Chapter 5

Fast Money: Small Down Payments and Property Flips

In This Chapter

Debunking no-money-down strategies

Choosing the best fast-money strategy

Uncovering those buy-and-flip properties

The only thing better for a small-time investor than getting rich is getting rich quickly. Entire books have been written about hitting the real estate big time with little money to invest through buying and flipping properties to turn quick profits.

Does this scenario sound too good to be true? Of course it does! In rare cases, these strategies have proven profitable — but those success stories are few and far between. That’s why we warn you about the realities and truths of the get-rich-quick-and-with-little-money sales pitches in this chapter, and we offer our best advice to guide you in case you choose to walk these dangerous paths despite our persistent warnings!

Purchasing with No Money Down

If you’ve ever had insomnia and turned on the television in the middle of the night, you’ve likely seen the late-night infomercial real estate gurus who claim to possess the true secrets of buying real estate significantly below market value — and they don’t even use their own money! They tell viewers that anyone can buy real estate tomorrow using their no-money-down strategies. And it gets even better — they tell you that you can actually receive money from the seller to buy her property.

Although finding a buyer who is so motivated that she’ll actually pay you to take a property off her hands is possible, the reality is that the vast majority of such properties don’t prove to be profitable for you in the long run. Ask yourself — why would anyone give away a property unless it had some really serious problems?

The birth of the no-money-down movement

The popularity of no-money-down investing peaked in the early-1980s when most real estate loans were assumable — the buyer of the property essentially took over or assumed the payments on the current loan from the seller. Properties weren’t appreciating that quickly in that time frame, so many owners didn’t have significant equity in their homes and were willing to take small down payments or carry seller financing as part of the transaction. The advent of the due on sale clause in many mortgages virtually eliminated the ability of buyers to assume the seller’s current loan.

Understanding why we recommend skipping these investments

The concept of buying real estate without using any of your own money is clearly dependent on finding an extremely motivated seller. A motivated seller is one who faces circumstances that don’t allow him the flexibility to achieve full market value for his property. For sure, a certain number of motivated sellers exist in any market.

The late 2000s downturn in the real estate market may seem a perfect opportunity to explore the benefits of putting less money down to purchase a property. The reality is that most lenders are no longer in the creative financing business after being burned by the stated income or “no doc” and similar subprime loans in which the buyers have no vested interest and were counting on unsustainable appreciation to create equity.

There are also fewer sellers with significant equity in their properties so the margin for seller financing is diminished. Low money down and/or installment sales are much more likely and feasible when you have a seller with plenty of equity. However, many of the most motivated current sellers are owners of properties in which they owe as much or more than the property’s current market value.

The stock market is a relatively liquid market where buyers and sellers can enter or leave the market quickly with broad knowledge of current pricing. In contrast, real estate assets are illiquid — it can take a relatively long time to enter or leave the real estate market. Real estate is also unique: A share of your favorite stock always represents the same investment; not so with real estate. This creates the opportunity to profit from pricing inefficiencies between one property and another. Also, the ability to complete a real estate transaction quickly provides an additional factor that can affect the price.

The following are examples of motivated sellers who may be willing to accept a no-money-down offer:

• A seller who’s relocating and needs to sell in a hurry: An owner who’s leaving the area may need to quickly sell his home so he can buy a replacement home in his new location. In order to complete the sale in a timely manner, he may be willing to lower the price to slightly below the full market value (the price he could have received if he were not in such a hurry).

  Finding a seller in a hurry is one of the most reliable ways to buy real estate with little or no money down.

• A seller who’s desperate to sell and exasperated by the effort: The owner of a property that has been vacant for an extended time period or that requires extensive renovation may be eager to sell. The property may have a deadbeat tenant, or maybe it’s vacant after being destroyed by the last tenant and the owner lacks the cash to make the significant investment in repairs. This type of seller may be willing to offer generous seller financing terms or even pay you to remove him from his liability.
• The current owner may have challenges in his life with his health, relationships, or job. Managing rental properties is time consuming and at times draining, both emotionally and financially, especially when something major — such as replacing a roof — needs to be done. Also, any reason that the current owner no longer has other sources of income that can support rental properties with negative cash flow can be an opening for you. Most owners have mortgages with payments due each month, and if the property isn’t generating enough income to cover the mortgage and operating expenses, the owner has to come up with the additional cash from other sources.

