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The Art of Creative Financing
Monday, December 21, 2009
Sources of Creative Funding
The following is not a complete list by any means, but it should give you a few ideas of where to start your search for sources of funding:
Other investors
Partners
Hard-money lenders
The property itself
The seller
The Realtor
The buyer
The renters
Options and leases
Underlying mortgages
Special first-time home-buyer programs
Down-payment assistance programs
Your rehab contractor
Local city, county, or state government (i.e., special loan programs)
Government grants
Private grants
A wealthy relative or family friend
An often-overlooked way to help finance a property is to use the Realtor as a source of funding. If the buyers/investors have done a good job of selecting their Power Team, they will have a creative set of Realtors to work with. You may well have to educate the Realtors on your team to think outside the box, but the effort will be worth it in the long run. Creative Realtors will be willing to work with you to put together solutions to get the deal done.
Most people just assume that the real estate commission is a fixed-cash portion of a real estate transaction, usually paid for by the seller. In reality, however, the real estate commission is not fixed in any way. Real estate commissions are a negotiable item and are flexible in form, source, and rate. If the real estate industry were to publish uniform, fixed rates, there would surely be legal trouble and allegations of price fixing.
How and whenthe commission is paid is also a negotiable item. Most people just assume that the commission needs to be paid in cash at closing. This creates higher cash-outlay needs for the seller of the property. Your goal as the investor/buyer, however, is to conserve your cash outlay on each property so you can buy and control more properties. In other words, you want to come up with the smallest down payment, in cash, that you can. With a real estate agent, normally you have a greater cash outlay but you want to part with less cash. So, how do you resolve this problem?
One way is to get the real estate agent to carry their commission on a note, which you will be responsible for paying. This doesn’t lower the amount of the down payment amount, but it does lower the amount of cash the seller has to pay at closing; thus, reducing the amount of cash you need to bring to closing.
For example, let’s say you are purchasing a home for $200,000 and the home is listed with a real estate agent who is owed a six-percent commission. The seller is willing to carry a contract on the property if he gets $20,000 cash at closing. In other words, he wants $20,000 cash out of the deal and will carry the balance of $180,000 on a first-mortgage contract. But he will owe a six-percent ($12,000) real estate commission at the closing. He will still do the deal, but he wants you, the buyer, to come up with $32,000 down, so he will still get his $20,000 in cash, minus some closing costs. You have the $20,000, but not $32,000.
What do you do? One thing you can do is negotiate with the real estate agent to take a note for the $12,000 commission. If two agents are involved, then two notes at $6,000 each would be required, or even four notes depending on the agent’s contracts with their real estate brokers. Just remember, everything is negotiable, so be creative. Most real estate agents are shrewd enough to realize that a commission, in the form of a note, is much better than no commission at all. So ask! In this case you would end up with a seller carry-back note of $168,000 and a real estate commission note for $12,000.
The notes carried by real estate agents can be created in many different ways and with a variety of terms:
Simple promissory note with one balloon payment for the face value of the note, due at some point in the future (no-interest note)
Simple promissory note with one balloon payment of principal and interest due at some point in the future (interest-bearing note)
Simple promissory note with monthly payments starting when you get the property rented and a balloon payment due for the balance at some point in the future
Simple promissory note with monthly payments starting immediately and a balloon payment due for the balance at some point in the future
A simple promissory note due and payable when you sell the property (if your plan is to fix and resell the property)
A mortgage note, secured by a second mortgage on the property
A mortgage note, secured by a mortgage (first, second, or even third position) on another property you own
Rather than creating a note, you could give the agent a percentage ownership in the property and they could share in the monthly cash flow from a rental or the proceeds from a sale
Instead of a note, you could offer your services (i.e., if you are a contractor, painter, landscaper, website designer, merchant, or restaurant owner) in exchange for the commission
You could offer to trade something of value that you own (i.e., a car, a motorcycle, a boat, or anything of value) for the commission
This is only a partial list of the ways the real estate commission payoff could be structured. Let your creativity run wild. Think outside the box.
If the real estate agent really needed money now, they could sell their note at a discount and get cash now. Notes secured by a mortgage against the property would be more saleable than just a promissory note.
