and earning 12% annually??
By far, the most frequent response will be a request for more information, ?What are you talking about? What?s this all about??
The short answer is, ?I?m a rental manager for an investment company that offers to pay monthly income to folks who want to earn 1% a month, or 12% annually.?
If they can?t come up with a name (most can?t), smile and say, ?That?s fine. You don?t mind if I check back with you another time, do you?? and ask the next person.
During future social exchanges, still smiling, alter the question slightly to
?Hi, Mr. Acquaintance, have you spoken with anyone YET (very slight pause) that you believe is unhappy with the rate of return that their certificates-of-deposit are earning, and who might want to double their interest income and benefit by earning 12% annually??
Eventually, if they see you regularly, people will search for someone in this category to avoid having to say ?No? repeatedly. They can?t stand the pressure. More often than not, they will be considering their own situation when they reply.
Another thought is that whenever someone asks how your real estate activities are going, reply, ?Everything is going great. I just increased the interest that I pay to my investors to 12% a year. Compared to the teetering Dow Jones Averages, one percent a month has them dancing in the streets, so now I?m able to accept smaller-sized deposits, too.? You never know, someone may come back with, ?Hey, what about me??
Although I am going to offer 9% in the future if I decide to accept new investors and get back to work, twelve percent is all right to pay for a semi-secured loan and gives you more money to play with. This would be my first reduction in investor payouts in 23 years.
Put your explanative response on hold for now. Just for a moment, assume that because there are more investors having little to modest cash available than there are those that have big bucks to place, an investor with one, two, or three thousand dollars is forthcoming. These people might be sophisticated, or may not be, but all are mentally down-to-earth people who want a better return on their money than they have been presently receiving and are seriously worried about the Dow. If they ask for a prospectus, you?re talking to the wrong person, or, more likely, using the wrong terminology, and wasting your time.
The vast (repeat: vast) majority of investors in Fortune 100 stocks can?t understand the financial statements of the company whose stock they?re buying. What they do know is that a stock broker or magazine article told them that it?s a solid company and said the company?s share price will probably go up in value.
We can offer an alternative that will probably go up in value without the roller-coaster effects of the stock market. Don?t worry; they won?t read our financial statements, either.
Sans details, what you have to offer is a six-month, fully-amortized note discounted to yield 12% APR secured by the rents from high-quality residential leases that includes the right to take over your lease with the landlord if you default. It?s a loan. The security for the loan is not to be dramatized. It will be a secondary concern to the majority of your investors and only semi-understood by them at best. They want a simple explanation, not an elucidation. Don?t overcomplicate things. You are not selling them an investment opportunity. You want them to lend you money evidenced by a note Don?t use other types of indebtedness, start calling the notes something they?re not, offer or advertise these to the general public, or do anything else that may lead to SEC oversight. If you refer to this as ?a note fully-secured by my (not the firm?s anymore) real estate interest in 123 Main Street,? that?s often all that?s ever needed. Less is more. It?s for reassurance purposes, and not to be used as a selling point. The selling points are limited exposure due to the short term of the note and the assignment of your lease, the high-percentage of interest return, and their right to do the whole thing again in six months.
Why are your tenants, which are the primary source of funds for the note repayment, of such high quality?
Assuming that they don?t trash your place, better tenants are better because they pay their bills on time. They often have less disposable income than do others at the same earning level that will either pay late for goods and/or services rendered, or pay not at all. Quality tenants actually have a greater incentive to reduce expenditures than do deadbeats. You picked the tenant, and because you did the screening, of the group that was vying for lower rent, you chose the best one available.
Tenant screening is your most important job.
This isn?t a totally risk-free approach. It?s possible that your tenant will never make a payment after moving in. However, your risk is reduced by screening carefully and by the short-term of your obligation under your lease to the landlord and the note given to the investor. Remember, though you would emphasize the three to five or ten year term of the lease when negotiating with the landlord, it?s optional for you to renew. You?re not at risk to the landlord or to your investor for more than six payments at a time.
To use an example that can be applied to all rentals, assume that investors with modest resources who approve of your renters are available to you every six months, and that the monthly rent in the current market for the unit under consideration is one US dollar due on the first of the month. I ran the numbers out so they could be applied to differing rents to get the traditional six decimal places for financial reporting.
The illustration is per dollar received; you can plug in any number for the rents and multiply
You rent a housing unit for six months by paying $5.00 in advance with the option to renew at the same rate for a MINIMUM of five additional six-month periods. To get a good, long-term tenant, you will sub-lease this unit at a 10% discount when compared to similar units, or 90¢ a month.
