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The fact is that you make your money when you buy (you realize that money when you sell). If you buy it for too much, then you will lose money – it is a simple as that.
So what is the right price? For rehabbing, there are several formulas out there – I like the following:
Max Offer = ARV – Repair cost – Holding Cost – Buy/Sell Costs – Desired Profit
This can also be expressed as
Max Offer = ARV x Z% – Repairs
But I would only use this short version when I am very comfortable with how long my rehabs take and the amount of time my end product is on the market. The difference between 100% and Z% accounts for the Holding Cost, Buy/Sell Costs and the Desired Profit, so you need to be very comfortable with the estimates of these Costs before you can use this as a percentage.
After Repair Value (ARV) is your expectation of the amount for which you will be able to sell your end product in a ‘short’ time. For single family houses, this is usually found by finding comparable properties nearby that sold recently and estimating your end product value based on this information. Remember that your end product needs to be either ‘a better product for the same price’ or ‘a similar product for less’ in order to get sold quickly. In general, I would like to see the 5 closest comparable houses (up to 1 mile away) that sold within the last 6 months. I look at the features of these houses to price my end product house.
Repair Cost is an estimate of how much it will cost to change the condition of the house today to become the desired end product house. Will you upgrade the property to low end, moderate, or luxury condition? Are you just going to clean up the property, or are you going to gut it and start over (or somewhere in between). What does it take to get permits or zoning changes in your area? Who will be doing the work? All of these decisions need to be answered to come up with a good estimate of the repair costs.
Holding Cost is an estimate of how much it will cost you during the entire time you own the house. I usually calculate my monthly cost and multiply it by the number of months I expect to own the house. This includes payments on mortgage(s), utilities, insurance, property taxes, etc. The number of months is determined by the scope of the repair work and how that work is being accomplished (are you swinging the hammer or contracting the work?)
Buy / Sell Cost is the amount that you will spend for all of the process of buying and selling the property. When you buy, this includes the escrow fee, the loan origination or points for your loan, inspection fees, title insurance or fees, taxes, etc. When you sell, many of these same fees may apply plus you may need to pay commissions.
Desired Profit is what you would like to earn from this flip. You need to decide this number and then compare the actual profit after completion – that is the only way to improve your flipping business. A couple things to consider when you determine this number:
- Is the yield on your money better than other investment opportunities? For example, earning 10K on a 200K cash investment in 9 months is the equivalent of 6.7% interest. Could I invest my 200K someplace else with less risk and make as much? Do you want to establish a minimum yield?
- Do you want to establish an absolute minimum that you want to earn per deal? Will this set a boundary on the type / location of your desired house?
Max Offer is the resulting number. This is the maximum value that you can pay and still make your desired profit. If you pay more, you will make less!
This is, of course, a cash offer on the property. If you got good terms, you could pay more if your exit strategy gave you additional profit because of these terms. For example, if I can get seller financing for 2% less than any of my other sources, then my holding costs will be less. I may then be able to sell the end product with seller financing and make some extra profit on the interest spread (if I charge 8% to my buyer and the seller charged me 4%, then I make 4% each month of payments). In this example, I could afford to pay more for the house originally and still make my Desired Profit.
Also, this is a formula for rehabbing. If your goal for the property is a long term hold, then you need to look more to the long term Return On Investment (ROI). But that is a subject for a different post.
The hunt is on. You are in front a house that you may want to buy. Do you have everything you need?
Here is my recommended list for what you should have with you.
- Map or GPS Unit – to find the property
- Something to record notes. This can be a pad of paper and pencil, a voice recorder or anything else that works for you. I recommend a form on paper that lists common rooms and items within each room – this insures that you looked at each item for presence and condition. I also like to have this on a clipboard
- Camera – still or video. Taking a picture of the front of the house and some interiors now can save you from having to revisit the property later.
- Tape Measure – 100’ would be nice so that you can measure the outside dimensions of the house.
- Flashlight – especially required for a REO or other vacant, powered down house
- Marble – useful on hard surfaces to determine if the floor or countertop is level. Sloped floors can indicate settling or foundation issues which can cost you.
- Binoculars – useful to look at roof conditions. Sometimes the only way to see a roof from the ground is from a distance from the house. Also useful to look for house numbers when the house is away from the road.
- Plug Tester – used to determine if electrical outlets are wired correctly and provide adequate ground
- Awl or knife – useful for checking wood rot
- Your notes about this property. Did you already talk to the seller? What things did they mention that are issues you should inspect? If the property is listed, bring a copy of the listing information.
- Calculator – used to total the estimated repair items and calculate your offer price.
- Blank Offer form – don’t waste time. If you like the property, write the offer!
When I walk-through potential houses, I wear casual clothes since the place may be dirty or ‘interesting’. I do not crawl under the house or into the attic spaces, so I don’t need coveralls. My inspections generally take under a half hour.
Note that I always hire an inspector when my offers are accepted – even without an inspection contingency. As a worst case, I may need to walk away from the earnest money deposit – but that can be a WHOLE lot cheaper than buying a house with expensive issues that I missed on my initial walk-through.
