Copyright 2010-2011, Lex Levinrad, Distressed Real Estate Institute
Many real estate investors often only look at a real estate investment from their own investment perspective. However, sometimes it can be beneficial for you as the investor to put yourself in someone else’s shoes in order to see things from their perspective.
Here is an example of a very common situation in today’s real estate market. Current renters would like to become first time homebuyers. They are aware that prices are cheap and they would like to take advantage of the cheap prices to buy a house at a good price. The American dream of home ownership is alive and well and there are many renters that would love to own their own home.
Some of these individuals have good credit and should be able to qualify for an FHA loan if they have a FICO score of over 620, are currently employed and can document their income. Many of these potential first time homebuyers do not have much of a down payment. As an investor, the strategy for dealing with these first time homebuyers is to have a good relationship with a mortgage broker that has pre-approved first time homebuyers.
In this scenario, an investor can purchase a cheap bank owned property or short sale using borrowed money from a private lender or hard money lender at a discount price. Once the investor owns the property, he/she can fix up the property and then resell the property to the first time homebuyer at full market value. Done correctly, an investor can purchase, fix and sell one of these houses within 6 months for a very handsome profit. The most attractive homes to do this with in today’s market are first time homebuyer’s homes which are usually in lower income neighborhoods. As an example, in South Florida our investors can purchase properties for $50,000, spend $15,000 repairing the property and then resell the property to an FHA buyer with a mortgage for around $99,000.
The challenges with this strategy are the following:
‘¢ You need to have pre approved buyers
‘¢ You need to know what the house will appraise for
‘¢ You need an appraisal to get the mortgage
‘¢ Market prices can change while you are repairing the house
Most novice investors trying this strategy are at the mercy of the appraiser and are dependent on a listing on the MLS. If they do sell via this strategy they will have to pay the realtor commission and probably offer to pay some of the closing costs (since FHA buyers have very little money). The seller should expect to lose 10% to 12% of the sales price to commissions and closing costs. Ultimately whether or not the investor manages to pull off a quick sale will depend on:
‘¢ Finding a pre approved buyer
‘¢ Getting an appraisal
‘¢ The realtor
The two most critical components are the appraisal and pre-approved buyers. If the appraisal comes in low (say $80,000 instead of $99,000) then after deducting realtor’s commissions and closing costs the investor may be looking at a very small profit or in some cases even a loss. Remember that while the investor is repairing and marketing the property they are still paying interest payments, property taxes and insurance which also need to be deducted from the net profit. The new HVCC law makes getting an appraisal to come through even more difficult since the appraiser may not be familiar with the local market. For this reason it is imperative that investors use very conservative estimates for what they thing the house is worth before entering into any transaction to purchase a house. Instead of thinking to yourself that “this house could be worth” think instead “this house cannot possible appraise for less than” (use the lowest comparable retail sale). Being conservative in your buying decision will mean waiting for the right opportunity to buy at the right price.
You should try to network with as many mortgage brokers as possible. Investors need pre-approved buyers. Some mortgage brokers have pre-approved buyers. Ask these pre-approved buyers what they are looking for and then go and find them a house. If you find a house that will work for them get a deposit from them and then buy the house. One interesting anomaly about this marketplace is that often mortgage brokers with pre-approved buyers have no houses to offer them and investors with houses have no pre-approved buyers. Every investor should look to network with and find a good FHA mortgage broker that can help them find pre-approved buyers.
If you do not have pre-approved buyers and you are worried about the house appraising then you should consider the following creative real estate strategy.
An overlooked but highly profitable strategy is seller financing. The advantage of seller financing is that when you sell the house you do not need an appraisal. You also do not need a pre- approved buyer. What you do need is someone that has more cash than your typical FHA buyer.
There are many individuals that have lost their home to foreclosure or have negotiated a short sale and walked away from their home. Many of these people are looking for a house but don’t like the idea of renting. They cannot get approved for a mortgage because they just ruined their credit with their foreclosure and that is where the opportunity lies. You are tapping into a huge pool of people that would like to own a home again. These are people that owned homes before and do not like the idea of renting. They are also people that lost their homes to foreclosure, short sale etc. If you put yourself in their shoes you will see that they are looking for a house that they can stay in for a long time and they are looking for payments that they can afford. They would also like to ultimately own the home. If they only have 3% to 5% of the purchase price as a down payment consider a lease option (rent to own). If they have 10% to 20% consider offering them seller financing.
