In this article I am going to touch on the highlights of one Creative Finance technique which can enable you to structure an acquisition with $0 of your money in the deal. I can not possibly go into as much detail as is necessary within the scope of this article. But, I do hope to whet your appetite and point the space craft that is your thought-process in the right direction. Much research on your part will be necessary should you desire to utilize this technique. This is advanced creative finance stuff; it’s not for the beginner and it’s not easy. But – it works…
Before I begin with the specifics, I must alert you to the fundamental reality which, although indeed fundamental, nonetheless gets missed by a lot of investors, and it is this:
All value in real estate does not reside in bricks and mortar. In fact, a lot of value in any given real estate transaction resides in terms of financing and what you can and cannot do with this financing. A lot of the expandability in any given transaction is therefore a function of the financing package, and the technique discussed herein certainly falls squarely within the subheading of expandability (I’ve covered this concept in many other articles). And with this, let’s dig in:
Related: 4 Things to Remember When Shopping for Multiplex
EXAMPLE
Suppose you find and want to purchase a nice little triplex in a solid B neighborhood. Each of the 3 units in the building can rent for plus or minus $600/month, for a total gross income of $1,800. Let’s just say, for the heck of it, that you are like me and you manage to finance the entire $120,000 purchase price – it wasn’t easy but you did it.
Now, let’s say that at the time of acquisition 2 out of the 3 units are vacant, and you take this opportunity to immediately remodel the units in order to attract better-qualified tenants. Let’s say that you finance the rehab with a line of credit, so it doesn’t take any money out of pocket.
Let’s say that between the purchase price and the remodel you are into this deal at $130,000, and fully rented it cash flows over $200/door per month for a total of $600/month.
45 days after the purchase, or as soon as all of the leases are in place, you go to your commercial lender and begin the process of refinancing the building. Why – many reasons, but mostly because you want to cash out that line of credit that you used to fund the rehab since you want to do another deal just like this one utilizing the line.
Well – your lender advises you that he will refinance purchase and rehab not to exceed 70% of the appraised value. He orders the appraisal, and let’s just say that the appraisal comes back at $155,000.
BUT – THAT’S NOT ENOUGH
Well, of course that’s not enough – you are sharp kid indeed! 70% of $155,000 is $108,500 – that’s what you have to play with. But, you are into this property at $130,000 of which $10,000 is the rehab. Besides, you want to wrap the closing costs into the loan as well as pay for the rate caps.
To keep it simple, let’s just say that if you were to take as much money out of the refi as you need to cover your costs, based on a valuation of $155,000 you’d be short about $30,000 relative to being able to cash out the original loan for $120,000.
But, this has to be cashed-out as part of any refinance – or does it…
Related: Pop Quiz: A Challenge in Creative Financing
HERE’S WHAT YOU DO – if you are anything like me, that is…
The total amount of the cash out is $108,500. You allocate $18,500 toward your finance charges, rate caps, and to recapitalize your line of credit. This leaves $90,000 available. You cash out $90,000 of that initial loan of $120,000, which leaves a shortfall of $30,000 – this is where you get creative, as in Ben Leybovich creative…
SUBSTITUTION OF COLLATERAL
You move, as in re-collateralize, this $30,000 with another property. In other words, while this money started out being collateralized by the subject, as part of getting this transaction completed you substitute a different piece of real property as collateral on this $30,000…
This little maneuver is called Substitution of Collateral (Substitution of Security). Obviously, the lender will need to go along with this, and as far as this is concerned – don’t look to your vanilla banker to saying yes on something like this. This is an act out of a play called Private Money.
OK – in concept this is as simple as that; you’ve just financed the purchase and rehab of an asset that in the end still cash flows $500/month (less than at the outset since now you’ve financed higher balance, but enough).
Simple it is, but simple it’s not. I could spend an hour discussing all of the caveats and all of the moving parts. I don’t have an hour, but I will give you a few pointers here and you know how to find me if you need more information:
CAVEAT 1:
The original Note holder must agree to substitution of security; this isn’t something you can do behind someone’s back unless you are comfortable with fraud – not recommended. So, what kind of lender do you work with that will go along…?
CAVEAT 2:
That $30,000 which is now sitting collateralized by a substitute security needs to be SAFE, which means several things:
- Substitute security must have enough equity to sufficiently collateralize $30,000
- Substitute security must throw off enough income to sufficiently cover the payment of an added $30,000 debt service.
- The DSCR (debt service coverage ratio) must be no less than 1.2. In fact, I suggest that the DSCR should be no less than 1.4 for everyone to feel safe.
- Substitute security must be of quality equal to or higher than the original subject.
CAVEAT 3:
You must have a workable and reasonable plan as to how you will eventually cash-out $30,000.
CONCLUSION
Well – there it is. Just like this you can finance purchase and rehab of a cash-flowing asset with the eventual result of having no money in the deal. In case you are wondering, yes – I’ve done this rather routinely over the last decade, so this is not just theory.
Someone once told me that not having money is easily overcome in the world of real estate by having knowledge. They were right! Some day you will have the money, but for now remember – not having money is not a good reason not to start in real estate.
This is just the tip of the iceberg of what you need to know, but hopefully it gives you a moment of pause.
Thanks indeed for reading.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
