Many years ago, I made an important discovery: The most important thing we can do to improve our income, net worth, and our lifestyle is to do things today that will result in an income stream for several years into the future. When money is received in a lump sum, such as a salary, a fee, or from the sale of an asset, a part of it usually goes for taxes, much of it is spent, and little or none is saved. As a result, we must continue to work to get more cash flow.

This habit of “doing things today that will provide an income stream for years into the future” has served my family well. It has allowed us to sample some of the finer things in life and the financial freedom to do the things we want to do. The recent sale of a mortgage reminded me this important discovery. After providing a net income of $2,500 a month for most of the fourteen years we held the mortgage, it was sold for $363,000 cash. The remarkable thing about it is that our original investment was only $20,000.

Negotiate for Great Terms

About twenty years ago, we purchased a rental property from an owner who was tired of managing and maintaining the property. (Although this particular property involved apartments, the results could be the same with mobile home parks or other rental property.) During my discussions with the owner, it became obvious that he was more concerned with getting his price of $250,000 than he was with the terms. So we agreed to pay his price while negotiating better terms. We paid the seller $20,000 down and assumed his current mortgages totaling $71,000. We gave him a mortgage for the balance of about $159,000. He agreed to payments of $1,000 a month including 6% interest for seven years, at which time the payments would increase to $2,000 per month. After making payments of $2,000 for a few months, we were able to convince him to reduce the payments to $1,200 in return for increasing the interest rate from 6% to 7%.

Improve the Value of the Property

In the meantime, after doing some fix-up work and raising the rents, we sold the property for $509,000 with $50,000 cash down. The down payment was enough to recover our entire investment, including fix-up work. The buyer gave us a $459,000 “wrap-around” mortgage, payable $4,700 per month, including 10% interest. The wrap mortgage was put into a trust for the benefit of my family. For fourteen years, the trust collected $4,700 a month, including 10% interest. It paid $2,200 a month, including 7% interest, on the smaller underlying mortgages. Because the payables were being reduced at a faster rate than the receivable, the equity in our wrap mortgage actually increased each month, even after the trust received a net cash income of $2,500 per month.

Go Back to the Seller for Better Terms

Last year, I convinced the seller to satisfy his mortgage (then about $104,000) on the rental property and substitute a mortgage on our home, leaving the payments and interest rate the same. Once that was done, the wrap mortgage became a first mortgage, making it much easier to sell. The trust recently sold at a small discount and collected $363,000 in cash.

Needless to say, the income from the mortgage was far greater than the income we earned while managing and maintaining the property. After paying off enough mobile home loans and other debts to offset the drop in monthly income, the trust still had more than $200,000 cash left over. It was reinvested in other profitable ventures, which are expected to further increase the trust’s income and equity growth.

Those who take the time to learn the business will find that the combination of rental property and creative financing is a great way to create wealth. While the experience with this particular property may seem complicated, keep in mind that steps were periodically taken to make the investment more profitable. It’s okay to go back to a seller and ask them to change the terms of your agreement as long as you can show them how the change will benefit both parties.

Should I use cash or credit? ARM loan or fixed rate? Ten percent down or twenty percent? Should I pay down debt or keep a cash reserve? These are all good questions, and here’s some of the answers.

Cash vs. Credit: The Concept of Leverage

In order to understand real estate financing, it is important that you understand the time value of money. Because of inflation, a dollar today is generally worth less in the future. Thus, while real estate values may increase, an all-cash purchase may not be economically feasible, since the investor’s cash may be utilized in more effective ways. Leverage is the concept of using borrowed money to make a return on an investment. Let’s say you bought a house using all of your cash for $100,000. If the property were to increase in value 10% over 12 months, it would now be worth $110,000. Your return on investment would 10% annually (of course, you would actually net less, since you would incur costs in selling the property).

If you purchased a property using $10,000 of your own cash and $90,000 in borrowed money, a 10% increase in value would still result in $10,000 of increased equity, but your return on cash is 100% ($10,000 investment yielding $20,000 in equity). Of course, the borrowed money isn’t free; you would have to incur loan costs and interest payments in borrowing money. However, you could also rent the property in the meantime, which would offset the interest expense of the loan.

Taking leverage a step further, you could purchase ten properties with 10% down and 90% financing. If you could rent these properties for breakeven cash flow, you would have a very large nest egg in 20 years when the properties are paid off. Balance that with what you could make by investing the cash flow on one free and clear property for 20 years. And, of course, look at the potential risk of negative cash flow from repairs and vacancies on ten properties. Finally, consider the tax implications – if you have cash flow, you have taxable income; if you have increase in equity, there’s no tax until you sell.

Cash Flow vs. Cash Reserve

On a similar note, the size of your down payment will affect your cash flow on rental properties. Let’s consider two examples.

Example 1: $100,000 property with $20,000 down. $80,000 loan @ 6% interest, including taxes and insurance is about $600/month. Assuming you could rent the property for $800/month, you have $200/month cash flow or $2,400/year. Not bad.

Example 2: $100,000 with no money down. $100,000 loan @ 8% (higher rate is generally common for zero-down loans) would make your payments closer to $900/month. With zero down, you have $100/month negative cash flow.

Which is better? Well, it depends on what your goals are and what the rest of your financial picture looks like. Let’s say your goal was to hold the property for 10 years. In the first example, you have $200/month cash flow, but no cash reserve. In the second example, you would have $100/month negative cash flow, but you have $20,000 in reserve. The knee-jerk reaction of some people is that example #1 is safer. But is it really?

