Real Estate 010: How to buy Real Estate through Seller Financing

How to buy Real Estate through Seller Financing

A lot of newbie real estate investors have a common problem when first starting out - lack of capital. As discussed in previous blog posts, there is more than one way to successfully invest in real estate, and that includes financing. An investor can save their money and purchase a property all cash, obtain a conventional or commercial mortgage, or look for private or hard money lenders. Another method that experienced investors love to use is seller financing, or owner-carry.

This simply means that the seller of the property becomes the bank and the buyer will now pay the monthly loan amount to the seller, and not a bank/private institution. Let's take a quick look at some of the advantages and disadvantages of seller financing:

Advantages:

1. Flexibility of terms (Interest Rate, Downpayment, Amortization period, payback period, balloon payment amount, etc.)

2. Easier to qualify (No bank involvement means less paperwork, as long as you and the seller agree)

3. Cheaper closing costs (No bank fees, appraisals)

4. Purchase through an entity (Corporation, LLC - this is generally not allowed for conventional mortgages)

Disadvantages:

1. Premium for flexibility (Higher interest rates/purchase price)

2. Balloon payment

3. No bank underwriting (No objective third-party that may identify blind spots in the deal that may make it a “dud”)

4. Property may not appraise for expected ARV (After repair value)
   

These are general pros and cons, and typically, the pros far outweigh the cons. Experienced investors know that conventional fannie mae or freddie mac mortgages are the cheapest money that an investor will find in the market. This is because they are backed by the government, have no balloon payment, and the loan is amortized over 30 years, which drastically improve your cash flow numbers as long as you are a long term buy and hold investor. However, there may be situations where investors have issues with repairing their credit, do not have enough reserves to meet fannie mae guidelines, or want to purchase a distressed property to rehab and refinance down the road. These issues may lead to the investor not being able to obtain a conventional mortgage, and where seller financing comes in handy.

Case Study: Bo’s seller financed deal.

Let me give you an example of a recent deal I took down with a partner of mine in the midwest. These two duplexes that were in the same neighborhood (Not same street) were being listed on the MLS for above what I thought market prices were at the time. However, I knew the market well and wanted to explore the option of “making” it into a deal that would work for me.

(Note: The best advice I got from my mentors is that in real estate, you only need to win ONE of the two: purchase price or terms. If the seller is focused on receiving an X amount for his properties (within reasonable range of course), then you can dictate the terms to make it into a good deal. Contrarily, if he was Y terms, you can negotiate the price to still win on the deal).

I flew out to the market and looked at both duplexes and knew that it needed a little bit of work to get it to my standards (read: meat on the bone). The properties have been on the market for quite some time so I knew I can negotiated. My first order of business was to talk to the seller and agent to understand why they are selling and what their motivation was. Through multiple conversations, I found out that the seller was an experienced investor who has owned the duplexes for 20 years free and clear, looking to retire and move to another state. I verified this information through online searches as well as looking at his other properties he had in the area that he was selling off one by one.

This taught me three things: 1) The seller is motivated 2) The seller may also benefit from a stream of cash flow, and not necessarily a lump sum. 3) The property is owned free and clear which is perfect for owner financing (No bank involvement and triggering of the “due on sale” clause).

I ran my numbers conservatively and made the following offer:

• 40K off of purchase price X

• 6% interest

• 10% downpayment

• 10 year balloon

• 20 year amortization
  

Quickly thereafter, the seller accepted my terms, but countered at only 20K off of the purchase price. I called the seller myself explaining my reasoning for requesting 40K off of the purchase price (read: its very important to build rapport with the seller/agent and not get emotionally tied down). He agreed at came down to 30K off of the purchase price. I agreed to the terms and we signed the contract.

I quickly performed full house inspections, sewer scoping, termite inspections on both properties and found multiple issues, and estimated that the property needed atleast $15-20K worth of work after closing. This was not too far off from my estimate at $10K, but still higher than expected.

I went back to the seller and told them I will need to go back to my original offer of 40K off of the purchase price for the above reasons. (At this point, the seller was irritated that I was attempting to “retrade”, however, the inspections discovered new issues that I was unaware of before, as such, this is normal in the due diligence process and I knew I needed to be courteous, but firm in my numbers and reasoning).

