NUTS & BOLTS
ACCOUNTING
he goal of every real estate investor is to purchase investment property below retail, improve the property and then sell it for a big profit – that, or lease the property out and generate a positive cash flow. The challenge is that often a seller will not budge on the sales price and, with your knowledge of the market, you’re hard-pressed to disagree that the asking price is out of line. When an investor can’t make the numbers work in such a situation, he or she may pass on the transaction without first fully understanding the motivations of the seller and attempting to structure a “win-win” proposition for everyone involved. TYPICAL RETAIL TRANSACTION Let’s look at a retail transaction that investors see every day. Let’s say you find sellers who are looking to sell their single-family home for $500,000. Based on your investigation of the market, you feel this is a reasonable asking price. You believe that if you purchase the property, invest $10,000 to refresh it and place it back on the market, the home will be worth $570,000. The challenge, however, is that if you finance the property with a conventional mortgage, you’ll need to make a 20 percent down payment because this is a non-owner-occupied property. Assuming that you sold the property for $570,000 and then paid the sales commissions and closing costs, you would end up making only $3,000 or so in profit. Not worth the effort. Big Returns by Paying Retail UNDERSTANDING SELLERS’ NEEDS AND OBJECTIVES CAN LEAD TO IDEAS FOR CRAFTING ‘WIN-WIN’ FINANCING OPTIONS. by Carter Froelich, CPA T RETAIL SALES PRICE WITH CONVENTIONAL FINANCING Sales Scenario Sales Price Less: Commissions/Closing $570,000 $57,000
Charles Schwab was paying 0.23 percent on its money market accounts. Assuming that your buyers net approximately $450,000 on a sale, if they put all of their earnings in a Schwab money market account, they will earn about $1,050 per year. That isn’t going to subsidize much of a retirement. But what if you asked the sellers if they would consider a proposition whereby they provide $480,000 in financing at 3 percent interest only or more, due in 10 years and secured by a first trust deed on the property? Under this scenario, the sellers could receive interest income of $14,400 annually or $1,200 per month—a 1,200 percent increase in their interest earnings from the Schwab account would provide! Under this scenario, as you will only have to cover monthly financing costs of $1,575, you more than likely will be able to generate a positive cash flow leasing the property.
payment that allows you to recoup your down payment and repair costs at 7 percent interest only. Your buyers also agree to a balloon payment due three months prior to the underlying loan with the original sellers coming due (e.g. 10 years). Under this scenario, you’ll receive monthly payments from your new buyers of $3,150. From this amount, you will pay the initial sellers $1,200 each month for their underlying financing ($480,000 at 3 percent), allowing you to net a monthly cash flow of $1,950. This scenario is made possible by the fact that you did not include a “due on sale” clause, allowing you to sell the property and “wrap” the underlying loan with that new $540,000 promissory note.
Sale Price Less: Down Payment Wrap Note Amount Monthly Wrap Payment
$570,000 $30,000 $540,000
What if you try to lease the property out? Given the amount of cash necessary for the down payment and the amount of rent required to pay yourself a 15 percent return on your equity (which includes a $100,000 down payment and $10,000 in repair costs) you would have to lease the property for $3,550 just to cover the financing costs on the property. The chances of renting a $500,000 home to cover financing costs in excess of $3,550 are slim to none.
RETAIL SALES PRICE WITH SELLER FINANCING
$3,150 $1,200 $1,950
Purchase Price Down Payment Improvement Costs Mortgage
$500,000 $20,000 $10,000 $480,000 $1,200 $375 $1,575
Less: Underlying Payment NET MONTHLY CASH FLOW
RETAIL SALES PRICE WITH CONVENTIONAL FINANCING Lease Scenario
Mortgage Monthly Payment Equity Cash Return (15%) TOTAL MONTHLY PAYMENT
SELL THE PROPERTYAND SUBSTITUTE THE COLLATERAL
Purchase Price Down Payment Improvement Costs Mortgage
$500,000 $100,000 $10,000 $400,000
Alternatively, because you included the ability to substitute the collateral from the loan’s original subject property to another that you own, you can inform the sellers than you want to exercise this option and move the deed of trust from the subject property to another. Under this option, you can then sell the property free and clear of any security interests and net $522,900 after paying closing costs and returning your initial $30,000 equity investment.
OTHER FINANCING OPTIONS As you aren’t involving a bank in the financing of the property, you’re not at its mercy in terms of other requirements that banks typically require, such as a “due on sale” clause. As you will create a handcrafted promissory note and deed of trust, you can keep the “due on sale” clause out of the transaction and give yourself the ability to substitute the collateral for the $480,000 promissory note from the single-family home you are purchasing to another property you own, so long as there’s sufficient equity and cash flow to secure the promissory note. With these options inserted in your financing instruments, you have created the flexibility to execute one of the following transactions. SELL THE PROPERTYWITH AN ALL-INCLUSIVE DEED OF TRUST (WRAP NOTE) Assume that you sell the property for $570,000 after it has been refreshed and that you provide $540,000 in financing to the new buyers. That’s after they put down a $30,000 down
Mortgage Monthly Payment Equity Cash Return (15%) TOTAL MONTHLY PAYMENT
$2,168 $1,375 $3,543
Sale Price Less: Commissions/Closing
$570,000 $17,100 $30,000 - $522,900
On the surface, it appears that purchasing property at retail prices is a zero-sum game—or is it?
Less: Investment Less: Mortgage ESTIMATED PROFIT
RETAIL DEALWITH TERMS What if, during your discussions with the property’s owners, you learn that they own the home free and clear and want to put the sales proceeds in the bank? That way, they could use the interest earnings to subsidize their retirement. With this additional information, what options do the sellers have when they go to invest the net sale proceeds? At the time of writing for this article, Bank of America was paying 0.01 percent on passbook savings accounts.
> Continued on :: PG 111
Less: Investment Less: Mortgage PROFIT
$110,000 $400,000 $3,000
Carter Froelich, CPA, is the founder of the Web-based software The Property Ledger and the author of “The Real Estate Wealth Building System.” For more information on these and other knowledge prod- ucts, visit www.thepropertyledger.com.
86 | think realty magazine may :: june 2017
thinkrealty . com | 87
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