Think about it… in the first example, if your property becomes vacant for one month, you’d be out of pocket $600. It would take three months to make that up. In the second example, you have $20,000 in cash cushion to make up the deficit. With $20,000 in the bank, you could handle $1200/year negative cash flow for 16 years. If the property were in an appreciating market, you’d come out fine, even with negative cash flow. Another factor is the choice of loan. You could buy a property with nothing down and an interest-only loan fixed at 5% for three years. If your exit strategy is a lease/option that should cash you out within 36 months, why do a fixed-rate loan?

The point here is that you should not automatically go with a fixed-rate loan. Nor should you seek positive cash flow as the only goal. Likewise, you should not buy properties with nothing down and negative cash flow and assume that short-term market appreciation will be the only source of your profit.

Paying Down Debt

For years, our parent’s generation discouraged debt as a “bad” thing. For some investors, the goal is to own properties “free and clear,” that is, with no mortgage debt. While this is a worthy goal, it does not always make financial sense. If you have free and clear properties, you will make certain amount of cash flow and pay a certain amount of income tax. If you need more cash, you are forced to sell the asset, creating a taxable gain.

If you refinance a property, there’s no taxable event. And, since mortgage interest is a deductible expense, the investor does better tax wise by saving his cash. Think about it… the higher the monthly mortgage payment, the less cash flow, the less taxable income each year. While positive cash flow is desirable, it does not necessarily mean that a property is more profitable because it has more cash flow. More equity will obviously increase monthly cash flow, but it is not always the best use of your money. On the other hand, paying down debt may make sense if you can’t get a higher return elsewhere in the market. Also, if paying down debt can have other rewards, such as bringing a loan below 80% LTV, you may be able to cancel private mortgage insurance and save additional money.

In Short, Don’t Rely on Assumptions… Do the Math!

Can you buy real estate and get wealthy despite having ‘No,’ ‘Marginal’ or even ‘Bad,’ Credit? How about compounding the problem by having no cash either? The answer is a resounding “Yes”: but only if you have lots of other stuff: drive, determination, sincerity, maturity some modicum of sales ability and a burning desire to achieve.If you are missing any of these qualities, you chances of success are minimized proportionately with each missing element.

Without disrespect to those who have sacrificed, scrimped, and saved to maintain perfect credit, I’d like to say that I couldn’t express the degree of respect I have for them and their achievement (and no small degree of jealousy). However, I have never been blessed with a lot of money and perfect credit at the same time. Throughout the many phases of my financial development, I have had both…just not simultaneously. Nevertheless, even without an abundance of cash and/or credit, I have managed to acquire a few million dollars worth real estate, and absolutely none of it has been acquired with, or because of, credit (or cash).

And now that both attributes are greatly improved, I still prefer to acquire property without a cent out of pocket and without a mortgage loan and with any monthly payments (they’re FREE that way). For anyone who has damaged his or her credit, reestablishing it is necessary, to be sure. However, don’t forget that one’s not “using” their credit (the American Stoic approach) is far worse than one’s not having any…and many of tend to do alright without it. In my own case, I filed a business BK in 1989, and gave away and spent everything I had ever owned in my life (everything) in order to pay off my creditors.

It took a while, but I did it, and I didn’t suffer much in the process. However, within a month of having gone through the BK ordeal, I acquired a beautiful $520,000 home without a penny out of pocket and without the tiniest need for credit. I even gave the seller, a Mr. Gil Burrell of Granada Hills, California; now of S.D. Ca. (for the benefit of J.T. Reed if he’s checking) a full credit report (it was 4 feet long and horrible). I also gave Mr. Burrell all the data re. my bankruptcy. He didn’t care…I got the property solely based upon my sales ability, my demeanor, a plausible explanation for the BK and bad credit; and because of the sincerity that I portrayed and my offer to provide my plan for correcting the problems. Credit was NOT an issue. Since that time we have continued to do reasonably well in acquiring a modest amount of other real estate by the same means…and wholly without credit, and with very little if any cash (usually none).

Without ANY apparent “credit worthiness,” I have managed to acquire credit cards (secured and unsecured), and to financed several automobiles. Over the years, I have felt little pain because of the absence of credit; and as a matter of fact, I’m sure my credit restrictions following the BK allowed me to avoid some temptations and maybe some mistakes I might have had to endure otherwise.. The point? One should do everything in his or her power to get their credit back in order: but in the meantime, never let its absence negatively interfere with, or affect, your investment pursuits. You don’t need cash OR credit to be a successful real estate investor…assuming you know how, and assuming you have a good source for information, education and encouragement.

Following–in the order of their overall importance–are the tools you need in the No Down, No New Loan, real estate investing business.

1. Dissatisfaction with the status quo.
2. An honest need for increased abundance.
3. A burning desire to achieve.
4. Tenacity: the ability to stick-to-it, no matter what.
5. Resiliency: the ability to shrug off a failure and move on with undiminished zeal.
6. Selling skills: Acquired and/or natural sales ability (listen and think at the same time, while not talking until its necessary).
7. A professional and business-like demeanor.
8. A good business background or sense (…or a partner with same).
9. A solid understanding of Real Estate and Real Estate Finance.
10. Good Credit (or not).
11. Plenty of available cash (or not).