Recall that a rent payment paid on the first of the month pays for the upcoming month, i.e., rent due May 1 pays for the month of May.
Consider:
90¢ a month paid in arrears and discounted to yield 12% annualized ROI fully amortized over a 6 month period = $5.215928827.
So where are we going to get the money to live on? Let?s use a rental term of three years (our minimum) as an example.
The lease is signed by one we carefully chose, who, unlike us, has impeccable credit and good income ratios. We give an investor a six-payment note secured by our real estate interests or our signature. He or she gives us $5.215928827. We give the landlord $5.00 and have $0.215928827 left for us. We may ask our tenant for a security deposit, although, because we have to give security deposits back, it would be preferable to use Ray Como?s mandatory option technique (housebuyingking.com). Since we didn?t have to pay a security deposit (?Isn?t five months up-front enough security, Mr. Landlord??), we might let the tenant in without one, but require that the first and last months rent be paid in advance prior to moving in. I usually don?t ask for a security deposit.
The renter gave us the first and last months rent, or $1.80. After adding this to the amount left over from the investor?s money, we now have an amount of $2.015928827 available for our use for the first half of the year. The second half there?s no additional payments or deposits from the tenant, so we get to keep the $0.215928827 remaining after paying the landlord another $5.00 in advance to cover the rent for the second half of the year.
In our 3-year example, it?s the same gross of $0.215928827 for each six month period in the second year and the first six months of the third.
Recall now, that a monthly note payment on May 1 pays for the period from April 1 through April 30. When the tenant, paying in advance, makes his last payment due under the lease, you will have only five payments in the last period to pay your investor, who is being paid in arrears.
We want to limit our liability by utilizing cash flow that we have reasonable cause to believe will actually be there for us. There is no sixth month payment because the tenant paid it when he moved in. For the last six month period of our lease, 90¢ a month paid in arrears and discounted to yield 12% annualized ROI, fully amortized over a 5 month period, = $4.368088115. That?s not good in this situation because it?s less than the five dollars we need for the landlord.
Many short-term financial instruments are sold with terms of 30 or 90 days, six months, or one year. A five monthly-payment note appears different from the norm to investors that aren?t used to buying irregular cash flows. It disrupts their idea of continuity, raises questions, and it?s too much for you to quickly and easily explain why the pattern changed. Our investors are not wheeler-dealers or rainmakers. They are primarily retirees, busy M.D.?s, DINKs (double-income; no-kids), or empty-nesters.
For the sake of simplicity and popular acceptability, when our investor reinvests for the final period, we have to sell a six-payment note and eat the last payment. The funds to pay for the short-fall in the last period must come from profit that has been received previously.
As before, 90¢ a month paid in arrears and discounted to yield 12% annualized ROI fully amortized over a 6 month period = $5.215928827.
$5.215928827 less $5.00 to the seller; less 90¢ for the sixth payment of the final period; equals minus 0.684071173 (a negative; a deficit). This wipes out most of the accumulated profit for this single lease after the first semi-annual period.
A remaining-cash summary of the 36-month lease would be:
First year:
Initial six-month period = +$2.015928827;
Second six-month period = +$.215928827.
Subsequent semi-annual periods:
All other six-month periods prior to the last six-month period (#3, #4, and #5 in our example) = +$.215928827;
The final six-month period of the lease is negative = ($0.684071173).
The revised projection of realized gross profit per dollar of rent that you pay to the landlord is:
Months 01 through 06 = +$2.015928827;
Months 07 through 12 = +$0.179644135 [$0.036284692 from the amount left over after paying the landlord is needed to pay the final payment to your investor];
Months 13 through 18 = Zero; (used for the last investor payment)
Months 19 through 24 = Zero; (used for the last investor payment)
Months 25 through 30 = Zero; (used for the last investor payment)
Months 31 through 36 = Zero. (used for the last investor payment)
Don?t go into brain-strain here. Spend what?s left over between the first lease period income and your project expenses. If you save the rest, and pay the last-period shortfall, you?ll come out on top and be prepared for the next round.
So what?s the real life application?
