It’s Not What You Pay, It’s How You Pay For It

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Topics: Financing

    Different States treat debt obligations differently; so borrowing money to buy houses carries different levels of risk associated with financing.  In California, a person can owe hundreds of thousands of dollars on a house, and if things don’t work out, simply hand the house back to the lender and walk away without any liability.  But, in many States, if you personally guarantee a loan, even after a house is foreclosed, you will still have to pay any losses the lender incurs if the house sells for less than the loan balance.  You could spend years working to repay off what you owe while the interest-clock ticked on.

    When I buy a house for resale, I seek financial terms that don’t inflict personal liability for debt.  My favorite target is a house that has an existing loan on it that I can take over with no liability.  Here are some ways I do this:

1.    If I take title by means of a Grant Deed or Warranty Deed, I want to include language to the effect that “the Grantee is taking title SUBJECT TO any liens, encumbrances, encroachments, covenants, easements, and restrictions of records.”

2.    With a Quitclaim Deed, I don’t need to add any of that language because it is implicit in a Quitclaim Deed that I’m only being conveyed the equity that the other person has, subject to any defects of claims on title by others.

3.    As a Trustee, Corporate Officer, LLC Managing Member, if I add “and not individually” after my name, I bear no personal liability for loan repayment, and can hand the property to the lender if I can’t make things work out.

4.    If, instead of borrowing money to buy a property, I give the seller the same down payment, but for an Option to buy the property at an ever increasing price in lieu of paying interest on a risky loan.  Thus, I avoid all liability for any debt.

5.    I can buy the property on a contingent contract, and don’t have to complete the sale unless certain contingencies are removed.  My favorite contingency language is: “The buyer shall not be bound to this contract, and all earnest money shall be returned until the buyer has examined and approved the condition of the premises, the title, and the financial arrangements as of the date of settlement.”  This gives me a lot of last minute leverage to get no-risk financial terms.

Price is critical when I buy a house to resell, but when I buy a house as a long-term rental, financial terms are paramount.  I’m willing to pay more to get seller financing that I can comfortably repay out of rental cash flow.  Suppose a free and clear $200,000 house could be bought for $160,000 for quick cash, but I had to borrow the money at 10% interest-only from a private lender; my payments would be $1,333.33 per month plus another $3,000 or so per year for taxes and insurance.  Let’s say that over a full year, my rents averaged $1,250 per month less about $250 per month in operating expenses.  It’s going to cost me about $4,000 per year to own this house.  I might be able to afford one house like this, but not ten houses.  In other words, negative cash flow seriously limits the total wealth I can build by holding houses for long-term appreciation and amortization.

    Suppose, I pay full rental value for the house in return for two things: a small spread on cash flow and zero interest.  Let’s say my financial terms might call for two $100,000 loans:  The first loan to be paid back with payments of $1,000 per month for 100 months.  The second loan to be repaid in a single balloon payment at the end of 100 months.  I would raise this by either refinancing the house or selling it.  The seller will be paid in full in 8.5 years.  Using the same operating expenses, I will break even on my cash flow from day one, and can continue to buy houses.  Comparing these two approaches, if the house appreciated at 5% per year, at the end of 10 years it would be worth $325,779.  In the first instance, I would still owe $160,000 and have paid $40,000 out in negative cash flow.  In the second instance, I would have amortized $100,000 of the debt and have $100,000 debt left to pay.  Over the long term, financing, not the market, is what creates the equity.

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