Investor Tip #1 – Whenever you create a note as part of the purchase of the property, whether it is a seller note or a real estate agent note, be sure to add a clause to the terms of the note that gives you (the note payer) the first right of refusal to buy the note should the note holder (the seller or the real estate agent) decide to sell the note. If you have the cash at the time, buying your own note at a discount makes a lot of sense.
Investor Tip #2 – If you create a note with a balloon payment due sometime in the future, always try to negotiate a clause in the note that says if you cash out the note early, you will get a discount off the face value of the note. For example, if you have a $12,000 note due in full in two years, you could negotiate a payoff of say $10,000 if you pay the note off within the first year, and an $11,000 payoff if you cash out the note before 18 months. Be creative. Remember, you will never get anything for which you do not ask.
Investor Tip #3 – Negotiate an automatic extension for the due dates on the note when it is created. You don’t want to be in a position of not being able to pay the note off when it is due and having to beg for an extension. Most agents will work with you, but it is always better to have an agreement in writing defining what happens if you can’t pay off the note when it comes due. If it is an interest-bearing note, you may need to increase the interest rate on the note, or add some other sweetener to get an automatic extension. Hope for the best, but plan for the worst. If you are prepared, the worst is usually not that bad.
As a real estate investor, you should always try to conserve your cash. Putting the least amount of your cash money into the down payment on a property is one way to conserve cash. Say you have $20,000 cash to work with and you find a $100,000 property that you can buy, subject to the $80,000 first mortgage. You could use your entire $20,000 for a down payment and do the deal. Nothing wrong with that, but you will only control $100,000 worth of real estate.
Instead, why not try to structure the deal to have the seller carry a $15,000 second mortgage, allowing you to get into the property for $5,000 down. Do that three more times and now, with your $20,000, you control $400,000 worth of real estate. Do you have the potential to make more owning $100,000 worth of real estate, or with $400,000 worth of real estate?
As you can see, there are many different ways to structure a deal. The key is finding out what the seller really needs out of the deal and then being creative in giving them what they want. And don’t forget to ask those real estate agents to carry their commission on a note. If the agents on your team are not willing to carry notes for their commission, you should consider adding other agents who will.
The more creative techniques you are familiar with, the easier it will be for you to successfully negotiate a winning deal for all parties involved. We will discuss additional creative-financing techniques in future articles in this series.
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The following is not a complete list by any means, but it should give you a few ideas of where to start your search for sources of funding:
Other investors
Partners
Hard-money lenders
The property itself
The seller
The Realtor
The buyer
The renters
Options and leases
Underlying mortgages
Special first-time home-buyer programs
Down-payment assistance programs
Your rehab contractor
Local city, county, or state government (i.e., special loan programs)
Government grants
Private grants
A wealthy relative or family friend
An often-overlooked way to help finance a property is to use the Realtor as a source of funding. If the buyers/investors have done a good job of selecting their Power Team, they will have a creative set of Realtors to work with. You may well have to educate the Realtors on your team to think outside the box, but the effort will be worth it in the long run. Creative Realtors will be willing to work with you to put together solutions to get the deal done.
Most people just assume that the real estate commission is a fixed-cash portion of a real estate transaction, usually paid for by the seller. In reality, however, the real estate commission is not fixed in any way. Real estate commissions are a negotiable item and are flexible in form, source, and rate. If the real estate industry were to publish uniform, fixed rates, there would surely be legal trouble and allegations of price fixing.
How and whenthe commission is paid is also a negotiable item. Most people just assume that the commission needs to be paid in cash at closing. This creates higher cash-outlay needs for the seller of the property. Your goal as the investor/buyer, however, is to conserve your cash outlay on each property so you can buy and control more properties. In other words, you want to come up with the smallest down payment, in cash, that you can. With a real estate agent, normally you have a greater cash outlay but you want to part with less cash. So, how do you resolve this problem?
One way is to get the real estate agent to carry their commission on a note, which you will be responsible for paying. This doesn’t lower the amount of the down payment amount, but it does lower the amount of cash the seller has to pay at closing; thus, reducing the amount of cash you need to bring to closing.
For example, let’s say you are purchasing a home for $200,000 and the home is listed with a real estate agent who is owed a six-percent commission. The seller is willing to carry a contract on the property if he gets $20,000 cash at closing. In other words, he wants $20,000 cash out of the deal and will carry the balance of $180,000 on a first-mortgage contract. But he will owe a six-percent ($12,000) real estate commission at the closing. He will still do the deal, but he wants you, the buyer, to come up with $32,000 down, so he will still get his $20,000 in cash, minus some closing costs. You have the $20,000, but not $32,000.
