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Choosing a Creative Finance Technique that Works | By: Multiple Speaker(s)

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Choosing a Creative Finance Technique that Works
By Vena Jones-Cox

There’s a saying about how, if all you have is a hammer, everything starts to look like a nail.
Unfortunately, much of what we learn about real estate investing in traditional bootcamps, classes, and home study courses is relatively formulaic: sort of a, ‘here’s a hammer, now go find some nails’ approach.
There’s nothing wrong with learning a narrowly focused strategy so well that it becomes a ‘cookie cutter’; there are plenty of real estate entrepreneurs in the world who ONLY know how to buy properties subject to the existing loan, or control them via a sandwhich lease, or get private money.
But truly creative buyers take another approach: they focus on adding new skills to their repertoire, so that when a metaphorical screw, rivet, staple, or thumbtack presents itself, they have the right metaphorical tool for the metaphorical job.
A creative investor doesn’t ask the question, “How can I make strategy ‘X’ fit this situation?”; he asks the question, “What strategy fits this situation?”.
Even so, it’s easy to become enthralled with the very idea of creative, ‘no money down’, no-qualifying deals. It’s thrilling to get sellers and partners on board with your creative project. It’s also common to get overwhelmed by the fifteen different ways in which you could structure any given deal. And, unfortunately, it’s not too difficult to look up from that signed contract and realize that, while you’ve put your blood, sweat, and tears into working out something that’s super-creative, you aren’t really sure it’s super-profitable.

Enthrallment. Thrill. Overwhelm. That’s a lot of powerful emotion to deal with going into what is, at its heart, a business decision. And just as we know (or quickly learn) not to ‘fall in love’ with a property (because the fact that it looks just like grandma’s house or that it has a fireplace just like you’ve always wanted doesn’t mean you should overpay for it), we HAVE to be able to evaluate the financing of any deal in an objective manner. The question isn’t, “Can I get into this deal without any money?”, it’s “What structure makes this deal make sense?”.

That’s why, before you put pen to paper to figure out the numbers, it’s crucial that you understand the BUSINESS goal you’re trying to reach with that particular deal.

The decision to make a creative deal at all—and if so, which kind to make—depends on four criteria:

What is the exit strategy or strategies for the property?
What are your financial goals for that exit strategy? In other words, are you looking for $x monthly cashflow? Or to capture x% or $x in equity? Or to pay off properties as fast as possible? Or for short or medium-term cash of a certain amount or percentage?
What are the details of the particular deal—in other words, what’s the after-repaired value? What will the repairs, if there are any, cost? What will the gross income and expenses, not counting any debt service, be? How long will the property be out of service?
Who else is on the playing field—do you have a seller who’s willing and able to talk terms? A private money lender? A cash or credit partner?

Thinking through—or better yet, writing down—the answers to each of these questions can assist you enormously in putting together deals that work instead of deals that are creative for the sake of being creative.

The first two questions—what’s the exit strategy and what are your financial goals—are, of course, intrinsic to YOU, and not to any particular property.

You have already, I hope, become educated about the execution of your chosen exit strategy, and you know what the timelines and numbers look like. For instance, if you’re a retailer, you’re already aware that you must build in a ‘fudge factor’ to your repair estimates in order to cover unforeseen problems; that you’ll need to plan on a minimum of X months to sell the finished product (and factor in the associated holding costs), and that if the rehab runs over budget or the property doesn’t sell, you may be forced into a secondary strategy that causes you to hold the property for income for some additional period of time.

Those are the realities of your chosen strategy; the next question is: what is your profit goal? For many investors in more expensive markets, it’s something like a net cash profit of at least twenty percent of the after-repaired value. For those of us who live in areas where a starter home can be worth as little as $90,000 fixed-up, it’s often twenty percent of the ARV with a $25,000 minimum.

So let’s say you’ve found this deal:

After-repaired value of $100,000
Repair costs, including fudge factor, of $25,000
Holding costs, including taxes, insurance, utilities, lawn upkeep, etc., but NOT including debt service, of $500 per month
Sales costs of ten percent of the ARV: $10,000—in agent commissions, probably financing concessions to the buyer, and closing costs
If it becomes necessary to hold the property, $995 per month is the market rent
The seller owes $20,000 on an adjustable rate mortgage with a current interest rate of four and a half percent and a principal and interest payment of $179 per month with twenty-three years remaining

If your profit goal is $25,000 net of all expenses except income tax, you could theoretically pay this seller:

$100,000 after-repair value
-$25,000 profit
-$25,000 repair costs
-$10,000 sales costs
-$3,000 holding costs

So far, so good—IF you plan to pay cash for both the purchase and repair. However, if you plan to finance the deal in some way, you’ll have to subtract the finance costs from the $37,000, as well.

So what, now, are your options for getting the $65,000 in cash you’ll need to buy, fix, and hold this property?