Without at least the first five in the above list, you are destined for failure in the business. With #1 through #5, along with any one of #6 through #12, your chances of success are almost assured. With all of #1 through #9, you’re success is unavoidable. With all of #1 through #10, abundant wealth is already yours and you need only reach out for it. You are truly on top of the world. With all tools…you OWN the world and everything in it.

This discussion leans toward answering questions asked most often by our youthful men and women in there early twenties. They often begin to ask themselves the question, “Should I consider buying a home, condo/town-home or some other type of real estate that I can call my own?” Due to the fact that housing has up to this point always been provided for or lived in on a rented basis we tend to find that our newest contributing members of society find themselves at a loss for the most beneficial and advantageous way to enter this next phase of self-sufficiency.

Due to the fact that most of us grow up in either a rented apartment or our parent’s single family home, it stands to reason that most people, when beginning to ask themselves the question of purchasing their own dwelling, will come to the conclusion that a condo or small house is probably the way to go. That’s a result of conditioning and it’s a hard mindset to break! After taking the time to talk to or personally guide a respectable number of people in their twenties, I have come to find that firm, direct and accurate information can really adjust the reality of how real estate can be acquired and used to their best advantage starting with property that sets the tone for a much more profitable and rewarding future.

Everyone understands the concept of paying rent, so to begin with a great opening question to our real estate student is, “How would you like to collect that rent as opposed to pay it!” Naturally this question gets their attention and we can begin to open the door of enlightenment. I like to use the duplex example to illustrate the two homes under one roof concept. Some people are unfamiliar with what exactly a duplex is and how it works, so I simply state that quite often you find duplexes composed of one building that has two bedrooms and one bath on each side, all under one roof, some larger, some smaller.

These are as easy to finance as a single family home and in many cases allow you to qualify for a larger loan amount which leads to using leverage and more of other people’s money to get ahead faster in life. Using an example lets say you find a duplex for $150,000 (California is higher), your loans interest rate is 6% that would cost $899.33 a month to pay principle and interest back on a 30 year loan. They would have to insure it, so we use an average of $5 per $1000 of home value to average insurance costs. So $5.00 x $150.00 = $750.00 a year for insurance. We divide that by 12 months to get a figure of $62.50 a month for insurance. We also have annual taxes that are based on what the home is worth multiplied by a millage, or mill rate.

Let’s use a tax rate of $11.00 per $1,000 of the homes assessed value: $11.00 x 150 = $1,650.00 a year. Now divide that by 12 months to get a monthly tax of $137.50 and by adding principle, interest, taxes and insurance (P.I.T.I), we get a total monthly mortgage payment of $1099.33. Now when you rent one side out for (in many cases, approximately $750.00 a month) you are left to pay only $349.33 out of your own pocket every month. When I get this point firmly affixed to the gray matter of their brain, it becomes clear that this amount is much lower than the amount of rent they are now paying to live under someone else’s roof and rules. Now the questions start coming in the following order. Well? How do I buy something like this? The answer most often begins with, “By getting pre-qualified for a loan,” and I go on to say you will need to gather and bring the following things to the bank loan officer to get started:

* Copies of three years of tax returns for first time buyers + schedules and W2 forms.

* Copies of most recent pay stubs within the last 30 days.

* Copies of your most recent three months of bank statements.

* A list of all creditors with name, address and account numbers.

With these initial documents the lender can begin to process your application for a loan. They will determine your assets and liabilities (net worth) as well as verify where you live now, your credit history and a host of other information that begins to validate your existence and ability to borrow money now and in the future. Once they’ve had a chance to review and verify your information they can pre-approve you for a certain loan amount. Once your approved you can begin your search for a home of your own, typically as a first time home buyer you will find that there are programs that let you put as little as 3-5% percent down in order to buy a home that satisfies the lender’s guidelines according to its value and conformity. Now on a $150,000 loan the down payment can be anywhere from $4500.00 – $7500.00.

There are ways to lower these costs and a great place to start is by attending a first time home buyer’s class. These classes introduce you to the basics and give you further information on programs that are currently available that may offer you the opportunity to buy with nothing down! So with that said, the next step is to get to a free class and get familiar with the process. Often I recommend going to the class before going to see a lender so you don’t appear so green and unprepared upon your initial introduction. Since I usually find these poor souls wondering and wandering in the land of the lost, the next frown I see come over them is the realization that they just don’t have the money required to start. So the question comes up as to where to get it. I usually ask about savings, whether parents or grandparents can help, if they can sell valuable possessions or take second jobs, get grants, gifts, use trust funds, personal loans or co-signers, or a combination of these alternatives with a complimentary loan program usually gets the ball rolling. Options and hard money lenders usually come later as alternative funding and acquisition sources, so I won’t confuse any one with those now.

The bottom line is this: If someone wants something bad enough there is always a way! The nice thing about duplexes is that the lender will take into account the fact that 75% of the rental income from the other side of the property can be used to offset your qualifying ratios, so in this case they can use 75% of the rentals $750.00 income to reduce the amount you must earn to qualify for what appears to be an unaffordable loan. Seventy-five percent of $750.00 equals $562.50. Now subtracting that amount from the original mortgage payment of $1099.33 leaves you with a payment of $536.83 which the bank says you must be able to repay every month out of your own pocket. You can do this!

