Chapter 17

Tactics and Financing

Bulls make money. Bears make money. Pigs get slaughtered.

—Wall Street Saying

Money Makes the Deals Go 'Round

Access to financing is critical to real estate investing. As we learned earlier, it is a key driver of economic fundamentals, and while access to capital can't impact a shift in the real estate cycle on its own, access to financing is one of the factors that can team up with other key drivers to force a cycle shift. The central role that financing plays in virtually every real estate deal also makes it a tactic that individual investors can employ to manage their own portfolios.

In the wake of the global economic meltdown, lending institutions have tightened their regulations and made conventional financing less accessible. There are more rules and regulations in place and, as we discussed earlier, the financing cycle followed by banks may or may not coincide with the needs of a strategic real estate investor. Consequently, strategic investors will likely find themselves employing creative financing tactics at different times of the real estate cycle. Creative financing can take on many forms, with joint-venture partnerships, vendor take-back mortgages and RRSP mortgages being the most familiar tactics utilized by strategic real estate investors. Again, strategic investors align their financing tactics with their experience and expertise as real estate investors in order to mitigate risk.

Novice investors should steer clear of creative financing tactics until they have acquired the experience necessary to be considered strategic real estate investors. Joint-venture partnerships, vendor take-back mortgages and RRSP mortgages all require access to other people's money, and mitigating the associated risks demands a level of sophistication new investors do not possess. Issues with novice investors and the various creative financing options are discussed further in the next sections.

Alert

Before using other people's money you must

• know your strategy
• chose your investment tactics in conjunction with the cycle
• prove your track record
• always treat the money as if it were your own

Joint-Venture (JV) Partnerships

A joint-venture partnership is defined as an agreement between two or more parties to undertake an economic activity together. Depending on what resources each party contributes, there are many ways to structure a JV agreement. In its simplest form, one of the parties is responsible for finding a potential property, doing due diligence, handling the purchase and undertaking property management, while the other party provides the down payment and closing costs. The latter is sometimes called the money partner.

Investors generally turn to JV partnerships when they have used up their own financial resources and need more capital to expand their portfolios. It is a creative financing tactic aimed to provide benefit for both parties. The “real estate expert” is able to grow his portfolio without injecting further capital and the “money partner” is able to invest in real estate without the hassles of looking after the tenants or properties. Of course, due diligence is required before entering into any joint-venture partnership and proper legal documents need to be in place in order to protect both parties.

JVs and the Cycle—JV partnerships are common throughout all phases of the cycle, although each phase brings distinct challenges. Experienced investors in need of financing will find that the boom phase is the optimal time to find and form joint-venture partnerships. This is when consumer confidence in real estate is at an all-time high and the immediate returns are appealing for those wanting a good return on their investment. There are many willing candidates, both experienced and inexperienced, who are interested in providing capital resources at this point in the cycle.

Strategic investors who enter into JV partnerships are mindful of the acquisition and exit tactics that they implement during the boom. They are aware that, in the boom phase, the market does a lot of the hard work for them and they carefully consider the timeline of their investment and take measures to execute within the parameters that give the best ROI.

The boom phase is also when inexperienced investors enter the market on both sides of JV partnerships. Novice investors who have had success in the boom, usually with buy-and-holds, soon run out of funds and look to JVs as their source of capital. Unfortunately, many of these new investors are not following the real estate cycle and do not factor the impending slump phase into their pro-forma investment plan. They soon find themselves and their partners in an uncomfortably negative cash flow/equity buy-and-hold position with limited management or exit solutions.

Obtaining JV financing in the slump and early recovery phases will be a lot more difficult than in the boom phase. With confidence in the market at an all-time low, the immediate returns are not necessarily enticing. Strategic real estate investors wanting to attract JV partners during this time will need to produce a well-documented track record to obtain this type of financing. They generally will be looking for long-term investors and thus need to provide realistic financial projections that take into account the upcoming phases of the cycle.

Vendor Take-Back Mortgages

Also known as seller financing, a vendor take-back (VTB) is a type of mortgage in which the seller offers to lend funds to the buyer to help facilitate the purchase of the property. A VTB mortgage can represent the full purchase price, or can be used to top up conventional financing and be done as a second mortgage on the property.

VTBs and the Cycle—In the boom phase, when times are good (the economy is improving, employment and incomes are rising, etc.), you often see fewer VTBs. This is because the access to credit (getting loans/mortgages/lines of credit) is often easier and houses are selling at a steady-to-fast pace. As most homes sell quickly, vendors are not as willing to carry financing. In the slump phase, when the economy is slowing down, access to credit is more difficult and properties are not selling as quickly. Here, vendors with properties that they are motivated to sell are often more willing to offer financing in order to unload them.

In the slump phase, offering a VTB can often mean a quicker sale at a higher price for a vendor. Regardless of the phase of the real estate cycle, there are plenty of potential benefits to a seller who chooses to offer a VTB. The biggest benefit is that the seller can continue to profit from the property through the interest payments they will receive—even after they no longer own it.

