Management is the least favorite subject of most of the entrepreneurs that I meet at seminars and real estate conventions — and many of my readers — but I can’t resist revisiting the subject from time to time. In the process of writing the book for my new seminar called “Creating Cash Flow With Creative Deals” which was presented in February in Tampa, it struck me how much income and gain was being lost by people who refused to learn how to manage single family houses.
As any speaker knows, his first task is to find a way to get people to listen before delivering the message, so, before proceeding further, let me motivate you to keep reading: If you have plenty of money in the bank, you may be able to put a lot of money down on a house, or to feed a negative cash flow alligator, you may be able to pay the price of not learning how to manage rentals. On the other hand, if you are being hampered in your quest to establish high net worth and income by the lack of money and negative cash flow, being able to manage property will give you tremendous advantages over those who won’t or can’t manage. How?
Being able to acquire and support highly leveraged houses is the how real estate fortunes are made. When I first started buying houses, interest rates were just about at the same level as they are now. With virtually no credit or money in the bank to fall back on, when I bought a house my principal tactic was to take over the existing financing and to get the seller to finance most of the remaining equity.
Those times weren’t much different from today. When owner-occupants could borrow almost all the money it required to buy a house, and pay the owner cash, seller financing wasn’t easy to get. Most sellers had absolutely no reason to sell on any terms other than cash. I made a decent living from brokerage commissions during this period, but I wasn’t getting any richer. A long time ago someone coined the phrase, “Necessity is the mother of invention.” I finally figured out that the only people I’d be able to buy houses from were those who either couldn’t sell their houses with conventional financing, or who couldn’t find buyers who would buy them.
Long before the “Ugly house” guys were out of diapers, I was making it a point to find houses that couldn’t be financed on FHA and VA terms. More often than not, this was caused by some problem with the title, lot size, zoning, design of the house, or the way it had been constructed. I made the rounds of accountants, lawyers, and title companies to let them know that I was willing to buy houses at wholesale prices and to solve the financing problem if the sellers they came into contact with would be willing to carry the financing until the house sold.
In other situations, anytime that a sale fell through because a buyer got cold feet at the last minute, or because a loan wasn’t funded, I paid a bounty to any title company that would tip me off. I’d rush over to try to buy the house on creative terms from the disappointed sellers. Often, they who had mentally already spent his profits, or who had actually gone ahead and either bought a replacement house, or who had contracted to buy one. I’d also rescue the buyer and try to sell him a house that I might have for sale on creative terms. Sometimes, I could work both ends against the middle by finding a way to combine buyer’s and seller terms.
As I came up with more and better creative ways to do this, I began to see a pattern emerging: I had less and less competition and was being called by new customers referred to me by title companies, lenders, and other brokers to whom I paid a fee based upon my profit. I advertised in the National Roster of Realtors that “Jack Miller Pays 20%” (of the net profit he makes on any deal) which led to my my being sought out by brokers in other towns who sent me people who were relocating to Tampa and for whom they were selling homes. Then I had a my epiphany: Don’t sell, buy!
EXPLOITING SELLERS’ URGENCY . . .
If anxious sellers don’t like creative financing, and are willing to wait for months to find a cash buyer, and/or are willing to accept a lower price for their house in order to get a faster sale, there is an opportunity for the entrepreneur. I tried to exploit the sellers’ impatience in a number of ways:
1. I would encourage them to seek a “bridge loan” which would give them the cash with which to buy their next home (if I could participate in the commission). I’d lease their old home with an Option to buy at a wholesale cash price and they would thus be able to move into their new home, knowing that their payments would be made. I’d only do this if I felt that I could sell their home quickly with only minimal cosmetic fix-up. As you’ll see below, if I found a weak buyer, I could sell the home on a contract while I continued to make my payments on the sellers’ loan whether or not I received any on my contract. This way, my credit rating protected the seller while I got paid a profit for taking a chance on my buyer’s ability to sustain payments.
2. If the sellers had very little equity, I would buy the house on a “One Dollar Wrap”. I’d sign a non-recourse wrap-around Note and Mortgage and make arrangements with the collection department of the local bank each month, out of payments on the “wrap” that I deposited into the account, to make payments on the underlying loan . This made the owners feel secure while I let the bank do the bookkeeping for me.
I’d immediately try to re-sell the house at a higher price, interest, and payments to buyers who couldn’t qualify for conventional financing. I used an installment sale contract, thereby “wrapping” my “wrap” without conveying title to the buyer.
