On today's podcast, John talks about the pitfalls and perils of nothing down deals with George Eaton.
John Wilhoit: [00:00:00] Today’s topic is No Money Down Deals: Pitfalls and Perils. I have with me George Eaton. George is a longtime friend. We've known each other for over 20 years and George has recently retired from the Maryland Housing Fund. George was the Director of Credit Assurance.
George Eaton: [00:00:19] Multi-family, but within the Division of Credit Assurance; multifamily, single-family and neighborhood businesses.
John Wilhoit: [00:00:26] I bring him to the program today because he has a world of experience dealing with exotic transactions and those exotic transactions have had all the layers in the capital stack and that's something that George has had to deal with for a very long time.
[00:00:45] With today's topic, which is no money down deals, or nothing down deals, George and I don't necessarily agree on every point and that's what hopefully will make this for a good discussion. Because we have so many points to cover anticipate that Nothing Down Deals will be Part 1 and Part 2 on this podcast.
[00:01:06] So George, with that, where would you like to start?
George Eaton: [00:01:09] Well we can start with the concept what does nothing down normally mean? Most people think, oh well nothing, down means I don't put anything down on a project and I move forward and I'm very successful. The story is not always that way. Coming from my background, one thing I do bring to the podcast is we did a lot of loans. We did a lot of loans where there was very very little money down, like with HUD, VA the same kind of loans done by those institutions where you can get a loan with almost no money down. Instead of thinking of these loans being for single-family houses that you and I might live in they were multi-family houses because they came with different regulations and responsibilities.
John Wilhoit: [00:01:56] That that part of the capital stack, or that layer of financing, brought not only a level of complexity to the transaction but, also I would suppose, an added layer of risk for the borrower.
George Eaton: [00:02:10] It certainly did. In fact, one of the things that would take place and most people (Consumers) aren't aware of this; that many of the multi-family loans that were given in not only are state but in other states have an aspect of what’s called "Cash Flow loans." In other words, if you don't make any money you don't have to pay an additional principal down on that particular loan. That's something you don't get with loans in the regular consumer market.
John Wilhoit: [00:02:41] And I think that's a distinction we have to make in our discussion here. When we're talking about no money no money down deals, most people are thinking about single-family homes or small multifamily. But the same types of transactions occur at a much larger scale.
[00:02:56] So George we need to distinguish if we're going to talk about single-family predominantly or multi-family predominately. The single-family market probably has more usefulness to are our listeners. And then maybe we can bring in retail and the same types of information that relates to larger multifamily deals.
George Eaton: [00:03:18] That would be fine. I agree with you.
John Wilhoit: [00:03:20] Let's start by talking about the pros and cons of no money down deals.
George Eaton: [00:03:27] Let's talk about the first thing with a no money down is that it’s very attractive because you're sitting in your living room looking at an investment and you say, well, here's one where I don't have to have any money down and I can be an investor and a player in a real estate market. That's absolutely true. But with no money down comes certain things. One of those is usually when you're asking for no money down, it's hard to ask when you purchase a property, for any kind of a concession; a concession being painting, a small plumbing repairs, fixing some electrical items or some small carpentry items. So all of a sudden you've taken away one of the benefits that you have of being able to ask for something more than just no money down.
John Wilhoit: [00:04:10] You are really saying the negotiation is already bent towards the seller in a no money down transaction because the seller is holding all of the cards including all of the equity in the property which you are asking them to either carry or structure in some other format.
George Eaton: [00:04:29] That's absolutely right. One of the questions I would always ask as an investor is; do you have any money going forward to carry property-related issues? One of the things that was always said in the industry is one's ability to make a down payment is a clear indication of one's ability to handle loan terms. In other words:
…if you don't have enough money to put some money down where are you going to have that money you run into a bad month and you have to make a mortgage payment to the person who you borrowed the money from?
John Wilhoit: [00:05:04] Right. In the most simplistic example as if it's just a simple single-family and the property is $100,000 and it rents for a thousand dollars a month, property that you purchased with no money down, if you do not have a tenant or a resident paying that $1000 a month, where does that money come from that month if you don't have any cash reserves? So even in a no money down deal it really does behoove the buyer to have cash or capital on hand to cover those rough spots.
George Eaton: [00:05:36] And that's a considering too, as you just stated, that you have a vacancy. If you don't have a vacancy what you find is when you buy a property at or above full value without any down payment (cash down payment) then your mortgage payments is probably going to be equal to and in many cases may even exceed your monthly rental income.
John Wilhoit: [00:05:58] If it's in no money down deal and the PITI (principal, interest taxes and insurance) is a thousand dollars a month but it only rents for $800 then that's a $200 monthly negative but it's $200 monthly negative every month until such time as rents increase. And that presumes no vacancy. So people who say I can carry $200 dollars a month. Well that's before repairs.