Just suppose that you live in a location where virtually everyone in town works at the fish cannery for minimum wage. The area?s top-of-the-line houses have a FMV of $35,000 and rent for $250 a month. You take a few sick-days off from the cannery, work hard all week, and, finally, one landlord agrees to take 5 payments now and give you credit for six. You also find a good tenant who can use the price break on his rent. The auto-repair shop owner and the only lawyer and the sole Doctor in town will take your 12%-yielding notes as quasi-participants in your project.
If you are speaking to, and questioning a significant number of people, it?s relatively easy (I can?t believe I just said that.) to find investors when you only need one or two thousand short-term dollars at a time. Try friends and immediate family first, but don?t rely on them. After the first six months, folks will be throwing money at you. {?Sorry to hear about your 401K woes, my friend. I?m sure glad that I don?t have those problems. I?ve got a guy who pays me 12% annually, one percent every month, like clockwork. Of course, I?ll give you his name and phone number, you?re my Bo.?}
Your investor gives you $5.215928827 x $225 (monthly market rent receivable discounted by 10%) or $1,309.98. The new tenant gives you 2 months x $225, or $450.00, so you?re up to $1,753.98 cash in hand. You pay the landlord 5 x $250 or $1,250.00 in advance. This leaves $503.98 in your pocket, and another $44.91 to be received in six month?s time. Three deals a month in this relatively low marketplace will certainly beat minimum wage at the cannery.
It?s been my experience that when using this method of cash production it is good to focus on price ranges that appeal to qualified upper low to mid-level white-collar workers and blue-collar workers of any income level. Low-income rentals without an option-to-buy seem to be used too hard physically for us to gain anything from a net rental. High-income tenants for costly SFH rentals are usually looking at a short tenancy. Otherwise, they have the means to buy and are better used as a stop-loss.
Since the illustration is per dollar received, you can plug in any number for the rents and multiply. If rentals in your area lease for $1,500 a month and you re-rent for $1,350, your annual gross profit per deal completed under this scenario is $3,293.34. If you do one deal a week, and take four weeks vacation, you?ll make almost $160,000 a year.
There?s no depreciation or 1031 exchanges, and only minor deductible expenses to reduce taxable income when you?re using a sub-lease like this, so make sure that you allocate funds to pay your estimated income taxes when due. You do your own withholding.
Possible profitable tweaks:
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Raise your tenant?s rent every year after twelve months. If everyone else is raising theirs, you will still be under market. Since your renewal rate with the landlord is fixed, it?s all profit.
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Remember when I said the landlord will have additional questions that would act as a springboard for profit? Many times the landlord will have an initial objection to a rolling-type option. If the deal, as envisioned, makes sense, and for many landlords this approach does make sense, any objection is to be treated as a request for more information.
?Well, Mr. Newbie, the advance payments sound good, but I don?t want to be locked into the same rent for xxx years. My expenses increase annually.?
?I know what you mean, Mr. Landlord. Operating costs are extremely high; they can be even overwhelming at times. Expenses run what, 40% of rents? 45%; maybe more??
?No, I am landlord ?Superior.? Taxes, insurance, utilities, maintenance, and allowances for vacancy and repairs average much less than 30%.? [Make a mental note to duck for the Pinocchio-effect.]
?So if the rent is $250, and about $75 is lost to operating expenses, that leaves $175 a month, right??
?Right?
?Why don?t we do this? I?ll pay you five times the monthly net profit before debt service of $175, or $875.00 in advance, and our contract will stipulate that I’ll pay for all of the operating expenses during the time that I?m leasing regardless of how much they go up each year. Every one of those expenses will be paid by me. I?ll send you a copy of every receipt so you?ll never have to wonder if all of those bills that would normally go to you are getting paid. Your cash flow is exactly the same as it is now, and I?d have additional work for my handyman, so he could go full-time and stay on top of things (Give them a reason).
Would you like me to send the receipts to your home address or would you rather that they come to your office??
Though we don?t want to be the one paying property expenses, when this proposal is accepted, three things have been accomplished:
1 - The up-front payment to the landlord has been reduced by 30%, from $1,250.00 to $875.00.
2 - If you do enough of these, you open the door to some actual economies of scale on maintenance and repair costs.
3 - Most importantly, after agreeing on a net payment, you can segue into asking the owner, ?Mr. Landlord, have you ever thought of selling your property??
At this point, you possess inside knowledge about the LTV that this property will support. The mortgage payments (P & I) can?t be higher than the net rent payment that you and the owner have just agreed to because you have established that it?s net.
- Here?s one more enhancement:
Note well: Try this one after your financial resources and base of RE knowledge have built up for a while. A suitable number of bathrooms in the subject property are absolutely necessary when utilizing this approach.
