My Best Real Estate Investment Ever

Photo by Andre Hunter on Unsplash

Real estate can be a very sexy business. There are people that are legitimately making $100k+ on a single investment. Usually, those big checks are coming from wholesaling a property, completing a fix and flip, or building a home. The investment that I outline in this article is a more subtle win for our wealth building. I consider the following purchase, my best real estate investment ever because it created signficant wealth for us, with very little money invested. I had to create the deal from scratch, it wasn’t listed with a Realtor. It was also purchased with equity and with better financing than I could have gotten from a bank!

As a landlord, my goal is to plant as many seeds (purchasing rental properties) as I can, with as little of our own money as possible. No matter how much money you make, we all have a limit to the amount of money that we are able to invest and it is imperative to make that money work as hard as possible.

I feel extremely fortunate because I actually love my day job. It gives me the ability to interact with some of the most incredible investors and entrepreneurs in real estate and business. The only downside is that I consistently work a ton of hours which limits my ability to be a more transactional investor such as a wholesaler or house flipper. Thus, my wife and I have decided that building long term wealth with rentals properties makes the most sense for our situation.

As you read below, you will notice that the real estate investment that I outline is a good deal because of the terms associated with the deal. You may recall from a previous post, there are 3 ways to make money with a real estate investment, this deal definitely falls into category #3.

Below is an example of a seller-financed deal that we put together. To recap, a seller-financed property is a structure where the owner of the property is willing to let you make him payments instead of you paying cash for the property or having to get a bank loan. While we have purchased properties with more equity on the day of purchase, this is one of my favorite deals because we were able to buy a great house in a great area with a small amount of capital that also cash flows.

Price

The most obvious aspect that you negotiate with your seller is the price that you will pay. On this particular property, we negotiated a price of $120k, which was a fair discount at the time of purchase as I believed the property to be worth around $140k, in its’ current condition.

Interest Rate

This purchase was made a couple of years ago, when I could’ve acquired a loan with my mortgage broker for around 4.5% interest. The seller offered to finance the property for 3% interest.

It is important to note that the seller of this property was not some sucker that didn’t understand finance. In fact, he was so sophisticated that he understood selling the property outright would create a massive tax bill as he had owned the property for a few decades. Furthermore, he understood that he was simply going to take this big pile of cash from the sale of the property and simply put it is the bank to get a herculean 1% on his money, with a bank product like a Money Market or Certificate of Deposit. He understood that it was better to get 3% on an asset that he was comfortable taking back if I couldn’t make him payments versus 1% at the bank.

Length of Loan

I firmly believed that this property was going to be a fantastic long-term hold and I strongly preferred to have this seller financing be my permanent financing, especially since the interest rate was so low! If the seller was only willing to finance the property for a few years, I would’ve strongly considered putting a 30 year loan with a bank on the property just so that I would not get caught a few years down the road having to potentially refinance the property at a much higher rate interest rate. I tend to be very conservative with how we finance our properties.

After a bit of back and forth with the seller, we agreed to amortize the payments for 30 years with the remaining balance due in 20 years. Typically I do not like loans that have balloons, meaning that they do not fully amortize however, I realized that I would not owe a significant amount on the property 20 years from now. At that point, I felt confident that we would be able to pay off the balance due to the seller or get a new loan from a bank. I suspect that my preference at that time will be to pay off the balance as I will be 50 years old and presumably looking for a simple financial life with a portfolio of paid off rental properties.

Down Payment on the Property

Truth be told, at this point, I was thrilled with the negotiation. We were buying a great house in a great area with great terms but I was holding my breath to see how much money the seller would require us to put down on the property at the time of purchase. If he had said, I need you to put $50k as a down payment, I would’ve been dialing my mortgage broker before he could finish his sentence. When George told me he wanted $10k as a down payment, you could’ve knocked me over with a feather. I glanced up to see if he was yanking my chain, but he wasn’t. I am not a good poker player and I was a fraction of a second away from letting him know that he had offered unbelievable terms so I turned my back for a second to compose myself. I mustered the ability to create a pained look on my face and slowly shook my head staring down at the ground. I politely told him that it might be tough to come up with that much cash and asked if he could do $5k instead. He thought for a moment and stuck out his hand as an obvious gesture of agreement. I did my best to chat him up for a moment and then got out of there before I said or did something stupid that would torpedo this fantastic deal.

For those of you that have not purchased an investment property yet, expect to make at least a 20% down payment with your mortgage broker, plus fees such as origination fees, appraisals etc. The down payment alone would’ve cost me $24k with a bank/mortgage broker.

In retrospect, I had the great fortune of doing a deal with an intelligent individual that was simply looking to exit a rental property that he was no longer interested in dealing with. He had reasonable expectations and I suspect he might have even found it entertaining that a young buck, around 45 years younger, was attempting to do something entrepreneurial.