Can you begin to see how with a little information, effort and belief you can actually own something and pay less than what you are currently paying in rent? Let’s continue on with the way things begin to unfold once you begin the journey. Starting with the day you close the deal and become the new owner you will see that you now have just created a passive income stream that gives you an extra $750.00 a month without you having to punch a clock or trade a certain amount of hours to earn the money. Your new asset works for you day in and day out constantly generating income for you while you go and do other things. This is leveraging your time and money in a very beneficial way!

You also will notice that at the closing of your purchase that the old owners who sold you this property had to prorate or give you a share of the rents due and any security deposits that the tenants had given to them. Now add to that the likelihood that your first house payment won’t come due until about a month and a half after you move in and you find yourself with, low and behold, extra money, probably for the first time in quite a while! Let’s calculate it using simple math. Assuming you close on the 15th of the month, you will have 45 days before your first payment comes due, you will be credited with 15 days of rent, you will receive all security deposits of the tenant and you will receive another month’s rent on the first of the month from your tenant and you yourself will have no rent or house payment of your own to make for another whole month. What does all that add up to? Let’s break it down:

* Fifteen days of rent equal to $375.00.

* A half month’s rent as a security deposit equal to $375.00.

* A full month’s rent in another 15 days equal to $750.00.

* No payment to the bank for another 30 days and you’re not paying rent to anyone any longer, so you keep whatever you normally would have had to give to someone else as rent that month (let’s say that was $500.00).

* Another payment to you for $750.00 from your tenant as well as you having to make your first mortgage payment of $1099.33 on the 1st of the month which comes 45 days later.

* Side note: If you decided to rent your second bedroom to a roommate, they would pay $500.00 a month and half your utilities as well, thus your basically living and owning this property for free.
* Say goodbye to all those student loans as you divert all these freed up funds to pay off loans instead of a landlord!

Adding these up, we get $375.00 + $375.00 + $750.00 + $750.00 + 500.00 not paid to your old landlord. That equals $2,750.00 that you will now have as a result of your first month and a half of ownership. Now subtract your mortgage payment of $1099.33 and you are left with a reserve fund of $1,650.67 in your account. Take your parents out to a steak dinner and celebrate – you’ve earned it!

Let’s review: You decided to buy your own home, you made the choice early to offset expenses by looking at a multiple income property, you went to the homebuyer’s class, you went to see a lender and got pre-approved for a loan, you saved or arranged to have the necessary amount required to buy and you hunted, searched and analyzed more than a few properties in order to find a good one that would satisfy your criteria.

Your next phase is to begin to realize that you are now responsible for the welfare of another family or person due to your willingness to become a landlord. Your tenants pay rent and expect you to take care of their housing needs. If you chose a good property by carefully looking at plumbing, heating & A/C, electrical, foundation, structure, roof, location and price, then you should be well positioned to be able to successfully manage these duties. Often, you as the new owner will begin to make improvements to the property such as painting, installing new carpet and doing some inexpensive landscaping and repairs. These are the things that add value to your property and keep your tenants happy while at the same time not breaking the bank!

With $1,650.67 in your bank account, you’re not exactly Donald Trump just yet, but you’re getting there! Smart landlords establish 6 month reserve accounts and/or contingency funds, which protect them in times of vacancies or when expensive unforeseen repair bills pop up in addition to regular planned-for maintenance items. What I’m saying is don’t spend your reserves frivolously. In my case, a steak dinner is a tradition but the major portion of your funds should only be used to build, protect and enhance your asset’s ability to produce and sustain income generation. By taking on responsibility in the housing market at such a young age, you will have some added benefits and opportunities coming to you. Let’s look at what starts happening: the first thing is you have overcome fear and lack of understanding by acquiring your first property. In addition, you have begun to offset expenses while saving more money, you are establishing excellent credit while building assets, and you’re gaining tax advantages while getting management, home buying and repair education at an early age. These are outstanding life skills that you can employ for the rest of your life and the longer the period of time that you have to use them, the further the compounding effects will help you to go.

This type of initial home-buying strategy can and does lead to further opportunities to grow and achieve further benefits besides those already mentioned. Individuals who learn to accept responsibility early will by nature grow more mature throughout the process and in effect create for themselves a higher status in the minds of others by being looked upon as a current homeowner and landlord. Once established, you will become known for what you can do. If you were single when you undertook these challenges, then you will appear and become more self-sufficient to the opposite sex. What do I mean by that? What I’m saying is when you meet someone who may become your spouse in the future, they will recognize your ability to provide for their safety and protection and they won’t question or complain about your fooling around with wild ideas of becoming educated in real estate now. They will accept that this is something you do and will respect your ability to manage this part of your life.

As time passes on and you find this love of your life and the eventual marriage proposal ensues, the time will come when you’re going to want to separate business from pleasure. As a young couple the time will come when you may want to start a family or at least separate yourself from your tenants while moving up to a nicer single family home that suits your changing needs more appropriately. Perfect, because now is the time to consider renting out both sides of the duplex while you begin to investigate your new single family home.

How does this phase work? Hold on, I’m getting there! Okay, let’s assume its two years later and you have been living in and improving your duplex all along. Now taking into account that you bought a decent property in a good neighborhood and inflation and appreciation has been adding value in addition to your improvements, your $150,000 duplex should command a new appraised value of $175,000. Let me explain how the value grows: 3% annual inflation multiplied by $150,000 equals $4500.00 the first year. Let’s also say that appreciation due to demand also adds 5%, so 5% x $150,000 equals $7500.00. Now $150,000 + $7500 + $4500 = $162,000, which represents the new value for year one. The second year we do the same math on $162,000 and we get $12,960 for year two. Adding that to $162,000 equals $174,960. Okay, I was off by $40.00. Don’t forget any improvements and that you may have bought it at a discount because the old owners where motivated and you might find its worth even more.

