Real World Practice: Would You Make This Deal?

Tuesday, January 5, 2010 , Posted by Johnny Fuery at 4:19 PM

Originally Published 2007-10-10 10:35:57

House of BenjaminsThis proposition landed on my lap a couple of days ago. I've already made my decision, but before I disclose it, I'd like to see what kind of feedback my readership can provide (Yes, this means you!).

I have a motivated seller on a mixed-use duplex in an urban area in California. The two units are actually connected on the interior (picture one of those shared hotel room situations) but the place is legally zoned as a two units. The place is on a busy street with the front unit easily used as commercial space. The rear unit is away from the street and accessible through a side entrance with porch (it's tasteful). There is also a two car detached garage. The place has been remodeled and has new cabinets, flooring, dual-pane windows, etc.

Basically, it's a pretty fair rental property. The schools are mediocre in that area and the place is literally on the proverbial tracks. The "busy street" the property is on is more or less the dividing line between the city's bourgeois and not-so-blessed. It's in a dynamic area overall, however, and all of the economic indicators of the area are favorable. It's in the San Francisco Bay Area, after all. I'd have no problem renting the residential space in less than a week. The commercial space might not be quite so easy, but I'm by no means uncomfortable with the idea of marketing and selling that space.

I have an appraisal in hand that shows a value of $750K. Yes, I know. Property values in California are obscene. But it's not real money -- yet. This is just paper money for now. And it's in US dollars, so it's depreciating by the minute. :-)

There's a first mortgage of a little less than $500K and an investment by the owner (well, not quite, there's a partnership currently, but for the purposes of this discussion) of about $150K in cash. The place is in danger of foreclosure; I actually got the call from the lien holder on the second, who is trying to find a buyer who can put together a package of at least $650K -- for obvious reasons. If the bank forecloses, he plays second fiddle to the bank that hold the first mortgage. That lien is in pole position, and a sales price of $500K would wipe out the entire investment for him. I happen to know the gentlemen personally, and that literally represents a decade of thrifty living.

Ok. So in a sane market, this should be simple. If the place appraises for $750K, then the place should be able to fetch $700K -- enough to save everyone's shirt and feed a couple of real estate agents for a week or six.

But this isn't a sane market. It's hard to get loans, buyers with cash have it because they're uber-conservative and have been for years (really, folks, how long do you have to sit on the sidelines before you're ready to buy? I've met plenty of 45 year olds who have lived in the same area since college and still aren't "ready"!), and the nature of the market makes the tenuous even more hesitant. Investors like me are in a holding pattern. And people are panicking, struggling with the plight of becoming an accidental landlord, selling at a loss, or simply remaining stopped in their tracks like a deer in the headlights as their bills mount.

Basically, it sucks to be in real estate right now. But you knew that. Your shoe-shiner told you, right? (know the allusion?)

Which begs the million dollar question (almost literally): can this deal be salvaged?

Let's crunch the numbers.

$650K at 6.5% interest on a 30 year amortization schedule is $4108 per month. I think I can rent the place for $3600 per month. That's a bad deal at first glance, because we haven't even figured in taxes and insurance yet.

Property taxes at 1% with a 750K purchase price would be $7500 per year. There are some additional county fees hiding in the fine print, so let's call that a nicely divisible (by 12) $7800.

I can probably get insurance down to $1500 or so if I opt for high deductibles, but let's call it $1800 for our purposes here.

So the monthly cost for taxes and insurance is $800. That's an awful lot of negative cash flow, especially for the thankless job of being a landlord. (Don't try to screw your landlord, dammit. He's a nice guy. And he probably works harder than you.)

No deal.

But wait, we have a motivated seller!

Ok, so what would make it worth it?

6 Ways to Improve Value on a Real Estate Investment

  1. A higher monthly cash flow. More rent? Not likely.

  2. Cash up front to cover the monthly shortfall until the market recovers and the property can sell at a profit. Be careful with this. It's dangerously close to depending on a bigger fool. This depends directly on factors outside of your control like availability of credit, public sentiment towards real estate as an investing vehicle, etc.

  3. Cash up front to cover the monthly shortfall until the rental market price increases enough to yield zero cash flow, i.e., monthly break-even. This is ultimately a key factor (some would say "the" factor) in determining value, so if these numbers work, you're in a good spot.