Profitable Real Estate Clauses

Make that money! Photo by Colin Watts on Unsplash

As we approached closing, the seller and I started to communicate with his closing attorney that was drafting the closing documents. We were able to easily come to terms on some aspects to while other deal points were not deemed appropriate by his attorney.

First Right of Refusal

I was fortunate that the seller and his attorney had no issue with a first right of refusal on the sale of the seller finance note. This meant that if the seller ever decided that he wanted to sell, or get cashed out of the note that he was holding for us, we would have the ability to purchase that from him.

You never know when this tool could become very profitable. If years down the road the seller decided that he wanted a lump sum payoff we might be able to negotiate a discount on the balance. It is very common for the owner of a debt instrument to take a discount as most people understand that $90k today is more valuable than $100k 15 years from now. At that point, I could pay off the note or refinance with another lender, or I could allow the seller to sell the note to another lender that would have to honor the terms of the original note that we agreed to.

Substitution of Collateral/Security

Substitution of Collateral aka walking the mortgage, is one of the hidden gems of the real estate community. While it is a pretty simple concept, it isn’t something you hear talked about very much.

With a substitution of security clause, you are able to move the debt from one property to another, legally, while still honoring the integrity of the loan. The key is that the owner of the note has to approve the new collateral (property) that the loan is being moved to.

For example, let’s say that I moved the note on this deal to a triplex that I own. We will assume that at this point I owe George $100k, and the triplex currently has a mortgage of $30k on it currently. If the triplex is worth $400k, based upon the analysis from George and an appraiser, it is reasonable to assume that George would consider allowing me to move his note to the triplex.

Why would moving the note be important? I love the terms of this note, it is very likely that I will never get 3% financing from an individual or bank ever again. While I love the house that I brought from George, I might want to do a 1031 exchange into a larger property one day. In that situation, it would be ideal to be able to move the note to the triplex so that I could use all of the equity in the house that George sold me to buy an 8 unit building.

Imagine if I could find an 8 unit building, that I could purchase for $800k in a great area that didn’t need much work. It would be ideal to sell my house producing $1,200 to buy an 8 unit producing $8,000/month. If I do not have the ability to move the debt to another property that I own, I am stuck paying off my 3% mortgage and only being able to use the difference between what I sell the house for, and the mortgage balance. If I sold the house for $200k and I owe $100k, I only have $100k in equity to use as a down payment on the 8 unit building. Conversely, with the substitution of collateral, I could move $200k in equity, which would be enough for a down payment on the new building, without having to use any of my cash. I do realize that I didn’t factor in closing costs, I just wanted to give a clean set of numbers to work from. Flexibility with your investments is ideal!

Why would he let me move the note? He may not want to get paid off yet. When George looks at his cash flow he realizes that he actually makes more money being the bank than he did renting the property for $600 a month. When you factor in management, maintenance, taxes, insurance, vacancy, and capital expenditure, he was really only making about $200-300/month. This is largely due to the fact that his property manager had been renting the property WELL below market. A bad property manager can absolutely kill you.

Now that we agree that the substitution of collateral is a fantastic tool, I am pleased to announce that the attorney shot it down! Frankly, I don’t think that he understood the mechanics of the clause which means that I did a poor job explaining it (hopefully it is coming through better on this post). I think pictures would be helpful but please be patient, I’m not exactly a whiz with the aesthetics of The Lousy Investor yet.

Snapshot of the Deal

Purchase Price– $120k (worth around $140k at time of purchase)

Down Payment– $5k (roughly 4% down payment)

Loan Amount– $115k

Interest Rate– 3%

Length of Loan– 30 year Note with Balance due in 20 years (based on the amortization schedule, the remaining balance will be approximately $50k)

Payment– $484.84/month

First Right of Refusal– Yes!

Substitution of Security/Collateral– Fail

Cost to Rehab the Property– Approximately $4k (very light rehab as the tenants left it is good shape)

Current Rent Value– $1,200/month

Final Thoughts on the Deal

While the property discussed above does have equity as well as cash flow, I highlight this deal primarily because we were able to acquire this house with very little of our own money invested. If you count the down payment, closing costs, and rehab, we are contributing less than 10% of the purchase price of this property. With terms like this, I would have purchased this property even if there was almost no equity and it was cash flow neutral, meaning that we didn’t really make any money each month. Fortunately, the property is now worth over $200k as Charlotte prices have continued their upward climb, but if the values plummet, and the property is once again worth $140k, we will be very content with this acquisition.

What is YOUR best real estate deal? Did I make a complete mess of trying to explain a substitution of security?

For more information please go to The Lousy Investor.