Any suggestions for things to add to this list?
What is a Land Trust?
A Land Trust is an instrument used to separate ownership of property into two parts – control and benefits. There are generally three parties (sometimes 4 – which I will talk about later) which are described by the Trust – the Grantor, the Trustee and the Beneficiary.
The Grantor is the party that transferred the property into the Trust. The transfer can be at the time of purchase or at anytime during the life of the ownership. When the Grantor deeds the property to the Trust, they no longer have any control nor do they derive any benefit from the property – these aspects of ownership pass to the Trustee and Beneficiary respectively.
The Trustee controls the assets of the Trust. Usually, the Trustee is given this control with severe restrictions on when they can exercise this control. Specifically, the Trustee is usually given the ability to deed the property from the Trust to another entity – but they are only allowed to sign such a deed with written instruction from the Beneficiary. To do so without such instruction is embezzlement and fraud. The Trustee can be either a person or a business entity (corporation, LLC, etc.) and should be deemed trustworthy by the Beneficiary.
The Trustee serves at the whim of the Beneficiary. If the Beneficiary wants a different person or entity to fill this role, they can ‘fire’ the current Trustee and install a new one. The method to do this is described as part of the Trust document.
Likewise, the Trustee could resign. Again, this procedure should be part of the Trust document.
The Beneficiary derives all of the benefit from the assets of the Trust. This means that any rents collected or proceeds from the sale of the assets will ultimately be directed to the Beneficiary. The Beneficiary can be made up of any set of persons and corporate entities – in any percentage of ownership (i.e. Bob Smith could have 25% beneficial interest and Smith and Sons, LLC could have the other 75%).
The Beneficiary can also be changed during the life of the Trust. To continue the example above, Bob Smith could sell his ‘beneficial interest’ in the Trust to Sally Brown. This is considered to be the sale of ‘personal property’ rather than ‘real property’ because the property continues to be owned by the Trust and what is transferred is only an ‘interest’. Again, the method of documenting the transfer of beneficial interest should be described in the Trust document.
Depending on the laws in your jurisdiction, the change of Beneficiary may still be a taxable event (i.e. transfer taxes or excise taxes). However, the paying of this tax does not have to reveal the identity of the Beneficiary.
The Director is the 4th role that is sometimes used with a Land Trust. When used, the Director is responsible for directing the Trustee – and often the Trustee is to listen only to the Director and not the Beneficiary. This is useful when the Beneficiary is a collection of persons or entities and the Director is assigned to be the sole voice for them all. Another use would be if you want to give the benefit of a property to family members but you want to stay in control.
How Are Trusts Created?
A Trust is created in the same way that a contract is created. A document is created that describes the Trust and the role of each party in the Trust. The Trust document does not need to be filed with the government nor does it need to register with the IRS.
The Trust can be named in any way that the creator of the Trust wants. For example, a Trust could be called ‘Smith Family Trust’ or ‘123 Main St Trust’.
Why We Use Land Trusts
Trusts provide anonymity and continuity.
The anonymity is gained because of how counties record the ownership of property. When property is owned by the Trust, the county records show the ownership listed as the name of the Trust. Sometimes the name of the Trustee at the time of transfer is also listed as part of the ownership record.
We never want the Beneficiary listed in the county record, so we don’t file the Trust documents with the county. They should not demand them, but if we give them, they will record them. Remember that anything recorded is available to the public.
Additionally, our Trust document directs the Trustee to never reveal the identity of the Beneficiary without a court order.
The continuity is also a result of the county’s method of recording ownership. Since the property is owned by the Trust, the Trustee and Beneficiary can be changed without going back to change the listing in the public record. This can be used to mask the transfer of property from one Beneficiary to another.
How We Use Land Trusts
We use the rule of 1 property per Trust. This makes it harder to figure out how many properties are owned by the Beneficiary.
For example, let’s say that Tulsa House Buyers, LLC acquires 123 Main St. When we do this, we will take title in a new Trust called ‘123 Main St Tulsa Trust’. We will assign the Trustee role to either an attorney or to a corporate Trustee (some banks do this for a fee). The Beneficiary will be Tulsa House Buyers, LLC.
Whenever anybody in the public wants to find the owner of 123 Main St., they will look in the county records and find the name of the Trust and the mailing address for the Trust. This Trust will only own that one property. There is no easy way for the public to determine that Tulsa House Buyers owns it, or how many other properties are owned by Tulsa House Buyers.
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The real answer is ‘it depends’. It depends on the situation and the parties involved in the transaction. Let’s talk about it from the Seller’s perspective and the Buyer’s perspective. We’ll also talk about the investor’s perspective in each of these roles. Remember, I am an investor, not an accountant – please check with your own accountant to confirm how this would apply to your own situation!
For the purposes of our discussion, suppose that a house sells for $150K and the seller takes back $100K as a mortgage as part of the sale (the buyer pays the other $50K as cash to keep this simple). The Seller owned this property free and clear – or owed less than the net cash received. Say the note has an interest rate of 6%, interest only payments (or more), with a balloon payment of the outstanding balance in 15 years. This makes the payments equal $500 per month – assuming only the interest is paid.