After multiple emails and not gaining any momentum, I decided to let go of purchase price X, and focus on terms Y. I adjusted the numbers in the calculator to make the deal still work for me. As I am a cash flow investor, I crunched the numbers with the following new terms:

• 30K off of purchase price X (Same)

• 5.25% interest (Down from 6%)

• 12.5% downpayment (Increased from 10%)

• 10 year balloon (Same)

• 30 year amortization (Increased from 20 years)
  

As you can see, I left the purchase price and balloon payment period the same, reduced the interest amount, and amortization period, thereby increasing my monthly cash flow, but also increased the downpayment amount by 2.5%.

Negotiations is a relationship game (refer to my blog post on Book Review: Never Split the Difference), and I knew that if I only “took” from the terms without giving anything back, the seller would feel it as another loss and possibly want to increase the purchase price or back out of the deal. As I realized from previous conversations that purchase price and cash at closing was somewhat important to him, I increased my downpayment by 2.5% (couple thousand dollars), but reduced the interest rate and amortized it over 10 more years. This move allowed my property to cash flow $150/month better than the previous offer and made this financing much more competitive that a traditional conventional mortgage which would have required 25% down for 2-4 units and had quotes for 5.875-6.125% interest rates at the time of this deal.

I knew that in 10 years, we would have heavily paid down the loan, property appreciate it value, and cash flowed enough that we could refinance the balloon or pay it all off if we wanted to. In the end, the seller accepted my terms and we created a win-win deal. The seller received steady monthly mortgage payments and a nice interest rate on top of his equity in the property, and I did not have to use my conventional mortgage slots, and obtained 4 units with only 12.5% down. Further, I feel with the relationship built with this seller, I can reconnect in 6-8 months to inquire about purchasing his other 10-15 properties in the area.

The biggest lesson learned for me was that to succeed in real estate, you have to have many tools in your toolbelt and think outside the box. Figuring out the seller’s why, solving their biggest problem, and offering multiple options is a sure method for you to get your deal accepted.

As Brandon Turner from biggerpockets often says, to an investor who only has a hammer, every problem is a nail. Many investors say, I cant invest because I dont have THIS: time, knowledge, money, confidence, etc. I highly encourage you to think outside the norm and ask yourself the question “how can I do X”. By changing your mindset from a fixed mindset to a growth mindset, you will be able to force your mind to come up with new solutions.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision.

Good Luck!

Real Estate 009: 5 Tax Benefits for real estate investors

Many real estate investors and those seeking financial freedom know that the biggest "enemy" to creating long term wealth is taxes. One of the huge benefits of being a real estate investor, is that the IRS tax code is written to support business owners including those with rental real estate. As such, I want to discuss some of the tax advantages that rental real estate could bring to your portfolio. Please note that I am not a CPA nor attorney, so please talk to a professional that can assist you in your specific situation.

Top 5 Tax Benefits for real estate investors

1. Depreciation
According to the IRS, the building (not the land) portion of your real estate investment is depreciated over 27.5 years for residential buildings and 39 years for commercial buildings (as of this writing). That means on a $100K midwest single family home where the building is valued at $80K, land at $20K, you are able to off set $2,909 worth of taxable income with a depreciation loss of the same amount. As this is a "paper" loss, even though your property may be in great condition physically, you are able to take this depreciation each year starting from the year of acquisition.

Note: There is a downside to depreciation called "depreciation recapture". If you ever decide to sell your real estate property, you will have to pay taxes on any gains made on the sale. Lets look at two scenarios:

A - You (taxpayer) buys the property for $100K, and the taxpayer has taken $40K worth of depreciation over time, bringing the cost basis of the rental property to $60K at the time of sale. If the taxpayer sells the home for $70K, they realize a gain of $10K. As they have taken depreciation over the years, they are required to pay $10K worth of ordinary income taxes.

B - Same situation above, except the market is hot and taxpayer sells the home for $130K, resulting in a $70K gain on the cost basis of $60K. In this situation, $40K of the total $70K will be taxed as ordinary income (equal to the amount of depreciation taken over the years) and the remaining $30K is taxed at a lower capital gains tax rate.

