Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to [email protected].
Question from Louis in CT: Hi Brian, I’m looking for an innovative way to make real estate investments. I’ve been at this for a while and I’m tired of being a landlord. I’ve also dabbled with rehabs but I’m not the kind of investor that likes to get my hands dirty or hassle with contractors. My ideal investment could be done mostly from my home office. I’m probably pushing your creative side but what have you got?
Answer: Hello, Louis. I think I have something that might interest you. Seller financing is often associated with ‘For Sale by Owner’ or a one-off business deal when an investor has difficulty selling a property for some reason. However, there is a business model for investors that actually builds an inventory of seller-financed houses that creates a long-term stream of monthly income. The two most advantageous elements of this business model are that you don't have tenant problems as a landlord and you earn money using other people's money.
The way this works is you buy houses at a deep discount. There are plenty of them out there when you know where and how to look for them. Usually, these houses are in disrepair and won’t sell on the retail market. However, you don't need to fully rehab them when you are offering seller-financing. Seller-financing is what attracts buyers rather than a house in pristine condition. You might take some risk selling to people with less than a stellar credit history but big rewards can come from that risk.
Louis, this business model often works best in working-class neighborhoods. That is where you are most likely to find rental houses and other houses for sale that do not attract retail buyers. Rental houses that landlords have allowed to fall into disrepair and owner-occupied houses that have not been maintained. These aren't the only houses that work with this model but these make a good example.
Rehabbing these houses and flipping them is the business model most investors are familiar with. That's because the flipping model enables investors to pull all of their money plus the profit out when they sell to a fully qualified buyer. When you seller-finance a less qualified buyer, you don't invest in repairs but you do have to take your profit over 20 years instead of all at once. That's where other people's money comes in.
Private financing has become widely available for several reasons. For one, in our high-tech world, it's simple to connect with people that have money to invest. All sorts of funding sites have popped up on the internet. There is also plenty of money available to borrow. One major source for the money is the retirement accounts of the 71 million baby boomers. Many are looking for investments secured by real estate rather than gambling on Wall Street. A good place to look for these retirement funds is people with Solo 401k retirement accounts. Real estate is a primary investment for a Solo 401k.
The basic business model is to put two contracts in place. One with the investor to obtain the funding at a specific interest rate. This loan is secured by the real estate that you are purchasing. Your advantage is that you are cashing out the seller at a discounted price for a less than pristine house. You then write a second contract with a buyer who pays substantially more because you are offering seller financing.
Because you are taking a risk with buyers that have less than pristine credit, you can charge a higher interest rate to the buyer than you pay for the loan. Let's say you sell at 10% interest. Your cost for the other people’s money is 8% and you collect the 2% in the middle. For you, that's better than zero-interest financing. You are completely upfront with the person loaning you the money for the purchase because they will know you are immediately selling the property when the title transfers to the end buyer. It’s a business arrangement. There is no reason to hide what you are doing.
You're also selling for a big profit. Not only are you earning money on the interest rate spread, but you also sell for 50% to 70% more than what you bought it for. That’s fast cash in your pocket. You won’t be unscrupulous because you’ll sell for what the market is willing to pay. But with seller-financing, you don’t need an appraisal.
Some people are going to think this is unethical but you're actually providing a value-added service to everyone involved. A major key to the selling formula is that the mortgage payment has to be close to the average rent in the neighborhood. You enable buyers to own a home for the same cost they would otherwise be throwing away rent money (even when they are paying a higher interest rate). For the other people's money, you are offering a predictable rate of return secured by real estate. You do need to be upfront with the other people by letting them know that the real estate isn't always worth the full amount of the loan (you bought at a deep discount and didn't make any repairs). Your ace in the hole is that you have a business model that can again sell the house using seller financing if a buyer defaults on the loan.
The business model means you need multiple funding sources to get started and build an inventory of long-term seller-financed houses. That's where other people's money plays a key role. You may need 20 or 30 monthly income streams coming in before this business model becomes self-sustaining without needing additional other people’s money.
There are consumer protection laws that apply to this business model. Also, laws vary by state. Make sure you fully understand these laws before implementing this business model.
Please share your thoughts and comments about investing in seller-financed houses.
Also, our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions, inquiries, or article ideas to [email protected].