Over the course of a year a lot of property is offered for sale. Consider that at any given time, the majority of housing units are not on the active market. We put a lot of stock into locating the elusive ?motivated? seller and tracking down tired landlords. Isn?t it much less difficult, even easy, to find a landlord of a condo, townhome, or SFH who doesn?t want, or need to sell immediately, and in fact, may not have been thinking of selling at all? Think about it.
Same $35,000 house revisited; you?ve asked the question in #3, above, ?Mr. Landlord, have you ever thought of selling your property??; our dialog continues:
?I?ll probably sell when (my kids are grown) (the interest deduction drops off) (I?m ready to move to a warmer climate) (I retire to Sussex to keep bees) in (3) (5) (7) (10) (30) years.?
?When you do sell, Mr. Landlord, would you mind giving me the first shot at buying your property? I?d like the option of first refusal AND THE RIGHT TO BUY WHEN YOU SELL IN XXX YEARS (a reversal of the first refusal option). That?s O.K. with you, isn?t it??
?Sure, Mr. Newbie, I?ll give you a chance to buy. A buyer is a buyer.?
?Since I will be the one keeping the property in tip-top shape, and I know that I do a great job, I?m not going to try to say that the property will be worth less in the future than it is now just to try to buy it cheaper. I?m willing to pay full fair market value at that time, but I?d like you to give me a credit of 3% a year until we close. It will help the property to qualify for the loan that will cash you out, and it?s actually much less expensive for you, Mr. Landlord, than listing with a REALTOR® and wasting money paying commissions and extensive closing costs that will come directly out of your wallet.?
?How so? I don?t mind saving money, but I don?t know about a credit. What exactly do you mean by 3% a year??
?Well, let?s just say that in three years, when it?s time to sell, the FMV of this house is worth $42,000. REALTOR® studies nationally have shown that a property seller will net much less than that at closing. When average closing costs and holding costs over the time of sale are all counted and totaled, as much as 30% of FMV will disappear before the mortgages can be paid off. For many people, that?s more than 100% of their equity. What I?m proposing is that if the house is worth $42,000, three years from now, I will receive a 3 (years) times 3% or a 9% credit. If I am your buyer, I?d be responsible to get 91% in cash to pay you. The $38,220 that you would receive is in cash and not diluted by inflated appraisal or inspection costs, agency commissions paid on the entire sales price, and added junk-fees, so you?re that much further ahead. You want to keep as much money for yourself and your family as you can, don?t you??
?Ahh, ummm, why yes, I do!?
And so, by mutual consent, this is how we write it up. Of course, we don?t use an option agreement. We use our customized purchase contract with a long, multi-year escrow and distant closing date. The master lease is a completely separate and independent document. For those of you who think a seller-leasor would be offended by an option premium of fifty or one-hundred dollars, note that the cost of this option-to-purchase was zero. Zero cost is not a fantasy; it?s routine. It just depends on how you bring up the subject with an owner whose mind is on renting the property.
When the house in this example is sold, the seller is getting out at 91% of FMV. This is a fair deal for the seller, because he would probably net less if selling through a REALTOR®. There?s no obligation on your part to offer cash. Feel free to negotiate the future sale to include zero-interest loans, alternative security, discounts, and the like. Get the purchase contract locked-down and hold it in escrow with all (trust) documents necessary to transfer title, so there are no disputes if you chose to exercise your option.
Now, since we have the right to direct the occupancy, and we have the right to acquire ownership, we can sell the house on a CFD or via an EHTrust-type arrangement. One can sell a house on CFD or L/O agreement without taking title if he or she has the legal right to make good on the promise to deliver clear title to the buyer when their contract is fulfilled. It avoids future confusion and potential lawsuits if you hold all the executed documents necessary to transfer title in escrow, and you (or your lawyer) give the trustee appropriate instructions. It helps you to sleep at night, too. A policy insuring good title is essential.
Presently, in almost all stable, rising, or gradually declining markets, a borrowing-challenged L/O?r or R/B will pay at least 110% of FMV for the privilege of getting seller-financing and low up-front costs, and will happily make payments approximating 1% of the contract price.
Continuing with our same example, the $35,000 house is renting for $250 a month. The right to pay five months in advance and receive credit for six month?s rent is your incentive to do the management work for the landlord/owner. If the property?s expenses including allowances for vacancy and deferred maintenance are 30% of rent, a triple-net lease for $175 would leave the owner in the same position without having to deal with any of the landlording hassles.