Your first thought might be to take over the seller’s $20,000 first mortgage at 4.5% interest. This will get you part of the way there, and the interest rate is attractive, but it has several potential downsides:

If you’re trying to do this deal with no money, you’ll still need to borrow the $17,000 downpayment and the $25,000 repair costs elsewhere. If ‘elsewhere’ is a hard money loan, this won’t work—a hard money lender will not loan you such a high percentage of the purchase price WHEN HE IS IN 2ND POSITION. Furthermore, many private lenders want a higher rate of interest if they’re in second position. If you borrow the down payment & repair money from a private lender, the rate might be as high as twelve percent, meaning that even using a simple interest calculation, your holding costs will increase by $179 per month to service the seller’s first mortgage plus $420 per month to service the private second mortgage—adding nearly $600 per month to your holding costs and reducing your offer by $3,600.

Because the seller’s existing mortgage is, in nearly all cases, from a bank or other lending institution, there’s no option to NOT make payments while you’re fixing and marketing the property. If you buy this property ‘subject to’ the existing loan, you’ll have additional holding costs of at least $179 per month during the entire holding period, even if your other money comes from a source that doesn’t require payments.

If the property doesn’t sell, and you end up holding it for a few years as a rental or lease-option, you risk a substantial increase in payment if interest rates increase. Most adjustable rate mortgage have what’s called ‘two and six’ (2/6) caps, meaning that the rate can rise up to two percent per year and six percent overall. Assuming that the seller’s initial rate was four and a half percent, it could be ten and a half in as little as three years, meaning that your outgoing payment on this loan could rise from $179 per month to $273 per month, and the property will have negative cash flow.

On the other hand, you could simply borrow the entire $65,000 from your private fund or a private lender at eight percent interest with a one year balloon (in the lender case), which would bypass the ‘have to make payments’ issue, and the adjustable interest rate issue. Your payment on this mortgage at eight percent (remember, the lender is now in first position and will be willing to accept a lower interest rate) will be around $474 per month (this assumes a fully amortizing thirty-year loan), and you may be able to negotiate a ‘no payments until sold’ deal with the lender.

But this strategy, too, has its downsides:

The one year balloon means that you may have to seek out more permanent financing if the property doesn’t sell. This will, at the very least, mean additional costs for preparing and recording any associated documentation. This can, of course, be overcome by negotiating a longer balloon date up front.

The $479 payment may or may not be sustainable in a longer-term hold, depending on the income that the property will generate and the other expenses of holding it.

There are many other potential iterations of this deal: borrow private money to pay off the first mortgage and do the repairs, make the seller carry back his $17,000 profit as a no-interest, no-payment second mortgage; borrow the money to buy and fix, then bring in a credit partner to refinance at a lower rate of interest for the long term; pay just the seller’s $20,000 mortgage off an get a cash partner to foot the entire bill in return for a percentage of the profits that would leave you with your desired $20,000, and so on.

So what’s the ‘best’ way? That will be largely answered by the fourth question: who’s on the playing field? If the seller won’t let you take over payments, no ‘subject to’ deal is possible. If the seller will let you take over payments, but needs his $17,000 for something else, you’ll need a lender with $45,000 to make up the difference. If you have a lender with only $25,000, and the seller won’t cooperate, there’s no deal.

It’s important to evaluate these four factors for each deal individually BEFORE trying to construct an offer on any given property. Let’s look at another quick example.

This time, the situation is as follows:

You intend to hold the property as a long-term rental
It has an after-repaired value of $100,000
It needs no repairs
The property will rent for $995/mo
The monthly expenses once the property is rented will be $400/month, not including any debt service, but including a reserve for maintenance, vacancy and future capital expenditures
The seller owns the property free and clear

Let’s assume that you have access to any kind of financing you want: the seller will carry financing on any terms you name, you have potential cash partners, credit partners, lenders, etc. What’s the ‘best’ way to do the deal?

That depends on your goal: are you interested in maximizing current cash flow—in which case you should negotiate the minimum possible outgoing payment, or are you interested in paying off the property as quickly as possible, in which case you want to maximize pay down?

The first step is to calculate how much monthly income is available for debt service in the first place, which is:

$995 monthly rent
-$400 monthly expenses
$595 available for debt service

If your goal is to pay off the property as quickly as possible, you’ll want to negotiate a seller-held mortgage with no interest and payments of $595 per month. Assuming that you still want to pay seventy percent of value, the term of the loan will be 117 months ($70,000 divided by $595). You’ll make absolutely no money for almost ten years (unless rents increase), but at the end of that time, you’ll own a paid-off property.

If the goal is maximum cash flow, you have 2 choices: offer the seller a lower payment—say, $300/mo, for a longer period of time (in this case, $70,000 divided by $300 equals 233 months) or, if that won’t fly (most sellers won’t ultimately carry payments for that length of time), get a cash partner to buy the property outright in return for, say twenty-five percent of the cash flow but one hundred percent of the tax benefits and sixty percent of the equity. The latter structure would leave you with:

Monthly cash flow of $446 per month ($150 MORE than you’d get with the seller-held loan)
No depreciation—you’d pay income tax on ALL of your portion of the cash flow, but at fifteen percent you’ll still have more cash flow than with the seller-held loan option
Forty percent of the current equity of $30,000 (you’d get all the equity with the seller-held loan)
Forty percent of the appreciation in the future

The ‘best’ deal structure, all other things being equal, depends on what YOU want and what you’re willing to give up to get it.

Reprinted with permission of Vena Jones-Cox. To get more free articles and tips, subscribe at

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