3. I would buy their old home by taking title “Subject to” the original mortgage loan. I’d use a “Single Payment Note” which called for me to pay them the full retail value of their equity when I sold. I made it clear to them that I would make no effort to sell the property until I could recover at least 110% of all of my costs up to the point of sale. For example, on a $100,000 house on which there was a $40,000 loan, 110% over my price meant that I’d earn 16.67% on their $60,000 equity plus rental cash flow compared to a 7% brokerage fee. I soon discovered that this approach had hidden benefits that weren’t readily apparent to the naked eye:
A. It was perfect for relocating owners who didn’t want, or couldn’t afford, to make payments both on the house they were leaving behind and the house they hoped to be able to buy at their new destination.
B. This didn’t require much out-of-pocket cash. I usually bought the house with “Nothing Down” other than the financial breathing room I gave anxious owners.
C. In almost every case, because I only had to make payments on older loans with smaller loan balances and lower interest rates, I was able to enjoy positive cash flow from rents. As you can imagine, I was in no hurry to sell any property that produced net positive income. Eventually, impatient owners were usually delighted to have me pay off my Single Payment Note at 80% on the dollar of the loan balance in order to get their hands on cash without waiting for the house’s sale.
D. Even in a worst case situation, if I were able to collect $10,000 in net profit upon sale, it would have been $3000 more than I’d have made with a full commission; better yet, it would have been taxed as long term capital gain rather than ordinary income. I avoided payroll taxes as well as ordinary income tax rates that could be as high as 70%.
The key to #1 and #3 above was my being willing, able, and ready to manage the property until I sold it. I must admit that I liked all three ways to buy houses creatively, but I liked #3 best because in almost every instance I was able to realize almost 50% more in low-taxed profit than I would have made in real estate commissions, and often I made even more profit by buying the house at discount. This was my break-out technique. In Reagan’s real estate recession, brokers who shied away from management fell by the wayside in droves while I thrived on rents.
PROPERTY MANAGEMENT MEANS PEOPLE MANAGEMENT . . .
There are only a few fundamental ways in which equity can be converted to income: Income can be extracted via harvesting; such as when you mine it, fish it, or pump oil and gas out of it. It can be sold for cash, or on terms that produce interest and principal payments. It can be improved, and the improvements sold along with the property. (This is most remarkable when a mobile home is added to a vacant lot.) It can be rented to others who either can’t afford to buy, or who don’t want to. I’ve done all of the above; each has its pros and cons.
Harvesting depletes equity. When I chop down trees, I have to wait for a generation for them to grow back. If I sell, I’ve lost all future growth in value of the property, and the money or interest income received are taxed before I get a chance to use it. But, when I rent it, I get the best of all worlds. My equity produces indexed cash flow that I can increase almost at will, and equity continues to grow in value by virtue of loan amortization, market demand, and inflation.
As a long time low-level employee, I must admit that much of what I like about property management is that fact that I get to be boss. I look at my tenants in the same way that a supervisor looks at his staff. When I’m renting up a house, I’m doing a lot more than just filling vacancies; I’m selecting a team to help me increase my net profit at the least possible expense. So, not only do I check their credit references, but also their qualifications and overall attitudes, to make sure that their objectives will support my own.
When I’ve mentioned my approach to real estate agents and fee managers, they pose all sorts of legal reasons why I can’t select my tenants. They labor under limitations that an owner can avoid. First of all, their clients are less concerned with how hard they work than on gross income, so they adopt a first-come, first-in policy. The impatience and ignorance of their clients virtually guarantees that they’ll have higher turn-over, higher vacancy rates, and higher maintenance. In so many words, those who don’t like management create their own problems because they don’t rigorously screen out those applicants who would occupy their property.
I begin the process of managing a house at the time that I buy it. As a rule, the price I pay and the terms I negotiate are predicated on the use to which the house is to be put. When it is going to be held for long term income and appreciation, it must be selected so that it will attract the kind of tenants I want; and it must be financed so that it will produce income; or in lieu of income, extraordinary profit over my holding period. With the exception of mobile homes, highly leveraged conventionally financed houses rarely produce income unless they are older, smaller, and in bad areas. Creative financing affords me a chance to deal with middle class houses and tenants that I screen very carefully.
My first rule for applicants is that I won’t forgive even a smudge on their credit record. Boiled down to basics, a spotty credit record means that the applicant makes implied promises of future payment for services, utilities, credit cards and other deferred payment accounts; then pays only those that the most convenient. I have no reason to suspect that paying rent won’t also become a matter of convenience. The tenants I deal with have to manifest a firm resolve to meet their financial obligations, and the ability to earn enough net income to do so.