One way a savvy real estate investor can avoid the depreciation recapture is to defer tax liability with a 1031 exchange.

2. 1031 Exchange
The 1031 Exchange is named after section 1031 of the IRS tax code which allows investors to defer their tax liability when selling their property for a gain. In the example B above, the investor sold the property for a $70K gain, but if they use a 1031 exchange to buy a "like-kind" asset such as a single family, multifamily, land, etc. they can roll their gains onto the newly purchased property. There are strict rules when it comes to the execution of a 1031 exchange, so please do your due diligence in researching this option.

3. Tax Breaks for Pass-through entities
If you have a pass-through entity (Sole Proprietorship, Partnerships, LLC, S-Corp), the new Tax reform (TCJA 2017) provides a 199A pass-through deduction. In a nutshell, this allows landlords of residential real estate operating in a pass through entity, to deduct 20% of net income off the top. This means, if your 10 rental properties in an LLC makes $100K net income a year, only $80K will be deemed taxable. There are exceptions, however, where the 20% deduction is capped by the greater of 50% of the taxpayer's wages, or 25% of wages + 2.5% of the unadjusted basis of qualified property held by the business. A qualified property is a rental property that is subject to depreciation and the unadjusted basis is the property's original cost without any depreciation.

4. Deductions
There is a laundry list of items that relate to your real estate business that can be deductible:
   - property taxes
   - insurance premiums
   - utilities
   - repairs and maintenance
   - commissions, property management fees, legal and professional fees
   - travel costs to visit out of state rental properties
   - mileage to visit local rental properties
   - meals
  
The key is to keep a detailed log of your expenses to ensure that it was ordinary and necessary for your real estate business. Note that this list does not factor in the perks of being a qualified real estate professional and the additional deductions they can take. However, please note that the IRS is very strict on who qualifies to be a real estate professional, so again, please do your homework.

5. Long-term Capital Gains
If you decide to sell your real estate property, you will have to pay capital gains tax on the profits of the sale. There are two types of gains: short-term and long-term. If the investment was acquired and sold within 1 year, it is deemed a short-term hold and taxed as ordinary income. If the investment was held for longer than 1 year, it is considered a long-term hold and has a more favorable tax rate.

To put this in perspective, if you have purchased a property for $100K and sold it for a $50K profit in less than a year, at a tax bracket of 28%, you would be paying close to $14K in taxes. Conversely, if you held the property for more than 1 year and made the same profit, you would pay long-term capital gains of 15% in taxes resulting in only $7.5K, a whopping $6.5K in savings. Something to keep in mind when you are considering disposing of your assets.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!

Real Estate 008: BRRRR method of investing

In my previous posts, I have discussed different strategies to meet your real estate investing goals. I have recently come across a method that has been popularized by Brandon Turner at BiggerPockets.com but has existed and been used by savvy real estate investors who want to start investing using little to no money down. So what is it? The BRRRR method - stands for Buy, Rehab, Rent, Refinance, and Repeat. Lets take a closer look at each step below:

1. Buy

They say you make money in real estate in three ways: 1) buy 2) sell 3) cash flow. Knowing your numbers used in your BRRRR strategy is just as important as wholesaling, flipping, or buy and hold rentals. The main focus of the BRRRR strategy is to pull out all your money (in some cases, you may be able to pull out more than what you've put in) and end up with a cash flowing property with some equity. A general rule of thumb is to look for a purchase price that is 75% of the after repair value of the property.

For example: A home that has an after repair value of $150,000 * 75% (cash out refinance) - $25,000 est. rehab costs = $87,500 maximum purchase price.

If you are able to purchase below $87,500 or perform a quality rehab for under $25,000, then you will end up with more equity/less cash out of pocket. Note that the above calculation is a simple illustration and there are usually refinancing costs involved with the lender.