Additionally, if the property up for sale is not their primary residence, offering a VTB can defer the tax bill that results from capital gains if the property value has increased significantly over the ownership period. The benefit to the buyer is that she is able to purchase the property and can grow her portfolio without qualifying for conventional financing. The buyer also gets more control and flexibility over the terms of the financing agreement than she would if she was negotiating with a bank.

Strategic real estate investors who find they want to divest a property may want to consider offering a VTB to take advantage of the tax incentives and additional cash flow.

If you choose to hold a VTB, it's important to understand that there are drawbacks and risks involved. The level of risk varies depending on whether you are holding a mortgage in first position or in second position, and at what loan-to-value ratio the property is leveraged to.

Additional risks arise when VTBs are transacted in the boom phase of the real estate cycle. If you are holding a VTB in the first position and the borrower defaults, you will have to go through the foreclosure process. If you are going through the foreclosure process and the slump phase has already started, your property has likely lost equity—not a good position to be in. If you are holding a VTB in the second position and the property drops in value, there may not be enough equity left in the property to pay you out after it's been liquidated. The first-position mortgage holder gets paid out first and many second-position mortgage holders get paid a higher interest rate due to this risk. The risk can be mitigated by only holding a second-position mortgage that brings the total loan-to-value up to a maximum of 80 per cent. Depending on how far values drop from the origination of the mortgage, this still may leave exposed risk.

Strategic real estate investors can utilize VTBs if they are looking to purchase additional properties or want to divest and gain extra cash flow. Regardless of whether you are the purchaser or seller in a vendor take-back mortgage, both parties need to be in contact with their team of professionals to guide and advise them throughout the process.

A Case in Point

Switching Tactics, Not Strategy

Julie Broad and Dave Peniuk are married real estate investors who currently live and invest on the West Coast of Canada. They have been investing for more than a decade and have first-hand experience doing VTBs in buyers' and sellers' markets. Julie has written about the intricacies of VTBs on her real estate investing website www.revnyou.com. She recently shared some insight into some of her and Dave's experiences, including some details on how obtaining VTBs differs at the different phases of the cycle.

Dave and I started investing in B.C. and Ontario in the early 2000s; we started out doing buy-and-holds using traditional conventional financing. By 2002, the market was starting to pick up, but there were still a lot of people who had their properties on the market for quite a long period of time. Prices hadn't skyrocketed yet. We found a lot of sellers had paid off their property and a lot of investors were just tired of holding the property they'd owned for many years. We found there were quite a few sellers whose mortgages were long paid off and they were willing to carry VTBs as a way to continue to make money from their rental property without having to deal with tenants or toilets. After buying a few properties conventionally, we started to look for more creative ways to invest. We came across an investor who was ready to sell his property and who was willing to carry a second mortgage VTB to top up conventional financing to 100 per cent of the purchase price.

That same year we found another investor with a portfolio of properties she wanted to sell. She was slowly exiting the real estate market completely after decades of investing. In order to get a deal done she offered us a VTB for 80 per cent of the purchase price.

The great news for us was the market went up so much right after we'd purchased that property that we were able to put conventional financing on it within a year and use the extra money to buy the property next door!

For us, using VTBs was a way to continue to expand our portfolio and not have to qualify with the bank. It also allowed us to be a little more creative in setting the terms of our deals. One of the best parts of having a VTB in a heating market is the ability to get conventional financing on the property when the value increases, pay out the VTB without a penalty, and increase your cash flow (if the interest rate you're paying to the bank is less than the rate paid on the VTB). The downside was that these properties were older and in rougher areas—which was a motivating factor for the sellers to offer VTBs; they needed a lot more TLC and time commitment from us than some of our other properties.

We continued to look for more sellers willing to finance deals but as the real estate market went into the full boom they were really tough to find. Homes were selling fast and for so much more money than most sellers expected. There was little interest from any sellers to carry financing. In the rare case where we found a seller willing to carry financing, it was usually one of the worst homes in the worst neighbourhoods and not something that fit our investing profile.

Today, with cooler housing conditions, lower prices than some sellers want to accept, and terribly low rates on GICs, we're once again finding more sellers willing to entertain the option of financing some of the property to increase their return, speed up the sale and get a good price for their property, albeit the terms aren't as lucrative as they were in 2002. We find many builders looking to sell their final couple of homes in a project, homeowners and investors who are willing to offer a VTB. The issue for us is that most of them are only able to offer a smaller percentage or dollar amount, as they don't own the home outright. Generally any seller that openly advertises that they will carry financing is either looking to sell their home for much higher than its market value or their home is not as desirable. This is especially the case in the boom phase!

No matter what phase of the real estate cycle you're in, there is only one way to know if a seller is willing to carry financing . . . ASK!