{N.B. Carefully review the cautions that address potential risk toward the end of this post; especially, if you are investing in an area of rapidly appreciating housing prices.}
If you bumped a $35,000 house by 10% and sold it via an equity-holding trust for $38,500 and financed 100% at 11.999999% interest, fully amortized over thirty years, and due in say, three years, the monthly payment is $396.01. I chose the interest rate because 1% a month is easy to work with; it?s not too far off of our standard 11.65%/30-yr schedule. In three years, the principal paid down is $474.52. If the R/B did cash you out, he would owe you $38,025.47. With your 9% credit, if the FMV of your currently valued $35,000 house in 36 months is less than $41,786.23, you will make money. Compounded annually, that?s an average price increase of 6.085% per year. In most of the country I think that it is an acceptable bet that rising prices will be less. If your deal with the property owner is for straight cash, and prices increase faster than an average increase of 6.085% per year, you are going to have to pay the difference between what you owe the seller, and the $38,025.47 that your buyer owes you. It?s the risk you took when you accepted the buyer?s money up-front. If housing prices in your area are appreciating at a high rate, don?t transfer the right to all of your interest in the property to your buyer. Retain some of the property?s future appreciation; say 25% or 33%, for yourself. If it doesn?t make financial sense to sell, stick with re-renting.
Optioning at FMV is a ?double-edged sword? for the seller as well. If housing prices drop significantly during the cycle occurring during the option term, you can exercise your FMV option with the owner and simply wait to see what your R/B will do. The owner has lost any prior appreciation.
When we equate this to one dollar of rent, $250 rent divided by your $38,500 selling price is 0.006493506494. That means that in this location, every dollar of your rent is worth $154 of the sales price. The monthly note-receivable payment per dollar of rent (.6493506494 of 1% of the contract sales price) when the property is sold via L/O, CFD, or equity-holding trust at 110% of fair market value on a 30-year, 11.999999 APR note is equal to $1.584063281.
$1.584063281 a month paid in arrears and discounted to yield 12% annualized ROI fully amortized over a 6 month period = $9.180401479.
The ordinary first-time home buyer will have cash for closing costs, or for a down payment. They will rarely have both. The R/B will usually make a payment toward closing costs equal to approximately 5% or 6% of the contract price; let?s say 5%. This isn?t as uncomplicated as a simple lease, so 80% of that payment or 4% out of the 5% will pay for title insurance, extra legal fees, trustee fees, and third-party ministerial services.
In our continuing example, when the 1% left over is related to a dollar of rent it is the equivalent of $1.54 for each monthly dollar of rent that you pay to the landlord.
When $1.54 is added to the $9.180401479 paid by our investor for six monthly payments of $1.584063281, the gross amount available to us is $10.720401479.
$10.72 minus the $3.50 [$1.00 - $0.30 {expenses} = $0.70; $0.70 times five] triple net rent paid in advance to the landlord = $7.22 remaining for you for each dollar of rent.
It takes only slightly longer to find a R/B instead of a regular tenant. All are screened equally. The money he or she has for closing costs is the determining factor. $450 (2 x $225) first and last month?s rent for the tenant vs. the R/B?s $1,925 initial contribution toward closing costs.
Using the sample $250 monthly rental, as compensation for your efforts in seeing this deal through to completion, you will earn $7.22 x $250, or $1,805 for the first six months. Subsequent six-month periods will earn $9.180401479 minus $3.50, or $5.680401479 for each dollar of rent. During the second half of the year you will earn $1,420 for a first-year total of $3,225. This is straight gross profit because the R/B is paying in arrears, and you are paying your investor in arrears, so the timing of the incoming payments matches the timing of the out-flowing payments.
Don?t let the quantity of figures in this example mess with your mind. The actual numbers are for your perusal. In practice, the figures are parceled-out only if absolutely necessary. Landlords will hear ?5 in advance for 6? that will be paid very soon in a lump sum; that?s a lot different than, ?discount your rent by 16.666667% and I?ll consider renting this unit.? Buyers want to know what?s the monthly payment and how much is needed to move in. Investors are told. ?When you give me xxx dollars, you?ll earn a 12% APR, or six payments of $xxx.xx.?