2. Rehab

The rehab budget is always an area of discussion among investors for many reasons. Here are my thoughts on the dollar amount on spent rehab and value add upgrades:

• There is a key distinction between primary residence (Owner Occupied) and rental properties (Leased). Simply put, renters may not need, nor would they pay the extra $25-50/month in rent to have all the bells and whistles that you would want for yourself. Granted, if there are two homes in a neighborhood with all things being equal and 1 has granite countertops/backsplash and the other has none, it may be more appealing and rent out faster. However, you have to decide for yourself, at what cost? For me, I am mostly focused on replacing key CapEx items with little useful life to reduce deferred maintenance as well as making the house livable and suitable for the market/neighborhood (an A class neighborhood will definitely have different upgrades than a C class neighborhood).

• You also have to decide what value add upgrades - new kitchen/new bath/new flooring will being the most return on investment. This is a great conversation with your property manager and rehab crew as they will have the most insight into the neighborhood and experience dealing with tenants.

3. Rent

The next key step is renting out the property after it has been properly rehabbed. Whether you decide to buy and hold or sell the property as "turn-key" alternative, renting the property will help you obtain refinancing with the lender. You can advertise and rent out the property by yourself, or I would personally recommend using a property manager who typically charge 8-12% of the rental income. Their marketing efforts, tenant screening, and maintenance handling should be well worth their fees. Make sure to received referrals from active investors in the market and interview multiple property managers. Remember, a good PM can make a good deal into a solid deal, whereas a bad PM can turn a solid deal into a horrible deal.

4. Refinance

You have crunched the numbers, bought/rehabbed/rented the property, so now you are ready to refinance and pull out your cash (downpayment + rehab costs). Depending on the lender, there will be different seasoning requirements. A traditional refinance may require a 12 month period for which you will have to maintain the property then request a refinance. However, there are many portfolio lenders who have 6 month seasoning requirements or some who can start the refinance process the day after closing (zero seasoning). The lender will order their own appraiser to go to the property and draft an appraisal. 

In the example mentioned earlier, lets look at two scenarios with the same expected ARV of $150,000.

Example 1: Purchase price of $50,000 (bought distressed/foreclosed/divorce/REO) and put in $25,000 amount of repairs for an all in cost of $75,000. The bank appraises it for $140,000. You request a cash out refinance and the bank gives you $105,000 (75% of the appraised value). Now you can fully pay off the $50,000 loan and $25,000 rehab costs (if you used private financing or hard money lender) and have $30,000 in excess cash + 25% in equity.

Example 2: Purchase price of $75,000 (normal sale) and put in $20,000 worth of repairs for an all in cost of $95,000. The bank appraises it for $135,000. The bank does not allow for refinances greater than your all in cost. In this case, you will get back $95,000 to pay off the $75,000 purchase and $20,000 in rehab, and the remaining amount will be left in equity ($135-95K = $40K/135K = 30%).

5. Repeat

The above examples are cases of success stories in which you were able to cash out your initial investment and maintain equity of 25% or greater in the home. Now you will rinse and repeat the process and scale your rental portfolio!

Few thoughts on BRRRR vs. TurnKey/buying off MLS

Although I have bought my first rental property from a turnkey company, I eventually want to try the BRRRR method for a couple reasons: 

• Ability to cash out refinance and retain equity in the home

• Control over the type/quality/amount of rehab

• Ability to retain your "seed" capital for other investments (typical buy will lock up 20-25% cash each time you by, thereby significantly lowering your buying power)

• Allows for faster scaling of your rental portfolio

• Higher return on investment (more of other people's money = higher ROI)

However, there are also a couple reasons why I do not want to jump on the BRRRR bandwagon just yet:

• More risk is placed on the project owner overall (you are buying/rehabbing/renting/refinancing)

• Risk of appraisal coming in lower than expected (not being able to break even)

• Risk of rehab delays (A turnkey is already rehabbed and tenanted)

• Longer process than buying turnkey/MLS

• Risk of being unable to cash out refinance

  • Seasoning requirements

The BRRRR method has been a very popular method for investors to increase their return on investment as well as overall net worth due to the fact that they are leveraging other people's money and if done correctly, able to repeat the process over and over. However, if it was so easy, why doesn't everyone do it? As mentioned in the reasons above, the BRRRR takes careful planning, finding the right deals, using the right team, and comes with its own set of headaches as things can go wrong during the process. What is your strategy? I would love to hear your thoughts on BRRRR vs buying turnkey/MLS.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!