Now over those two years you have also been paying that old mortgage of $1099.33 each month and the principle amount that you owe on your loan has been reduced by an additional $3,965.96, leaving you with a loan balance of $146,034.04. The difference between the new appraised value of $175,000 and the current amount of $146,034.04 which you owe equals $28,965.96. This number represents the equity, or value, that you currently own in the home. Knowing this, it is entirely possible to apply for and receive a home equity line of credit up to the full value of the new appraisal! If you haven’t gone overboard on buying cars, boats and running up other revolving debt while at the same time your significant other or spouse-to-be has a job and good credit with manageable debt, than the bank is going to approve this line of owner-occupied credit.

Now what you have done is set up a line of credit which can be used to buy a $145,000 single family home with a 20% down payment. This allows you to avoid paying private mortgage insurance (PMI), thereby creating a very affordable new mortgage on your new family residence.

NOTE: Do not confuse homeowner’s insurance with private mortgage insurance. PMI protects the lender while homeowner’s insurance protects you. When you put down 20% of value on a home’s purchase in the form of a down payment, you are in effect protecting the lender from yourself because if they foreclosed on you for non-payment, they could sell the home fast for less than full value and still be paid in full. Don’t pay for private mortgage insurance if you can avoid it! Let’s not forget that as the value of your duplex has risen the rents should also be increasing along the same lines. Now instead of $750.00, you should reasonably expect to get $800.00 per month, per side, which now delivers $1600.00 a month to your bank account. Unfortunately you still have to pay for 28 more years on the original loan amount, so you will make that good old $1099.33 payment as usual. That leaves you with $500.67 left over to pay that new equity line back with. Your new $29,000 equity line which you used as a down payment on your new home costs you $336.71 @ 7% for 10 years. Now $500.36 minus $336.71 leaves you with $163.96 left over to maintain a nice little reserve account for vacancies and maintenance/repairs. This is a good example of how to transition to a secure lifestyle while using your existing asset base to buy more.

Review:

* Break the mold and look at multiple income property to start.

* Go to a first time home buyer class to get ready.

* Go to a lender prepared to qualify for an affordable loan amount.

* Focus your effort on learning how real estate works.

* Realize the sooner you start, the better off you will be.

* Offset expenses by renting to others.

* Manage tenants, deposits and property responsibly.

* Plan for the future using assets and equity lines to start.

* Keep reading and learning how to do new things with real estate.

* Find mentors and use knowledgeable people to help you along the way.

I hope this little plan of entering into homeownership has given you some ideas in your quest for independence.

Sometimes a seller requires some cash… for all or part of their equity. Don’t assume sellers know what the word “equity” means. I tell them “your equity is the difference between what you owe and the price I pay you for the house.”

Magic Words on the phone: “If I gave you part of your money now and most of it later, would you be able to move, because I could offer you a higher price if you can wait for some of your equity. Would you even consider that, if I could pay you more for the house?”

Do you need cash for purchase deposits, or repairs, or holding costs? How about cash to give the seller to sweeten the deal and get a bigger equity spread?

Here are a few ideas:

1. Use buyer’s purchase deposit or down payment.

If you are following my advice and methods for buying houses, then you’re occupying your houses with either Tenant/buyers or Buyers.

TENANT/BUYER: Rents the house and has the right to buy the house at a preset price. Most of my houses are occupied by tenant/buyers. They put at least 3% down, non-refundable purchase deposit on a sales contract. I prefer 5% down. If they don’t have 5%, I get a promissory note and have them pay extra money each month to build up to 5% as quickly as possible. If they have less than 3% then they may be able to get into one of my “sweat equity fixer upper” houses. Their down payment can be partial supplemented by doing required work to the house before they move in. This is work I would normally hire a contractor to perform so if I don’t have to write a check to fix up the house, the money saved is less cash I need from my tenant/buyer.

BUYER: Puts down 10-15% down and you close with owner financing, typically via a wrap. Or the buyer gets a new loan cashing you out completely, or perhaps you take part of your profit back in a second mortgage.

Every house I buy will be sold to a buyer or occupied by a tenant/buyer. Since I cannot predict which it will be, I get into deals where it does not matter to me either way. Most buyers calling on my ads do not have 10% down or the ability to get a new loan now. It’s much easier finding 3-5% down, so why not buy houses where that will work for you?

Bottom Line: You should be collecting at least 3% down on every house you buy once it’s occupied. If you need cash to do a deal, you have 3% of your “resell” price to commit for cash to seller, holding costs, closing costs, minor repairs and maintenance.

2. Private money or hard money loans.

If you pay cash for a house you’ll never offer more than 70% of the after repaired value less the cost of any repairs. You can borrow 65-75% of the value of a house from a “collateral” lender. The lender will charge you 11% to 16% interest, and maybe 3 to 10 points. They should only be concerned with the value of the property that secures their first mortgage. Many private lenders will offer you interest only loans so all their investment is working for them, getting them a nice return. If you borrow $75,000 on a $100,000 house, 12% interest only payments are $750 a month. You should be able to get more than that each month from your buyer in rental income or from a wraparound mortgage payment. This formula does not work as well on expensive homes.