  4. A lower purchase price. 'nuff said.

  5. A lower monthly payment. Lower interest than 6.5% on a commercial note with the words "credit crunch" still on everyone's lips?

  6. A significant down payment. If I had six figures lying around, I wouldn't be working so hard. Anyone need some software development services? Oh, and how are those ads looking?

So Are We Making a Deal or Not?

Well, let's look at our options. #1 is out. The place has already been upgraded, and the normal method for improving cash flow in my arsenal, a lease-option agreement, is probably not going to happen because it's a mixed-use duplex.

#6 is out. By the way, you don't have an iPod or Playstation you can sell, do you? ;-)

I'd like to be a hero, so let's try to work with a purchase price of $650K with no agent commission fees. So for the purposes of this discussion, #4 is out.

#2 and #3 are worthy of consideration because we have $100K in equity (on paper, at least) to work with. We'll get to that in a minute.

#5 seems insurmountable, but remember that we have a motivated seller who already has $150K floating out there, and right now it's keeping him awake at night. If we can turn a sour deal good and restore his confidence, we might have some room to work there.

The Nasty Math First

Let's look at our monthly cash flow issue. We're looking at roughly $5K per month in expenses (remember to include a little padding room -- one month of vacancy in three years will eat that up in one shot), so that's $1500 a month short. That's $18K per year, or $54K over three years. Add in the first month's payment, and we're looking at ~$60K.

But that's the future value of money. We're getting cash up front. Done any calculus lately? (Seriously. Newton showed that compound interest calculations required iteration, which is taught in first-year calculus as Newton's Method. Check out the first problem in the review questions -- it's exactly what we're talking about.)

This is actually a lot more complicated than that, because the amount of cash we need is actually less than $60K. We need an amount, X, that, when we stick it in a savings account (say, an effective 1.2% APR, or .10% per month), and withdraw $1500 per month, drops to exactly zero after 36 months.

You catch all that? Well, if your calculus is rusty, you can use a financial calculator to do it. The answer is $53,013.53. So we need $53K at closing to stay afloat for 36 months, assuming no changes in the rental rate during that time frame.

Now For that Investing Part

First off, are we making money on the purchase? Is this property going to appraise -- and, more importantly, sell -- for $750K in three years?

Well, let's give that appraisal the benefit of the doubt. Let's average it with our [effective] purchase price of $650K, giving us a cost basis of $700K.

Let's assume that both our rental rate and our appreciation rate (yes, I said it!) both roughly keep pace with inflation. Given our base price of $700K, in 36 months, with an appreciation rate of only 2.5%, the property value will be $753,823. The rental rate of $3600 will have grown to 3877.

It looks like holding this property long term is not a viable option, because servicing $650K in debt will still cost more than the monthly income in three years.

So, we'll sell it in three years for $754K. After sales commissions, we'll net around $710K.

Yawn. You Should've Broken This Up Into a Series of Blog Posts.

Yes, you're right, but I have a nasty habit of never finishing those multi-part articles unless people ask for them. And you know how you people are with the comment stinginess.

Right, so we'll make $60K on our investment in three years. That's good.

We now just need to structure the deal so that (a) we can get a bank to finance it, and (b) we get our $53K at closing.

With an appraisal in hand at 750K, I should be able, with lots of documentation, and perhaps some sexual favors, to get a 90% LTV loan. That's a note of $675000, which is not much more than the $650K I used to calculate the monthly payment above. So far so good.

Now is where the creativity comes in. I don't have the $75K or so needed to deposit into escrow. But the seller does. So, he'll need to gift the $75K to me, agree to pay all closing costs in the purchase agreement, and I'll deposit the $75K into escrow.

This is a taxable event, because the IRS has a tax-free gift limit. I believe it's $11K per annum, but I'm not an accountant. If we draw up a loan contract, however, then it is not a gift. This is a bit of an ethical quandary, because we have to tell the lender that this is a gift, yet tell the IRS that it's a loan.

In reality, our purchase price is $650K, though, so I'm owed $25K even after (if) the loan funds. I also need another $28K to meet my 36 months of cash flow requirement, so there's more work to be done.