But even when sellers find themselves in such positions, who will stamp “Desperate to Sell” on their forehead? Trying to determine a seller’s motivation takes effort and investigation. Check out Chapter 13 for more on the subject.

Although, clearly, such real estate owners exist, they’re not as common as some of the real estate investment gurus would have you believe. There are always anecdotal stories about an amazing success story, but there are many more untold stories of cocky novice real estate investors who found out the hard way that you get what you pay for.

Finding no-money-down opportunities (if you insist)

No-money-down sellers are in greater abundance in a weak real estate market (or buyer’s market) because sellers have fewer options. The target market for no-money-down deals is a real estate market environment with highly motivated sellers facing dire consequences (including foreclosure, which we discuss in Chapter 3) unless they dispose of their property. Usually, sellers that need to sell quickly are in one of the following situations:

• A seller who has had some unfortunate circumstances such as an illness, a death in the family, a divorce, a job loss, or a significant loss of income such that she can no longer afford to make the payments and handle the ongoing expenses of the property — this situation is often the one that leads to a no-money-down offer. Because of her compromised situation, such a property seller may not readily qualify for new or additional loans that would allow her to handle the cash flow dilemma she faces. Although home equity loans may be available in these circumstances, the owner may be so financially overwhelmed that she prefers to sell her property and downsize her financial obligations to a more manageable level.
• A seller with significant equity but limited options to tap that equity is likely to have cash flow problems, but the overall equity in the property can allow her to act as a lender to you (see Chapter 8 for seller-financing strategies).

  The two most common good candidates (as opposed to the classic definition of owners who would be flexible out of desperation) for no-money-down scenarios are

  • Folks at or approaching retirement age who would prefer a steady income stream to a lump sum.
  • Individuals who inherited the property and are looking for monthly income without the hassles of being a landlord.

In order to know whether the candidates you’re considering fall into one of the preceding scenarios, you need to assess their motives. Chapter 13 helps you do that.

Buying, Fixing, and Flipping or Refinancing

In a solid real estate market, you often find properties appreciating at an annual rate of 3 to 5 percent — a solid and sustainable rate of appreciation that rewards investors with long-term investment horizons who take the buy-and-hold approach with their real estate assets. This buy-and-hold strategy works and should always be the foundation of your wealth building.

But in some areas, the demand for housing has been so great that the limited supply of new and existing properties available in the market is insufficient to meet the demand. It’s in these markets of high demand and rapidly escalating prices that real estate speculators with a buy-and-flip strategy tend to appear.

There’s nothing wrong with the buy-and-flip strategy, but we prefer the more conventional and lower-risk strategy of buy, fix, and hold.

The buy-and-flip strategy

The buy-and-flip strategy can also work with existing homes that the investor can purchase from a motivated seller at a wholesale price that is below the market value. The investor may not even have to close escrow before finding a buyer willing to pay a retail price. There may be some minor cosmetic work or simple improvements needed before reselling, but typically, buy-and-flip investors really make their money when they buy at a discount and then locate a buyer at full market value.

You generally can only do work on a property that you have closed upon and own. Even if a seller allowed you to do work on it before closing, you’re taking a huge risk (loss of your money and time spent) doing it in the event that the deal ends up falling apart for some reason (such as you don’t get financing, an inspection finds something concerning, and so on).

This high-risk strategy requires a rapidly rising real estate market with higher than normal appreciation rates to allow for profits on short-term investments. Not only do you have to have excessive demand driving up the prices of real estate, but you also have to cover all of the costs of real estate. With online stock trading firms, you can buy shares of your favorite company in minutes with relatively low transaction costs. But with real estate, the costs of buying, holding, and selling a property are much higher and unknown, and generally include

• Acquisition costs: Due diligence and inspection fees plus loan fees/costs and points
• Transaction costs: Closing and escrow fees
• Repair or upgrade costs: Costs and contingencies to renovate or fix property to make it more desirable and generate the highest resale price (unless the property is brand-new)
• Holding costs: Property taxes, insurance, and any negative cash flow while the property sits vacant or if the rental income doesn’t cover the carrying costs
• Sales costs: Commissions and title insurance from the sale of the property

Even during the weak real estate market in the late 2000s, you saw late-night infomercials promoting the flipping strategy, but they often cited examples with just limited information. These ads featured an average Joe who invests his excess income in a fixer-upper down the street — he pays $150,000 for it and then sells it for $200,000 after replumbing the property and installing all new flooring, window coverings, and appliances. The infomercials implied that he just made a quick and effortless $50,000.