If the seller owes $50,000 on a $100,000 house, you can sometimes borrow another $25,000 on a second mortgage. Take over the first mortgage “subject to” which will have a better interest rate and no points. This saves you money and allows you to pay more for the house. You can give part or all of the $25,000 to you seller. If they have more equity coming to them, you can give them a 3rd mortgage on this house or a 2nd mortgage on one of your other properties.

3. Deferred down payments.

Take over an existing loan with good terms. Any equity still due to seller can be offered in the form of a deferred down payment. Basically, you will pay the seller the balance of their equity (if any) in a single lump sum payment when you resell or refinance the house down the road. Ideally, there will be no monthly payments or interest. If the seller insists on interest or monthly payments, get a lower price to make it worth wild. This is a “no money down” method. The cash you need for this type of deal comes from your buyer’s new loan, normally 6-36 months in the future.

4. Substitution of collateral.

I am buying a house on Thursday for $153,000. It is worth $165,000-$170,000. I’ll soon advertise it for $179,500 with “flexible owner financing” and enjoy a $26,500 equity spread.

The seller owes $18,000. He has agreed to take $63,000 in cash ($18,000 of which will pay off his lien) and $90,000 in second mortgages on several other properties I own. He wants 6% interest but doesn’t need monthly income. So his interest will accumulate for 5 years. 6% interest, no payments, 5-year balloon on $90,000.

This allows me to tap into equity tied up in my other properties at a low rate, and my seller is happy. He would have put his money in the bank at 1-3%. He is waiting for his mutual funds to come back up so he can get out of them. Good luck!

Here’s the kicker. I am borrowing $130,000 from a “hard money lender” at 10.99% and paying 8 points. I will net $120,000 in cash from that loan after costs. That means I collect $57,000 in cash on Thursday when I buy!

In my audio training course I reveal how to get a guaranteed 35% return on any extra cash you want to invest. That’s what I will do with this extra money.

A couple of weeks ago I collected an extra $24,000 in cash using this same type of method when my tenant/buyer closed on one of my houses.

5. Open an equity line of credit.

Raise cash by borrowing against equity you have in your personal residence or other investment properties. You can also pledge a number of second mortgages you hold as the collateral. Set it up as a line of credit. Use the money to do a deal and pay it back immediately when you sell or occupy the property. You only pay interest on that portion of the credit line you have tapped into.

Last month I setup a $100,000 credit line pledging $130,000 of equity I have acquired through taking back installment land contracts, all-inclusive deeds of trust and second mortgages.

Having this cash readily available allows me to make multiple offers to a seller:

A. All cash for lowest price. My offer price is 70% (maximum) of after repaired value less the estimated cost for repairs.

B. No cash for highest price. My offer is $30,000 less than my planned resell price. The seller gets their equity in the form of a deferred down payment. I take over existing debt “subject to.”

C. Some cash. My offer is somewhere between Offer A and B. The seller gets debt relief and some cash. The more cash, the lower the price.

Would you pay the seller 5% down if you could get an extra 10-15% off the price? You have that opportunity if you have established lines of credit to tap into. This could be a line of credit, a credit card or checking account overdraft protection. Be careful of having too much cash laying around in an operating account. You may be inclined to offer more cash on a deal than you need to, just because you have it.

6. Sell off a house or real estate note for cash.

I have been sitting on one house since February. Ouch! I bought it for $160,000 and I have $10,000 of my money tied up in it, which is unusual. It was on the market for $197,000. For one reason or another I just could not get it under contract. That’s a fair price and the home is in good shape.

I called a real estate agent I have used to buy listed “fixer upper bank owned houses.” I asked the agent to look at the house and tell me what he would market it for if I wanted to dump it fast. He recommended $179,500. I gave him the listing. Within a week I had a contract for $177,000. I decided to slash the price to get this house out of my hair and recapture the money I have into it. Plus I can focus on occupying my other, more marketable houses.

If you have cash or profits tied up in real estate or notes, one way to raise cash is to take some aggressive, proactive steps to liquidate some of those investments. Then put that money to work on better deals.

With the advent of 90%-100% LAV loans on investment properties, many investors are taking the opportunity to finance or refinance their properties at a higher percentage of value than normal. Many are taking cash out at the closing, and many are choosing to pay close to retail for properties that qualify for this financing, on the theory that a no money down deal is a good deal, even if it only cash flows a little. Smart investors avoid the temptation (and the strong come-ons by mortgage brokers) to do this. Here’s why:

1. You can’t “dump” properties in an emergency. I get calls from landlords in this position literally every day. Like from a guy who paid $78K (full value) for a rental last summer and got a purchase money loan for $76K. Now his tenants are driving him crazy and destroying the place, and he wants to sell now. He can’t sell to an investor, because he’s over-leveraged, and he can’t sell to a homeowner, because his tenants have destroyed the house. Or from the lady who bought a $100,000 duplex for $59,000…but then got a 2nd mortgage for another $50,000. She took cash out, spent it, and now can’t afford to sell the pain-in-the-rear property.

2. You can’t get consistent cash flow. I got a call yesterday from the owner of a 3 family who got a 2nd mortgage a few years ago to take some cash out. Now the city’s on his back and he wants to sell…but the 2 payments total more than the property would gross fully rented. Unless he pays off the 2nd of $20K, he won’t be able to sell.