What do you do? One thing you can do is negotiate with the real estate agent to take a note for the $12,000 commission. If two agents are involved, then two notes at $6,000 each would be required, or even four notes depending on the agent’s contracts with their real estate brokers. Just remember, everything is negotiable, so be creative. Most real estate agents are shrewd enough to realize that a commission, in the form of a note, is much better than no commission at all. So ask! In this case you would end up with a seller carry-back note of $168,000 and a real estate commission note for $12,000.
The notes carried by real estate agents can be created in many different ways and with a variety of terms:
Simple promissory note with one balloon payment for the face value of the note, due at some point in the future (no-interest note)
Simple promissory note with one balloon payment of principal and interest due at some point in the future (interest-bearing note)
Simple promissory note with monthly payments starting when you get the property rented and a balloon payment due for the balance at some point in the future
Simple promissory note with monthly payments starting immediately and a balloon payment due for the balance at some point in the future
A simple promissory note due and payable when you sell the property (if your plan is to fix and resell the property)
A mortgage note, secured by a second mortgage on the property
A mortgage note, secured by a mortgage (first, second, or even third position) on another property you own
Rather than creating a note, you could give the agent a percentage ownership in the property and they could share in the monthly cash flow from a rental or the proceeds from a sale
Instead of a note, you could offer your services (i.e., if you are a contractor, painter, landscaper, website designer, merchant, or restaurant owner) in exchange for the commission
You could offer to trade something of value that you own (i.e., a car, a motorcycle, a boat, or anything of value) for the commission
This is only a partial list of the ways the real estate commission payoff could be structured. Let your creativity run wild. Think outside the box.
If the real estate agent really needed money now, they could sell their note at a discount and get cash now. Notes secured by a mortgage against the property would be more saleable than just a promissory note.
Investor Tip #1 – Whenever you create a note as part of the purchase of the property, whether it is a seller note or a real estate agent note, be sure to add a clause to the terms of the note that gives you (the note payer) the first right of refusal to buy the note should the note holder (the seller or the real estate agent) decide to sell the note. If you have the cash at the time, buying your own note at a discount makes a lot of sense.
Investor Tip #2 – If you create a note with a balloon payment due sometime in the future, always try to negotiate a clause in the note that says if you cash out the note early, you will get a discount off the face value of the note. For example, if you have a $12,000 note due in full in two years, you could negotiate a payoff of say $10,000 if you pay the note off within the first year, and an $11,000 payoff if you cash out the note before 18 months. Be creative. Remember, you will never get anything for which you do not ask.
Investor Tip #3 – Negotiate an automatic extension for the due dates on the note when it is created. You don’t want to be in a position of not being able to pay the note off when it is due and having to beg for an extension. Most agents will work with you, but it is always better to have an agreement in writing defining what happens if you can’t pay off the note when it comes due. If it is an interest-bearing note, you may need to increase the interest rate on the note, or add some other sweetener to get an automatic extension. Hope for the best, but plan for the worst. If you are prepared, the worst is usually not that bad.
As a real estate investor, you should always try to conserve your cash. Putting the least amount of your cash money into the down payment on a property is one way to conserve cash. Say you have $20,000 cash to work with and you find a $100,000 property that you can buy, subject to the $80,000 first mortgage. You could use your entire $20,000 for a down payment and do the deal. Nothing wrong with that, but you will only control $100,000 worth of real estate.
Instead, why not try to structure the deal to have the seller carry a $15,000 second mortgage, allowing you to get into the property for $5,000 down. Do that three more times and now, with your $20,000, you control $400,000 worth of real estate. Do you have the potential to make more owning $100,000 worth of real estate, or with $400,000 worth of real estate?
As you can see, there are many different ways to structure a deal. The key is finding out what the seller really needs out of the deal and then being creative in giving them what they want. And don’t forget to ask those real estate agents to carry their commission on a note. If the agents on your team are not willing to carry notes for their commission, you should consider adding other agents who will.
The more creative techniques you are familiar with, the easier it will be for you to successfully negotiate a winning deal for all parties involved. We will discuss additional creative-financing techniques in future articles in this series.