But what they don’t say is that he has $3,000 in acquisition costs, $2,000 more in transaction costs, $15,000 in repairs and upgrades, and $10,000 in sales costs for a total of $30,000. That brings the theoretical profit down to $20,000 before factoring in holding costs. Even if everything works out well for Joe, his property likely sits empty for at least six months while he renovates it, puts it on the market, and shows it to prospective buyers. So by the time Joe has completed this investment cycle, he’s quite possibly spent another $6,000 in mortgage interest payments, plus $2,000 in property taxes and insurance. His pre-tax profit is now $12,000 if everything goes well. But wait — there’s more. Because he only held this investment for less than one year, he pays income tax at his nominal ordinary earned income tax rate of, say, 30 percent, which brings his amazing $50,000 profit down to a measly $8,400.

But what if there are some additional problems with the property when Joe opens up the walls to replumb his new investment gem? Maybe there are termites or roof leaks or problems with the foundation. What if the demand for this property diminishes and he has to hold the property for 12 months? (Some folks got burned in the late 2000s when the demand for housing suddenly evaporated.) Even in the best scenario, where Joe has accurately estimated the repair and upgrade costs and there are no surprises, he finds that just owning the property for six months longer than he expected doubles the holding costs from $8,000 to $16,000, reducing the pre-tax profit to $4,000. By the time he is done paying 30 percent of that in taxes, Joe has just $2,800 to show for his efforts.

You may be located in a market that has experienced rapid housing price increases, but be careful. If there is too much excess demand for new housing in the area, real estate speculators — not long-term investors or homeowners — can make up the majority of the purchasers. This tendency can be dangerous when the majority of buyers in the market are looking for the quick profit rather than a long-term, stable real estate investment. When enough of these speculators head for the exits (as happened in some areas in the late-2000s real estate market decline) and don’t return, prices can quickly turn tail. The speculators are then forced to mitigate their losses by renting out their properties (sometimes for years) until the real estate market rebounds and they’re able to sell the property to break even.

For example, the greater Las Vegas area in the early to mid-2000s became known as a place where investors could make quick cash. The large number of new home tracts and increased demand and rising new home prices over a relatively short timeframe created an opportunity for aggressive investors to place small cash deposits on new homes that were going to be built. Typically each new phase of a developer’s project would see price increases (annualized at 10 to 20 percent in many cases) so these savvy investors would sell their holding at a profit to a buyer just about the time the new home was completed for a nice return on their investment. Las Vegas wasn’t the only part of the country that experienced this real estate investment strategy, but it was the most prevalent with an estimated 40,000 to 60,000 of investor-owned homes (many of them vacant with no demand from buyers) after the financial and real estate markets collapsed starting in mid-to-late 2007.

But we’re pragmatists — we know that lightning may strike and you may run into a property that turns out to be a buy-and-flip candidate. So in Chapter 13, we detail how to keep this possibility open by using an assignment clause when completing a purchase agreement. And we also cover possible tax drawbacks of losing the advantages of lower capital gains taxes in Chapter 18.

The buy, fix, and refinance strategy

With the buy, fix, and refinance strategy, you invest in properties where value can be added to the property through repairs, upgrades, and improvements that take a distressed property and turn it into a solid and well-maintained property with a good stable tenant. Over the years, with increased equity in the property and as long as interest rates are attractive, you could refinance the property if you so choose and use some of your equity towards other real estate investments.

We strongly prefer this method because it has proven throughout the years to be the lowest risk, highest probability way to make money in real estate. You can think of it as the tortoise in the old tortoise-and-the-hare story, where the hare is the fast-money, high-risk, high-return strategy. The tortoise may be slow and steady, but he ends up winning in the long run. As an example, Robert is a conservative person by nature, yet he has acquired a significant real estate portfolio by simply purchasing well-located but often distressed properties and renovating, filling them, and then refinancing and holding them for the long run.