Most investors like to invest even amounts of money. If they tell you they have $5,000, $10,000, $30,000, or $300,000 to invest, tell them that they will receive priority and can have all the upcoming deals until they are fully invested. Then work hard to get them completed before they lose interest and send their cash to the widows of former high Nigerian government officials to free their entrapped billions. It?s a K.I.S.S. approach, all the way.
This is consistent, but uncomplicated work with little competition because you?re talking to non-sellers that gravitate toward longer option periods, and utilizing small-time investors. You?ll find that landlords will become used to the tenant-complaint-free environment and periodic lump sum payments. I?ve only done these for the past few years. Because I ask for extraordinarily long time periods I haven?t had too many of these come to the end of the rolling lease options. Although my sample size is modest and skewed, based on landlord comments, I believe the long-term rate of renewal will be very high.
Caveats, cautions, and concerns:
1 - This is all about the relationship between expenses and income. You have to put in enough effort to become knowledgeable about the prevailing rental rates and the associated costs of operating a rental unit in your area. Don?t make a net offer unless you are sure of the numbers affecting operations, and don?t make an offer of 5 for 6 of the gross rents until you know that the asking rent is at or below market for a property in that condition at that location and there are renters available.
All of the profit is on the front end, but responsibility and liability lingers. Carefully consider the ratio of total expenses-to-income before accepting a tenant or buyer. When selling without ownership in this way, it?s undesirable for a tenant to not follow through with a purchase because he is doing the take-out. As a simple estimator, I take a potential buyer?s income and divide it by three, then divide that amount by 1.3 to arrive at an amount that I believe they can pay for P & I. This might be over-kill, but first-time home buyers will face many more expenses in the initial 12 months than they can anticipate. By qualifying conservatively, they will have money to pay for taxes, maintenance equipment purchases, and the unexpected. The current mortgage rates are the lowest in forty years. Almost anyone who could conceivably qualify for a new home loan has done so. If you can?t find quality buyers with the intent to own, stick to renting.
2 - If you?re not immersion-research oriented, think of the first deal as a seminar experience paid for by physical work in lieu of tuition or fees. Use the profit to pay an attorney to write up the state- specific note and the forms to use for the assignment of leases and the provisions for release. Have your investor send the money to escrow and let the lawyer handle it. The attorney will have greater confidence that his fee will be paid and it will give your investor confidence that things are on the up-and-up. From this point onward you need only change the names and monetary amounts to use copies of the same paperwork. This will save the burgeoning CRE practitioner much wailing and gnashing of teeth. The second deal?s profit is yours to keep.
3 - The amount you make on each completed deal is relatively small. This will give you enough cash to live on, but not enough to retire twenty years earlier. By itself, this approach doesn?t increase net worth the way a buy-and-hold strategy would. It is like wholesaling in the sense that large money is made by large volume.
4 - Maintain the term of the notes at six months. It is philosophically acceptable, restricts the note term to less than 270 days, and improves the bottom line by reducing the actual dollar amount of the discount. Six months is also a natural break-point for the term of the lease. Landlords have heard of six-month leases even if they don?t use them. If you go to a one year lease the landlord would have to give up over three payments for you to maintain the same ROI. It?s a hard sell. The extended time of exposure during a sub-lease is also something to think about.
5 - It?s important to steer negotiations with the landlord so you ensure his obligation to approve of your tenant. Have your attorney include a hold-harmless clause within your ?right to sub-lease? language that releases you from responsibility for those sub-tenant actions that have not been assumed in writing by you, e.g., you might accept responsibility for repairs during the original term of the lease (six months for each renewal period), but not during a holdover sub-tenancy, which would be explicitly excluded. The lease agreement should state that tenant approval can not be unreasonably withheld by the landlord without penalty and then state the penalty. Approval should never be a problem because you only lease to high-quality tenants.
The purpose of this prior approval is to discourage a legal action against you if your tenant files bankruptcy, decides to live rent-free for a few years, and camps-out in someone else?s building. This is unlikely, given your screening, but it is foolish to assume an inordinate amount of risk for a few hundred dollars. Have all of the contracts and documents for all parties written in terms of a negotiable number of automatically renewable six-month periods unless you, unilaterally, cancel 30 days prior. In the event of actions untoward, you are responsible for the remaining months of the current six-month period. You would decline to exercise your option for the next period.
There?s no need to burden the landlord or ensuing buyer by elaborating upon this unlikely, but remotely possible scenario, however, it?s very important to you. They can read the docs, if they are so inclined.
