Purchasing A Property The Current Owner Is Upside Down In

[Brian Fiorillo]

Hey All,

A bit of a newbie here, but I came across a multifamily deal where the current investor is upside down in the mortgage. He purchased the property in 2004 for $95,000 and currently owes roughly $65,000. From a landlord perspective, he seems to have made several mistakes from not vetting his tenants and not requiring security deposits. Consequently, the place is trashed and will need substantial rehab. Based on the numbers I have run, the property is worth $40,000 at most in its current condition.

Has anyone ever worked out an agreement with an owner that owes more than the property is worth? It sounds like a longshot but if someone has a creative approach to these types of situations, I would love to hear it.

All the best,

Brian Fiorillo

[Erik W.]

@Brian Fiorillo, hi and welcome to BP!  I remember the first time I heard someone explain how they could buy an "upside down" property and make money.  First, I confess I have never personally done this scenario, so there may be some details I don't fully understand.  Second, I don't know anyone personally who has SHOWED ME how it has worked out for them except in a one-off scenario, so the repeatability of this strategy is somewhat suspect in my mind.  Third, there are certainly what I consider some ethical concerns with this approach, and finally, I'm not sure this is the ONLY way to do it, but it's the only way I know.

It's called a bait-and-switch....err, I mean a "Subject To" deal.  ;-)  I joke a little, but not much.

Here's how it works.  You convince the Seller that since they can't sell and pay off their mortgage that they should deed the property to you and you will take over payments subject to the existing mortgage.  This normally takes place without notifying the lender that a deed exchange has happened and could--in theory--trigger the Due on Sale/Transfer clause that is standard in most mortgage contracts.  Subject To gurus tell you the odds are against it, and I tend to agree.  But if it happens, the entire balance comes due immediately, and if not paid the original borrower gets foreclosed on and their credit is trashed.

In exchange, you give the Seller's a fee...maybe $2,500 as well as pay a monthly fee and take over maintenance to tempt them to do this deal.  It also supposedly shows up as rent income and helps offset their debt to income ratio in case they want to move somewhere and buy a new house.  That may not apply in this case since it is an investment property.  I think a bank will usually credit them 75% of whatever the monthly payment is that you make.

So how do you win on this?  Simple, you find another Buyer to give you a $5,000 - $20,000 lease option fee and also to pay you more rent than you are paying in payments to the Seller's bank and the Seller.  You agree to sell the house to the Tenant/Buyer for a higher price than it takes to clear off the mortgage.

Example:

You get a deed from the owners and agree to a purchase option where you will pay off the bank loan in 3 years.  In this case, about $65,000.  You agree to pay their note (let's pretend $500) each month, handle maintenance and pay the Seller $100/month in addition for a total monthly out of pocket of $600.  You pay them $2,500 to transfer title to you.   If you are able to close the deal in 3 years, your total out of pocket for this deal in 3 years will be $600/month * 36 month + $2,500 + mortgage payoff $60,000 (it will go down a little in 3 years) = $84,100.

Meanwhile you sell a lease with option to purchase the place to someone else....maybe an investor or someone who wants to house hack.  You charge them $10,000 down and $900 rent per month and set the sale price at $80,000.  You also make them take care of all the rehab and maintenance...that stuff you agreed to do for the Seller....gets outsourced.  Not illegal, just...interesting.  

In year 3, your tenant/buyer closed out the deal and here's your profit: $10,000 down + $900 rent for 36 months + $70,000 remaining sale price = $112,400.  Your profit: $112,400 - $84,100 = $28,300.  Not bad.

If the tenant buyer doesn't  or can't close you out, you either rinse and repeat with a new tenant / buyer (and a new option fee and a higher rent and a higher sale price) or you deed the house back to your original Seller and your profit is the option fee spread ($10,000 - $2,500) + monthly rent spread of $300 ($900 - $600) for 36 months = $18,300.

You, meanwhile, have little to no skin in the game.  If you can't close the deal or find a tenant/buyer, you toss the keys back to the Seller and are only out $2,500 + however many months you kept it.  You offload all the maintenance on your tenant/buyer and basically just keep the spread acting as a middle man between two groups of people who have money trouble.

The rock star version of this is you do it with nice $300,000+ single family houses and sell them for 20% above fair market value (sale for $365,000 or more) to people who have excellent income but crappy credit, so they're willing to overpay and bet on an appreciating market so they don't mind as much being skinned alive on both the above market rent and above market sale price.

Like I said....somewhat dubious morality here, but legal in many states.  Check your local laws to find out what all can go wrong for you, your seller, and your buyer, and ask yourself if you want to do this.