I suggest that you get a large deposit when you offer seller financing. If the new owner stops paying you then it could take you some time to get your house back through the foreclosure process. This is why you need the protection of a large deposit. You need the cash cushion to continue making your payments while they are not making theirs.
My experience has been that the larger their deposit, the less likelihood that they will walk away from their house. I like to offer seller financing with 20% down and an annual interest of 10% on the balance. I structure the payments as interest only with a two to five year balloon mortgage which gives them time to get approved for a traditional mortgage.
This is an example of how you can structure the deal:
Your purchase price $50,000
Cost Including Repairs $65,000
Sales Price to New Buyer $99,000
Buyers Down Payment $20,000
Buyers Monthly Interest Payment (10%) $658.33
Structuring the deal like this has numerous benefits:
‘¢ Very appealing to buyers that cannot be approved for a mortgage
‘¢ There are many people that have lost their homes but don’t want to rent
‘¢ Large deposit is cash in your pocket which protects you
‘¢ You get a portion of your profit up front
‘¢ You do not need an appraisal
‘¢ You don’t need a pre-approved buyer
‘¢ You don’t need to wait for a mortgage to be approved
The key is to have these individuals that are looking for seller financing opportunities before you purchase the house. I find that one of the best ways to do this is to advertise my existing homes as rent to own with seller financing available. Doing this attracts other potential buyers that I can store in my database. Have a pool of 20 or 30 buyers means that when I am thinking of purchasing a house I can have these potential buyers go by the house before I purchase the house and if they like the house then they can give me a deposit to secure the house. Many of these rent to own buyers can become seller financing opportunities down the road when they want to exercise their lease option.
If you use borrowed money from a private lender to purchase houses then you can do a wraparound mortgage more commonly known as a “wrap”. You need to make sure that your existing mortgage does not have a due on sale clause and if you have a private lender then you should let them know of your intentions to do a wraparound mortgage. The way the wraparound mortgage works is like this:
Let’s say that you borrow $65,000 from a private lender for the purchase and rehab of the property. You agree to pay 10% interest which is $541.66 per month (interest only). Then you find a potential buyer for the property for $99,000. They give you $20,000 down payment which you get to keep and you give them a mortgage for the $79,000 balance. Assume that you charge your new buyer 10% interest then your buyer’s monthly payment would be $658.33. Every time your buyer pays you, you would in turn pay your private lender. Keep in mind that you are still responsible for making the payment to your lender even if your buyer misses their payments. If your buyer defaults then you will still be able to get your property back via the foreclosure process. However you will need to continue to make all of the payments to your lender while you are waiting to get your property back.
In the above strategy, there is no appraisal required so you could probably just as easily have sold the house for $109,000 or $119,000. Selling the house for $20,000 more makes the payment go up by only $166.66. The buyer’s payment would now be $824.99 instead of $658.33. Compare those payments to current market rents for the same house. If that same house would cost $1,200 per month to rent then you might be able to easily increase the price. Because no appraisal is required you could sell the house for any amount that you and the buyer agree to. And the determining factor for the buyer is usually their monthly payment. Keep in mind that your sales price should still be reasonable relative to comparable sales comps. I suggest you print out 3 of the highest comparable sales comps and save them for your records to justify your sales price.
If you are going to do a wraparound mortgage it is critical that you utilize an attorney and do not try to do this by yourself. Using an attorney also has the added benefit of being able to establish an escrow account for the buyer where you can give the buyer a payment that includes their property taxes and property insurance. This way the buyer can send the payments directly to the attorney who in turn will send your portion to you and keep the remainder in escrow.
One final thing to note is that there are currently new regulations about seller financing that might require sellers to be licensed as a mortgage broker in order to offer seller financing. So you may need to get a mortgage license if you plan on doing this. Regulations may change so please consult with your attorney about current Federal and State Laws.