3. You’ll pay an arm and a leg in the long term. Check out the difference in total interest payments between a property financed at 80% of it’s value vs. 100%, and you’ll see what I mean.

There’s nothing wrong with having no money in a property—as long as your total debt is less than 80% of the retail value. Borrowing more may make you feel richer in the short term, but it’s a recipe for disaster.

At least once a week, someone posts to the commercial newsgroup seeking a way to finance 100% of the acquisition cost for an income property. I suppose it is fueled by the late night infomercials touting no money down deals and using pictures of Class A apartment buildings, never saying the one describes the other, but leaving a strong impression that that is the case. The way it comes across, one would believe that all you have to do to become a millionaire in real estate is to acquire the properties with “OPM”, meaning Other People’s Money, and then just sit back and collect the big fat checks they like to flash on the screen. Television is a wonderful thing. After the story is told and the product is sold, no one in the TV cast has to stick around and collect rent.

The quest for 100% financing in real estate reminds me of that joke about a dog chasing a car… what’s he going to do when he catches it? I wonder, has he thought this through? I laugh every time I see a dog chasing a car, and think how much he is just like an investor high on the “desire to acquire.” That’s the peculiar state of mind that surfaces when the target of our desires looks so good that we’ll do anything to get it, with no regard for the consequences.

The Desire to Acquire

In real estate, the “desire to acquire” is present when the investor is willing to do anything to get a deal, any deal. Convinced that once you own real estate you’re on your way to the good life, they tap their home equity, or find a seller that will owner finance, and get a bank loan on the bank’s terms, not theirs. Now they’re in a deal, but have they thought it through? Let’s take a look at what happens when you “catch” the 100% leveraged deal.

The infomercial gurus teach that if you find the right seller, then you can structure the deal so that there is no money out of your pocket, and leave the impression that there will be plenty of money in your pocket after you do the deal. More often than not, that’s not the result. Let’s say that you do find a lender that will loan 80%, and a seller that will carry 20%. In all but the rarest of cases, the combined debt payments are going to eat up all but the tiniest portion of the cash flow. It has to be this way, and I can show you why. Instead of projecting how much you’re going to make from the deal, think about it terms of the occupancy level it takes to break even. Then consider the difference between physical occupancy and economic occupancy.

Economic Occupancy vs. Physical Occupancy

Let’s face it, the deals that we look at with decent prices, motivated sellers, and opportunities for turnaround or upside are usually not the cream of the crop. If it were an “A” property, with well-screened tenants it probably wouldn’t be on the market at a price that would interest us anyway. So it’s pretty likely you’re going to inherit a less than stellar group of tenants. The first advice here is to factor delinquency into your projections to avoid a rude awakening later. Comparing the economic occupancy to the physical occupancy can be an eye-opening exercise.

Economic occupancy differs from physical occupancy, sometimes widely so. Economic occupancy is calculated as the actual cash collected divided by the total potential rents. The answer will be a percentage, and it is important, as we will see in a moment. Delinquency in apartment rent rolls is a fact of life. You are not going to collect 100% of the money due, on time, 100% of the time. It is not uncommon for even well-run apartment buildings to run a 5% delinquency rate, and poorly operated projects may run a 30% or higher rate. For calculation purposes, if the rent is past due past the due date it is not included in rent received.

In the same way, vacant apartments are also a fact of life in the apartment business. Vacancies are actually phantom expenses that only show up in an economic occupancy analysis. Together, vacancy and collection losses are typically projected to run 5% of gross income. In my experience that is a low number. In the twenty-five plus years I’ve been in this business, a more realistic figure is 5% for vacancy loss and 5% for delinquency and collection loss. In a twenty-unit complex with average rents of $416 per month, that’s equivalent to one apartment vacant for one year. Every investor quickly finds how easy it is to “tweak” these numbers on paper to make the bottom line more attractive. I prefer to err on the side of reality, and would advise that you, “Tweak at your own peril.” But we’ll use the 5% figure for this discussion, just to save the argument, and to prove the point that even using optimistic numbers a 100% leveraged deal is tough to structure.

Always Run the Numbers

Let’s use twenty-unit apartment building with potential gross income of $100,000. That works out to average rents of $416 per month. If it is a normal building, there will be about 40% expenses, ($40,000), including management, but not including vacancy and collection (delinquency) loss. Included in the expense estimate is a “reserve for replacement” deduction. This is an annual estimate of funds needed to perform capital improvements. An average figure is between $200 and $250 per unit per year. While many owners do not actually reserve the funds, some lenders will deduct the amount from the cash flow before calculating the debt coverage ratio. Other won’t, but that doesn’t mean the improvements won’t be required.

Lastly, if you use the standard projection of about 5% ($5,000) for vacancy and collection loss, then the building must have an economic occupancy of 45% just to operate (40% operating expense + 5% vacancy and collection expense = 45%). That leaves a Net Operating Income (NOI) of 55%, or $55,000. We call it NOI, but the lenders call it, “funds available for debt service.” Ever wonder why? Read on.

Most lenders require a minimum 1.25:1 debt service coverage ratio (DSCR) to fund a deal. Some are higher, very few are lower. There’s a good reason for that.

At a 1.25:1 DSCR, 80% of the NOI is used for debt service. (1/1.25=.80). In our example, the maximum debt service would be $44,000, ($55,000 x 80%), or 44% of the gross POTENTIAL rent. Add the 45% of expenses to the 44% of the debt service, and you need 89% economic occupancy to break even. That leaves 11%, or $11,000 for profit, pre-tax.