Seller – The Good:
The Seller can reduce the amount of tax they pay on the sale. When the Seller ‘takes back paper’ at the sale, that part of the equity of the house is not counted towards their capital gain. As payments come in over time, the principal received in each tax period is considered a capital gain for that tax period. Since our note is interest only payments, the $100K capital gain will be deferred for 15 years. This means that a seller can lower the tax they would need to pay for the house sale – both immediately and possibly as a total over time.
The seller gains an income stream from the note. For the next 15 years, the Seller will have $500 each month to spend – minus ordinary income tax (which will depend on the Sellers financial situation). The Seller actually makes more money for the sale of the house. The total amount this Seller earns is $150K + 15 years * $6000/yr = $240K.
As an investor Seller, this kind of financing can help you stabilize your income stream and result in better returns on your initial investment. Also, by offering seller financing, you may be able to demand a higher sales price at the time of the sale.
Seller – The Bad:
The Seller is still ‘attached’ to the house for the length of time that the note is collateralized by the house. This can be bad if the quality of the house is suspect, or the neighborhood value is declining – as the house decays or the defects are discovered, the security for the note (the house) looses value. This can be countered by requiring a larger down payment, charging a higher interest rate or doing more qualifying of the Buyer. For example, a Buyer who lives in the property is generally more likely to maintain or improve the property while a non-occupying Buyer may not have the same incentive to maintain the property (and the renter likely has no incentive at all).
The Seller may not receive payments on time. Ultimately, the Seller can solve this by foreclosing – which is a process defined by the area where the house is located. For example, in Washington the foreclosure process takes about 4 months while in Oklahoma it averages about 7 months. During this time, the Seller will not receive payments and the house may be vacant or damaged. Again, the Seller can mitigate some of these risks by requiring larger down payments or charging higher interest rates. In our example, the $50K downpayment can mitigate some losses. For instance, if the payments stop and it takes a year to foreclose, the Seller will have lost out on $6K worth of payments. Since the foreclosure process is not free, let’s assume $10K cost (remember that the cost will depend on the location of the property). This means that the Seller still has $34K in cash and now can resell the property. If the Seller can sell the house for more than $116K, then the Seller is still ahead (remember to also add the amount of payments that were received prior to the foreclosure).
As a rehabber, I feel that investor sellers can also mitigate the quality / damage issues more easily than a homeowner. Part of a rehabber’s job is to manage the quality and costs of repairs and to focus our buying in areas of town that are more likely to appreciate.
Buyer – The Good:
It can be easier for a Buyer to qualify for the loan. Mostly because the lender has already qualified the property – the lender/seller agrees on the current value of the property and they have some history with the property’s quality. Additionally, many Sellers do not require as much documentation as an institutional lender would require to qualify the Buyer. Institutional lenders have a process that they use to qualify Buyers – this process is supposed to reduce the risk to the lender (the current economic situation was caused by a loosening of this process). Most sellers who do Seller Financing don’t have a process but instead do just enough to feel comfortable with the Buyer’s promise to pay.
Seller Financing can reduce the amount of money needed to buy a property. Some financing situations can result in zero down payment. For example, in a ‘subject to’ purchase, the seller may loan you all of their equity. For example, the seller may owe $100K on a house that is in disrepair. This house may require $20K of repairs and when fixed up may be worth $200K. A deal could be crafted for a total of $120K where the Buyer takes over payments on the $100K and owes the Seller $20K (to be paid when the Buyer completes repairs and refinances or sells the house).
Seller Financing allows an investor to buy a wider range of properties. An instituitonal lender may not qualify a property if it is in need of some serious rehab work. As an investor Buyer, this means that I may not be able to get a bank to lend me the money needed to buy the property (they may be more accomodating for construction loans, but there are limitations there as well).
Seller Financing allows an investor to hold more properties. Currently, institutional lenders limit the number of loans that a Buyer may have in their name. As an investor Buyer, this limits the number of properties you can own at any one time. The current limit is actually 10, but the qualifying process for more than 4 loans is very difficult – making a practical limit of 4 loans. Most Sellers don’t have similar limitations and Seller financing often does not show on a credit report, so this can be a nice way to avoid this limitation.
Buyer – The Bad:
It can be difficult to find a Seller that is willing to accept Seller Financing. The most common objection I hear is that they just want to cash out. When I dig deeper, often the resistance comes from not really understanding the good and bad aspects (Why did I write this article?!).
I hope this article helped you understand more about Seller Financing. Please share your comments or experiences!
I found this clip to be very interesting for the historical perspective. Also implies that we have not hit the bottom on a national average.
I also just read that the median price of sold houses in Detroit in Dec 08 was $7500. Here in Tulsa is was closer to $125K.
Vena Jones-Cox hosts a radio show about Real Estate investing. Here is a clip from a show that discussed REO investing.