6 - Landlord/owners will consistently quote expense numbers that are lower than they actually are. Some forget some of the expense categories, and some are fudging to make their property appear in a better light. You need to make the correct assumptions. However, if you feel that their estimates are in the ballpark, don?t complicate negotiations needlessly. You have already invested the time spent locating and talking with a landlord/owner. Rather than risk alienating the landlord to the point to where the deal falls apart, accept slightly less profit and get it done. Try for more renewal periods. Do an extra deal to make up for it.
7 - Selling a property you don?t own is more profitable than a simple sub-lease, but your risk has increased exponentially. Know the risk, use safeguards, and don?t make promises that are difficult to fulfill, or those that are impossible to keep without large flocks of ducks lining up in row after row.
8 - The agreements, escrows, and trust arrangements used to sell a house when you don?t have the title should be left to true professionals. If your lawyer doesn?t do eight of these every day, pay NARS to do it.
9 - Thoroughly review your state statutes for the legal status of contract-for-deed buyers. If there are no specific references to evicting one who may have an equitable interest in the property or if the process in your state is tedious or if your attorney is not an eviction specialist, call NARS and use an equity-holding trust-type arrangement.
10 - I used a note that amortized over six months to eliminate concerns about repaying the investor?s principal in a lump sum, but this isn?t the only way, or necessarily the best way to do things. It depends upon you. As you become more experienced and knowledgeable, your options to profit will increase. The house that was sold in the example had a monthly payment of $396.01. By using that receivable to pay an investor twelve percent interest-only for five or ten years you?d have $39,601 available for your use. The term of the note should not be longer than your right to renew your option with the seller unless you have enough deals in the pipeline to treat it in aggregate. The example?s seller receives $1,750 a year for three years, so $5,250 has to be allocated, perhaps discounted for future short-tem earnings, and set aside. The remaining $34,351 is yours to invest as long as you are certain that you can get it back in the form of cash before your investor?s note is due.
11 - NB: Even when you sell a house at a 10% mark-up for carrying the financing, special attention must be paid to the anticipated rate of future appreciation if your option strike price to buy is at full FMV. The sample 3% credit is all right if prices rise less than 6% over a short term. If housing prices are going up 15% a year and the guy doesn?t want to sell for ten years, you will have to ask for rent credits, percentage discounts, and retain a portion of any future appreciation by splitting it with your buyer. Under these circumstances, your deal has evolved into a full-blown L/O rent-to-own re-sale. This is inharmonious with the goal to simplify our deal making. If you live in a fast appreciating location it might be wiser to negotiate an option?s strike price that is fixed and offer a fifty percent of future appreciation kicker to both the landlord and your buyer. The cash flow is yours to discount.
12 - Changing any of the parameters of the sample deal alters your profit.
For example, the reason I used 12% ROI for the investors is because I?ve used that simple interest rate of payment across-the-board since 1979, and I don?t need a calculator to tell an investor what the amount of his return will be each month. I?m more interested in easy availability to cash than I am about the actual interest rate that I pay. In the current investment climate, 9.00% ROI may be perfectly acceptable.
Again, these local investors are not day-trading currencies; they are putting money in savings accounts and C.D.?s. Merle E. Woolley, CRE investment practitioner extraordinaire, stated two years ago that 9% APR is what he was paying his cash investors.
You may be able to rent below market, so no additional discount is necessary to acquire quality tenants. (Is that the best you can do, Mr. Landlord?) The investor in the example would receive the equivalent of a full dollar of rent, instead of 90¢. Your lower costs will increase the profit per transaction, sometimes significantly.
13 - Consider each deal to stand alone regardless of future expectations. For example, if you spend money intended to provide for the sixth-month shortfall as it?s coming in and rely on potential future deals to meet your obligations, your CREI career may be short.
14 - Avoid putting more worry into this than the concept merits. If you follow the main or specialty discussion boards at www.creonline.com, www.landtrust.net, or even www.dealmakerscafe.com regularly, you?ll notice that very common responses given by experienced investors to the question, ?How do you address this or that seller?s concern?? is, ?It never comes up? or ?I tell them, ?This is the way we do things. It?s either my way or the highway, your choice.?? This response is a truism of CREI. When you keep things simple, the questions that are asked by your landlord/sellers, investors, and buyers will be simple also.
15 - At times, you can back into your investor discussion by talking about something else first. Some investments, that would otherwise be enticing, have one strong negative that limits its appeal. You can use a discussion of this kind of investment to drive the conversation so you can get to what you really want to talk about. Let your investor bring up the obvious negative. Nudge them, if needed. Then explain how your note completely avoids this negative.