The Proposal, At Last

On paper, the purchase price is $750k.

I get a new 90% LTV loan at $675K. The seller agrees to carry back the 10% on the loan docs with a zero percent interest rate and a balloon payment in 2273. I'll owe him that money back when the Enterprise leaves Spacedock. If that is not acceptable to the lender, then I'll create a new lien on another one of my properties for $75K and the seller will loan me that $75K in cash with the same loan terms. Perfectly legal and completely above-board. He can gift me $11K per year for the next 7 years and it all goes away.

The seller now has $250K in cash. He has $225K invested at this point ($150K noted above + $75K he just "loaned" to me), so $25K of that money is mine outright. I've come up with no dollars out of pocket at this point and I have a note of $675K on a house I paid $650 for.

Now, I still need that cash flow money, so we need to find ~30K (actually 28K) from somewhere. We'll, I just saved the seller's shirt, right? So have him loan me the shortfall. I like nice round numbers, so let's have him loan me $50K at the rate of inflation with a single balloon payment in 36 months. If everything works out as I've outlined, then I get an extra $22K right now in profit plus $7K when I sell in three years ($60K in profit less the $50K I need to payback to the seller less interest.

We just moved around almost a million bucks to make thirty grand, but hey, I started with zero dollars and a good credit score.

Ok, so where do we stand?

Give me the summary

  • I have $100K in notes with the seller at zero percent interest. The terms of the note effectively mean I never have to pay it back. This is good, because the effective purchase price is $650K, not $750K, and even though we moved around a lot of greenbacks, that never actually represented a change in ownership or value except to help qualify for the new loan. That $100K in debt goes away over the next ten years as he forgives a portion of the loan every year in accordance with IRS limitations.

  • I have $50K I owe the seller that I actually have to pay back in three years. The balloon payment at 2% interest works out to $53060. Love that Newtonian math.

  • I have a property worth $700,000 that I actually paid $650K for today.

  • If we see any appreciation [above inflation] in the next three years at all, I'll make out like a bandit. Remember that my only investment is time in the form of packaging this deal and managing the property. Now, I make a good wage per hour, but based wholly on the amount of dollars I put in out of pocket, the return on investment is infinite. The rate of return is based on the dollars made divided by the dollars invested. Since the denominator (the number we are dividing by) is really really small (because you can't divide by zero in arithmetic), the rate of return is really really big. This is child's play for you if you know what an asymptote is. ;-)

And we're done.

So, is this a good deal? Would you do it?


On 2007-10-10 16:10:24 4MySales said:
I personally am going to pass on the deal. I may have saved the sellers shirt, but where does he get the cash to fund the initial loans? Also, that is a lot of credit to tie up for a single transaction. I think I'm just too risk adverse, and the more complex the deal, the more things can go wrong. Murphy is my co-pilot.


On 2007-10-11 15:35:50 Barry said:
My name is Barry, and I have developed a keen investment interest in the real estate market. I would like to find credible information about investment opportunities that exist in this market, as well as the recommended strategies. I am also interested in relevant tips and suggestion regarding investing in the real estate market. I would also like to learn a bit more information about real estate opportunities and strategies implemented on the internet.

I am even more certain of my need to get knowledgeable on the subject after reading your article. I'm hoping to be able to educate myself to the point where I can begin making real estate investments.

Where would you recommend I start?

On 2007-10-12 07:23:01 Adryne said:
My name is Adryne. I’m not quite 30, but almost there. I am extremely interested in the real estate market. So I am looking for reliable information about proven effective strategies, tips, and efficient online opportunities in this market that result in a high investment return.

On 2007-10-15 23:21:51 Johnny Fuery said:
Getting started in real estate investing, hmmm?

(1) Subscribe to this blog.
(2) Get to know your real estate market. This means the price of rentals, the price of properties, and using a financial calculator to evaluate deals at a glance for profitability.
(3) Read up on your local laws.
(4) Bump elbows with people who have done it. This means everything from people in the business who live right next door to voiceless entities on the net like me.
(5) Get out there and do it. This is probably the single hardest thing to do for most would-be investors.
(6) Rinse, lather, repeat.

I'll be writing an article on #2 sometime this week, thanks to your comment. Please do let me know if I answer(ed) your question. Please feel free to post more, as well.