Next, I want to explore how closely their standards of cleanliness and routine maintenance matches my own. Bear in mind, that even if I’m merely leasing a house with an Option, one day I expect to own it or to sell it. I’ll want it to be in good condition at that time. If I expect residents to do minor maintenance and to meet my standards, I have to create an incentive for them to expend extra effort. I not only build bonuses into my rental agreement that reward them for this, but also will increase my investment in a house to expand space and make improvements if they will agree to participate by paying higher rents. When they offer to make improvements themselves, I don’t pay them, but I also don’t raise rents for years. I’d rather rent a better house with happy tenants than with higher rent. SANDWICH LEASING CREATES INCOME; OPTIONS CREATE WEALTH
Those of you who are unhappy landlords probably can’t imagine having tenants who average over ten years of residency. I’ve had two tenants who have lived with me over 20 years. I’ve had a tenant pay for their house twice over. I don’t work very hard. I usually see the outside of my houses once a year when I make a cursory check to be certain that the exteriors are being maintained. Good tenants get only token rent raises. On the other hand, poor maintenance is rewarded with high rent raises accompanied by a note explaining why residents are going to pay extra for repairs and landscaping if they don‘t do it. If they stay, my rent raise is a form of “paper training” to improve performance. If they leave, they will have done me a favor. Reflecting good and bad tenant performance in rents works wonders. Even with $1000 annual rent raises, I didn’t lose any tenants because of the quality of the neighborhood where my rental was located and the freedom from interference I gave them. Unlike many landlords, my houses are well maintained and even after increases, my rents are competitive. Moreover, unlike many landlords, I treat my residents with respect as I would any employee.
Being able to attract long term residents opens up two fundamental ways to use “Sandwich Leases” to make two different kinds of profit. The person who is just starting out without much cash or credit can negotiate to lease a higher priced property in a better area that wouldn‘t make any sense at all as a rental if its purchase had to be highly leveraged with a conventional loan. A “sandwich lease” is nothing more than a basic lease which contains a provision for the tenant to sub-lease the property. When approaching owners to obtain a sandwich lease, it’s important to make a good impression. Be neat, groomed, and convey a sense of reliability. Even though, by leasing their property you will be solving a financial or management problem, you’re still asking them to trust you with their house. One lady, who was nervous about leasing her pristine house, agreed to do so only if she could approve the tenant I selected. That worked out well for me. No money was due until her approved tenant had paid me his. When you can sub-lease it to a long-term tenant, you’re virtually guaranteed trouble-free income for years.
Another use of the Sandwich Lease is for the investor, who doesn’t like management, to fob off these chores to another in return for some of the gross rents. One eager young man formed a management corporation that managed houses for owners using a “performance sandwich lease”. He only pays 90% of the rent he collects from his sub-tenant, less out of pocket operating costs. He passes extra costs on to his sub-tenant. He makes several thousand dollars each year doing this. Sandwich leases can be magical when combined with a credit toward purchase Options.
When it comes to optioning property, there are all sorts of variations that can be used to solve specific needs of the parties. For instance, well-heeled sandwich lessees can pay owners more than is collected in sub-rents in return for a credit against the purchase of a home. For instance, a person might get a credit of 150% against an Option price for each payment to the owner in excess of market rents. Or, one might Option a house in need of a lot of repair in return for a percentage of the profit when the house is fixed up and sold. Rather than buying a pre-foreclosure and leasing the property back with a purchase Option to the former owner (which is a real no-no); have the owner convey the property into a Trust that you control. Let the owner occupy the house. Let the Trustee use Option payments to cure any loan default and keep payments current until you exercise your Option.
You can Option high-equity pre-foreclosures by offering to pay the distressed occupants monthly rental payments in return for part of the equity. For instance, suppose a $300,000 house had a $200,000 mortgage; but, because of being laid off, owners could only make $1500 of the $2500 payment. You could agree to supply the missing percentage of the payment (40%)for a corresponding percentage of ownership (40%) of the house. Where else could you buy what amounts to a $120,000 house already occupied by a happy resident with nothing down and $1000 per month?
Copyright © Sunjon Trust All Rights Reserved, www.CashFlowDepot.com. (888) 282-1882
Quotation not permitted. Material may not be reproduced in whole or part in any form whatsoever.