RRSP Mortgages

Canadian tax regulations allow self-directed RRSP funds to be used for a non–arm's length (one not involving a relative) mortgage investment, provided that the mortgage is insured. Most Canadians don't realize this is a great way to raise capital to grow a portfolio; it is likely the most underutilized form of creative financing available. It is beneficial because it reduces the need for bank financing and can enable you to buy with little or no money down. RRSP financing can also be used for more than just purchasing a property; it can be used to refinance a property to pay for renovations or to purchase more properties.

Just like any other tactic, RRSP money needs to be analyzed in the context of the real estate cycle. Investors must also understand that borrowing other people's RRSP money is the same as dealing with a private lender: you do need a plan to pay the money back.

RRSP Mortgages and the Cycle—From the beginning to the mid-boom stage of a cycle, RRSP mortgages are a great tactic to capitalize on the equity appreciation that occurs in a boom phase and own the property with little or no money down. Strategic investors are cautious of using this tactic after mid-boom, when balloon payments will come due in the slump and cash flow is strained. As with any tactic, it is important to do proper research and diligence. RRSP Secrets, written by Greg Habstritt, is an excellent resource for Canadian investors wanting to explore this tactic further.

A Case in Point

Bad Timing, Wrong Tactic

It was late 2007 and Jack had just completed a weekend seminar on how to raise investment capital using RRSP mortgages. Always one to take action, Jack hit the ground running Monday morning by picking up the phone and contacting a number of people he knew would be interested in earning higher rates of return through their RRSPs by investing in real estate.

The local real estate market was booming and it was easy for him to find people to invest their RRSPs with him. In a matter of three months, Jack used this tactic to purchase five properties with very little of his own money down. The terms were very straightforward, with a 10 per cent monthly interest payment with a principle balloon payment to be made in three years' time. Thanks to the boom, Jack had found properties with enough cash flow to service both the first mortgage and the RRSP second mortgage payment. Jack's plan was to refinance the properties and use the proceeds to make his balloon payments to the RRSP lenders at the end of the term in 2010, leaving him with five properties and very little of his own money put into acquiring them.

Initially the plan was working perfectly because values were rising. Then things began to change as the slump emerged. By the end of 2009, all five properties were worth less than what he initially paid for them. His refinancing plan was no longer an option, leaving Jack with almost $400,000 in balloon payments that would soon be due in 2010.

Fortunately for Jack's investors, he had a portfolio with enough equity built up that he was able to divest those properties and raise enough money to make his balloon payments. Unfortunately, that required divesting all his properties, minus the five properties that were now worth less than what was owed on them. In addition, once the slump occurred, rents also dropped and his five properties were no longer generating enough income to make the remaining first mortgage payment.

Implementing RRSP mortgages at the wrong time in the cycle taught Jack a very expensive lesson, and it's one that he vows never to repeat.

Chapter Summary

Always Prepare for the Cycle Shift

The creative financing options offered by joint-venture partnerships, vendor take-back mortgages and RRSP mortgages are essential to the strategic real estate investor's list of practical finance-management tactics. These are effective tools for the investor who seeks to grow his portfolio using non-traditional financing options.

But the two case studies printed in this chapter illustrate some of the intricacies that strategic real estate investors face when employing financial tactics throughout the different phases and stages of the real estate cycle. In the first, we see a couple who realizes the different trade-offs when obtaining vendor financing at different times. In order to grow their portfolio with full vendor financing at one time in the cycle, they were willing to assume the challenge of moderate-risk properties. With the cycle shifting, full VTB financing then came with a much higher-risk price tag, one that Dave and Julie were not willing to pay for properties that didn't even fit their profile.

In the second study, a sole investor gets caught up in the excitement of a booming cycle and fails to look at how a future slump—which is entirely predictable for students of the real estate cycle—will work against his investment goals. Instead of stress-testing his portfolio and working toward cash flow and equity appreciation with deals that work in any phase of the cycle, Jack lets greed (and the fear he may be missing out when there's money to be made!) destroy what he'd worked so hard to build.

The fact that Jack learned from his poor tactics and has vowed to never again make the same mistakes is laudable. But the real lesson is for investors at large: strategic real estate investors put knowledge of the cycle to work. Because they plan for what's coming, they can be proactive rather than reactive.

Cycle Secret

Strategic real estate investors are neither preoccupied by the future nor haunted by the past. But they do learn from the past, study the present and plan for what's coming next.

 

Alert

The Real Estate Cycle Is Real

• The real estate cycle always follows the same sequence—ignore it at your peril.
• The key drivers collectively propel the real estate cycle from one phase to another.
• Each phase offers optimal opportunity to employ different acquisition and exit tactics that work with the momentum of the cycle.
• These tactics should always support an investor's cash flow and equity goals and enable an investor to profit in all phases of the cycle.

Real estate investors who invest by these principles are strategic: they control what they can, mitigate where necessary and use the real estate cycle to make investment decisions ahead of cycle shifts.