On 2007-10-15 23:22:50 Johnny Fuery said:
See my comment above, to Barry.

If you have something more specific, like "I found a place worth... is it a good deal", I'm happy to provide some informal advice as a case study.

On 2007-10-16 12:16:21 Dan said:
Anywhere I can make a good amount of money for the time I spend is good with me. Hopefully within that 3 years the average appreciation rate is closer to 5% on I make even more money.

On 2007-10-21 04:48:44 Dwayne said:
Hi All,
I’m Dwayne, and I’m caressing the tender age of 34. I can no longer ignore the signals in various investment venues that the possibilities of great financial security exist in the real estate market. As a result of this, I am on a journey of self-education. Currently, my focus is the real estate market with the objective of finding ways to make money. I’m interested in finding out about real estate investment tips and strategies. I would also like to find out how effective the current online strategies used in the real estate market are. What are the ‘real’ money making processes of today’s real estate market?

On 2007-10-28 21:31:01 Barry said:
I really appreciate you taking the time to respond to my question.

Not only is your advice understandable, it is also not that hard to implement.

I can't get enough of your "rinse, lather, and repeat" perspective.

Are you emphasizing the consistency aspect, or are you saying jump right in but prepare to get dirty?

On 2007-10-28 21:46:46 Barry said:
What is consider a decent percent rate on investment returns?

On 2007-11-03 21:43:16 Johnny Fuery said:
"Rinse, lather, repeat" is from the fine print on shampoo bottles. When I use it, I'm simply referring to turning a winning formula into a habit.

If you can do an hour of work for the same amount of pay that you earn at your day job AND create some residual income, even if minor, you should. Then do it again. And again. And again.

Eventually that "minor" residual income won't be so minor any longer.

Make sense?

On 2007-11-03 21:44:42 Johnny Fuery said:
Every investor seeks to maximize their real rate of return. So a "decent rate" is simply the best possible return on investment you can receive for the level of risk you're willing to take.

I'll write a post in more detail sometime this week.

On 2007-11-03 21:48:45 Johnny Fuery said:
The 'real' money making processes of real estate investing?


It pretty much boils down to "buy low, sell high". Extrapolated a bit for real estate, that means "buy where the carrying cost of your debt is near-zero and wait for appreciation".

In terms of actually helping you, it would help to understand your position a little better. What are you starting with and where do you want to go?

On 2007-11-04 16:09:21 Dwayne said:
I unabashedly admit that I am just a beginner in the real estate market.

I do understand that real estate deals with properties. However, I would like to learn or be directed to resources that could enlighten me a bit further on specific strategies or ideal investment concepts currently being implemented by other more experienced and active real estate investors.

On 2007-11-04 16:12:50 Dwayne said:

Now, what I would really like you to tell me is what I can do in an hour for the same amount of pay that I earn at my day job with regards to real estate investment?

On 2007-11-04 16:17:42 Dwayne said:
Before I ask my question, I ask that you bare with me. Are you saying in this post that a real estate investor should consider an investment return of 3 yrs with a 5% return on the investment as the average for a good real estate investment?

On 2007-11-04 17:26:00 Adryne said:
I am new to this subject matter myself. Not to mention, I appreciate having someone else just learning the strings here with me.

You and I are in just about the same position. I intend to keep my eyes on this string of information.

On 2007-11-04 18:23:57 Johnny Fuery said:
I believe that the real rate of appreciation on US housing since WW2 is a little shy of 6% annually. Like stocks, of course, the year-to-year return varies pretty dramatically. This is the historical average.

That being said, if you're only counting your 6%, you're missing the point.

Real Estate is the only form of leverage available to the middle class.

Leverage means that you're using other people's money to improve your rate of return.

Given a 6% real rate of return, 20% down means that your actual rate is 30%. 10% down means a 60% rate of return.

Nothing down means an infinite rate of return. That's how you jump up to the next socioeconomic level. Rinse, lather, and repeat, and you're on your way to an empire.

I know this is a bit esoteric, and an example would help... I'll do my best to post an article on this very topic this week, k?

On 2007-11-04 18:31:43 Johnny Fuery said:
Do feel free to send me specific questions...

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