That’s with normal deal structure, and 20%-25% cash equity. At $416 average rent, the profit margin is equal to just over the annual rent on two of the twenty apartments. Or, looked at another way, if there are two vacant apartments for twelve months, and the rest of the complex operates normally, the project is going to lose money for the owner. The lender will get paid (in theory!), but the owner won’t. And that doesn’t take into account any increases in utility costs, insurance costs, property taxes, fix-up cost for a trashed apartment, or any other of a hundred things that can and do change during the year. Now can you see why the lenders are so tough on debt coverage ratios?

Pushing the Limits

So now let’s move to a deal that has 100% financing. Say you find the above building and the owner just has to get out. He’s willing to take $500,000. That’s an 11% cap rate on the $100,000 NOI, and sounds like a great deal. You’ve got a bank that will work with you on high leverage deals, and they offer to finance the deal with terms of 80% of cost, 7% rate, and twenty-year amortization. That’s probably a little low on rate nowadays, but a fifteen-year term is more typical of local banks. Further, we’re assuming you’ve got great credit, high net worth and are an experienced real estate operator and can get the best loan terms available. The seller wants out of town so bad he’ll finance the rest at 8%, with twenty-year amortization, but a balloon in three years. He wants out, but he does want his money.

The annual debt service on the first mortgage ($400,000) with the bank will be $37,214 with a DSCR of 1.47. So far, so good. The annual debt service on the second, seller held mortgage ($100,000) would be $10,037. That’s total debt service of $47,251, or 47.3% of gross potential income, and a cumulative DSCR of 1.16:1. Add 45% expense and a conservative vacancy/collection loss allowance, and the break-even economic occupancy level is increased to 92.3%. Or, stated another way, the best-case profit is 7.7%, or $7,700 per year. The most you can make is $641 per month, if everybody pays on time and nothing happens. That’s a cushion of one and a half apartments per year over break even, before any unanticipated costs or expense increases. That is a razor thin margin.

Now go back to the more realistic 10% vacancy and delinquency loss and the break-even economic occupancy becomes 97.3%. If anything outside the perfect world of the paper projection happens, anything, then you’re running negative cash flow. You’re upside down from the get-go, and few if any options to cure it. So now tell me, you’ve caught this deal, now what are you going to do with it? Can you imagine yourself a year from now being a “don’t-wanter” seller? I’ve seen it happen just that way so many times.

Is This Your Story?

I had a call a few weeks back from a fellow that bought a small apartment project we had looked at about a year ago in a town about thirty miles from our office. He wanted to sell, and called us because we are fairly well known as buyers in the market. He started describing the place and it sounded familiar, so I asked if he had bought it from “Mr. Jones”. He said yes, and I knew it was the same deal we had looked at.

I asked how much he was asking for it, and he said he was willing to take what he had in it, which was about $240,000. It had more land next door that could be developed with more units and he would include that with the deal. (We had offered the original seller $200,000, owner financing, no money down, and the development parcel next door free and clear, or $175,000 all cash. The Seller didn’t take either offer, and we walked away.)

I asked a few questions. Nothing much had changed. He had painted the place, but the rents were the same. I asked him how much he owed, and he said $240,000, twenty percent of which was financed by the Seller. He was three payments in arrears on the Seller’s note because there had been two vacancies he couldn’t get filled.

He mentioned that this was his first real estate investment and he really didn’t know what to do. I could hear the strain in his voice, and could tell he really wanted out. I said I was sorry, but I couldn’t help him. I didn’t preach this sermon, figuring he was already paying tuition for an advanced degree in the proper use of leverage. His desire to acquire was stronger than his desire to learn how to figure cash flow before jumping into a deal. He didn’t think it all the way through.

Pigs Get Fed…

If all of this doesn’t give you pause to think twice about high leverage, then consider this. If the building in our example is full, there are twenty tenants with payments due each month. That’s 240 payments due each year. That’s also twenty potential stories each month as to why you can’t get your money, 240 potential stories each year. What is the probability that of the 240 potential payment events per year, somebody won’t pay on time? That should make you wonder how well the tenants you inherit from the Seller were screened. Or did he just get warm bodies to fill the place to sell? Believe me, it happens.

Don’t get me wrong; there are situations where 100% leverage is possible and profitable. I’ve done it a number of times, but in every case there was considerable upside available, or a development opportunity that I could capitalize on to better the odds of success, such as my original offer on the deal above. We structured the two offers so that either way we could win. It had the potential to cash flow in the present, and plenty of upside in developing the property next door. We walked when we couldn’t structure the deal to win.

Someone else came along and wanted the deal bad enough to do whatever it took to acquire it. Now the Seller has a non-performing note behind a first mortgage that is barely being serviced, both secured by a property that is declining in value because of poor management and a tough market. Did anyone really win? There’s another saying that comes to mind here, “Pigs get fed, hogs get slaughtered.” That’s a barnyard expression to describe what happens when we reach for more than we’re entitled.

I hope you can see from this discussion why high leverage is a strategy that requires the experience, capital, and resources to use it properly. Be careful when you contemplate highly leveraged deals. Figure the break-even economic occupancy rate. Know what the costs are going in. Know the market. Know your own capabilities and be able to move quickly to capitalize upside. Above all, do not tweak the numbers to support your own “desire to acquire.”