For example, most mortgagors who intend to sell their real property sometime before the term of their mortgaged note has ended don?t realize that every dollar paid in excess of monthly P & I will effectively earn the rate of the loan on a tax-free basis. It?s tax-free because we are only taxed on gain. For someone who has an 8.00% loan and pays approximately 30% in federal taxes, that?s the equivalent of an 11.43% taxable return. The equivalent taxable return for one in a 40% tax bracket with a 9.00% interest loan is 15.00%. This is something to talk about that amazes non-real estate people over and over again. People pay many hundreds of dollars for a revised amortization schedule that?s available over the internet or at their bank for free simply because someone told them that they could save the homeowner $100,000 in interest payments. Why don?t you tell the folks that you speak with all about it at no charge?
The negative is that your money is locked in place and there are fees and costs required to unlock it.
If the risk is acceptable, the gross amount of profit in a given transaction is relevant only when considered in light of the effort by which it was produced and the amount of time that it will take to bring to fruition. Cash that is tied-up in a transaction is imprisoned and is unavailable to produce further profit until it is freed from captivity and again unrestricted.
Given this, some, who do understand the concept of pre-paying a mortgage, will be too concerned about the lack of liquidity to do anything about it. For these investors, the relatively short time of their expected commitment to you as a lender is very appealing. Remind them about Arthur Anderson, WorldCom, et.al. and ask them when they believe the next dip of the Dow Jones roller-coaster is coming. After considering and rejecting the guaranteed results of a mortgage pay-down, they?ll take your notes because they are liquid (in theory) and short-term. There is no sales-load.
16 ? ALERT: THIS IS INTENDED TO BE NON-PREJUDICIAL IN A SOCIAL SENSE.
As a generalization, unless you thrive on challenges and have no time constraints when looking for investors, avoid engineers. They require exhaustive details and take four months to make a decision. They?d be quicker it they could only get a little more information just one more time. With rare exceptions, at the end of my prospect list I?d also place anyone surnamed Patel; who will most likely also require extensive details, but who, extremely frequently, will ultimately decide to fulfill pre-existing familial or social obligations by doing something similar with a cousin or family acquaintance, so that now you?re superfluous. And investor-less.
This is not a comprehensive or all-embracing denunciation of a profession or any culture or a root family-surname; these are categories that simply sprang to mind. Since my premise was ?renting to eat,? after careful (define that as dreading e-mail assault) consideration, I decided to go ahead and mention this just in case someone has quit their job prematurely, has pressing needs that require fast results, and absolutely no time to waste.
Save the dissenting emails or letters; I?m not basing this on any prejudice other than the improbable likelihood of the folks in said categories immediately investing with you. There are exceptions, of course, but you would have to wade through a large prospect-pool to find them. Not an efficient use of time. The accuracy of my statement can be verified by almost any professional and experienced full-time commissioned salesman (excepting engineer-salesmen who will get back to you in a few weeks after they?ve they have peppered you daily with irrelevant queries and had time to consider all the implications of the question).
That?s all there is to this. I?ve written many words, but the idea is simple.
You can do sub-leasing anywhere because the landlord is the one taking care of the property. No-fee rental management.
In our $35,000 FMV example of a complete lease/option-through-sale, you triple-net leased a unit for $1,750 ($175 x 5 x 2) a year, sold it on contract, made some investors happy with a 12% ROI, and earned $3,225 for yourself. Forty-eight (4-week vacation) ?$250 a month rent? deals of this type a year is a gross income of $154,800. If you only do one a month you won?t starve with $38,700 a year. The nice thing is that each one of these first-year contract sale examples will earn you $2,840 every year after that until your buyer?s balloon payment is due ($1,420 x 2 semi-annual periods). The initial forty-eight weekly transactions would produce an additional $136,320 annually from the second year until your buyer?s take-out purchase.
How about that for a second year boost in income?
After you master the concept, try it; you may like it.
If the truth be told, creative real estate investing is buying property on terms. Beating down a seller on price, using conforming financing, and re-selling at a higher sales price is real estate investing, assuredly profitable, but it wouldn?t necessarily be classified as creative.
This sub-lease technique is what I?d do if I were starting out now and wanted to ease my way into creative real estate investing.
Now you can understand why I?ve abandoned my writing project.
Here?s to a profitable New Year.