George Eaton: [00:06:25] Well it's also based on how many months can you carry it. Because one of the things we just saw as recently as 2007 was a decrease in values of the property and all and then rents started shifting around and questions were coming out "how do I pay for this for four years, five years, six years" and for many people it turned into that. All of a sudden you see the value of your property decline because the market declines and you're wondering I've got a debt or I've got a mortgage note for the full amount of what I thought the property was worth and now it's worth 15-20 percent less.
John Wilhoit: [00:07:02] At which time most people want to walk away. But if it's a no money down deal there's a very high probability that you sign something that correlates to a personal guarantee. We'll get more to that later. But on the front part of the transaction, George, I presume that most people that are getting into a no money down deal are using some form of exotic terms. Explain that a little bit- something outside of the norm.
George Eaton: [00:07:32] With exotic terms, if you're trying to get that loan (a loan of the equity from the seller in a no money down deal) lots of times the seller will say, OK well I'll give you that loan, but let's just put in terms to I want to protect myself. One of the most common is a balloon payment. Here's the payment for five-years and in five-years I'd like you to pay it off (in full) which indicates to the buyer or the investor that they've got five years to deal with this extra money that you say we're putting up front and not getting any real income.
We've got five years to deal with this and by that time my equity would have increased, my property would be kept in a good position and I'll be able to get a loan and now get a new loan which is conventional and pay off that balloon or that mortgage note that's there. That's a good idea if everything goes that way. I think you were saying that earlier in the in our discussion was hey if everything goes OK, if all the stars align everything will be fine. So that's one exotic loan.
[00:08:33] Another exotic type of loan is interest only where you pay interest only for let's say five-years then the balloon comes up, well, you haven't paid down any principal. In many cases on some of these loans if you miss one or two payments the person who's got to note it's going to say I think I'd rather have the property.
John Wilhoit: [00:08:55] Right. And then all the time energy and effort that you placed into that transaction, even if it's been running fine, at the end of the term something has to occur; there's a trigger point on no money down deals, almost always, whether it's a balloon, whether it's an increase in payment, whether it's a required sale to get the original seller all of their cash.
Something happens at a trigger point that people (buyers of no money down deals) invariably are not prepared for. That's when no money down deals fall apart; when that trigger occurs and the buyer has not prepared for that event.
George Eaton: [00:09:38] Yes that's right. The important thing about this John, as you were saying, if you don't have a corpus of funds to use to take care of the property to meet these needs its going to happen very quickly and that's where your investment falls into trouble. And remember too when you bought this house, or this property, we've already said that there may be other terms that may be exotic but when someone some one asks I'd like to take money back on this, normally not only they're asking exotic terms but they're thinking why should I take a money back risk if I'm not getting just a little bit of immediate benefit, such as the full price, the absolute full price that I want or maybe a small premium. So you may at the beginning have backed yourself into a corner by paying a small premium just to get that no money that loan.
John Wilhoit: [00:10:26] And that gets back to that perfect world where the buyer is presuming that we have appreciation. Well that's not true. It used to be.
Appreciation is not an annualized event that you can count on like interest on money in the bank.
Even if it is only a quarter percent or a half percent that is money in the bank. But in the real world it's market driven with respect to real estate assets and markets are uneven. Economies are uneven. They can be regional. They can be city-specific or even one side of a city over the other. And let me just use Atlanta for example. Pre-recession prices were at X. Post-recession, ten years later, the northern part of Atlanta has covered recovered fully whereas the southern part of Atlanta is still at numbers, or valuations, less than prior to the recession. So it's the same market but various submarkets have not recovered. So there's an uneven recovery. We cannot presume appreciation is even. And if you're looking at a no money down deal, particularly one that's fully valued at purchase, as George was saying, it's an interest only loan you're still going to owe the exact same amount at the end of the term when that event happens when there is a payoff required, or additional equity infusion required at the end of that period.
[00:11:54] If it's interest only then the full amount is still due even if it is five years out. And we cannot presume that there is appreciation. Yes there are other types of yields on real estate such as income, depreciation, tax benefit that is different depending on your tax bracket. There is appreciation which is not guaranteed and there is a mortgage to pay down which in this particular example that we're using there is none. So you're really only relying on two, three at the most, of the types of yield that can be provided from real estate in a no money down deal. So, George with our last point here let's talk about what I consider to be the highest level of risk in any no money down deal. And that is personal guarantees.
George Eaton: [00:12:43] When you sign them you sign yourself up for the debt that you have for that particular assets but you also sign yourself up for a situation where you may be visited with the buyer saying I've got the property back now but now that I have property back I'm still missing $15-20,000. So I'm going to file a deficiency and that deficiency has to be filed against that person and it goes to the court and the court may come back and say well you know Mr. Jones you do own another $20000 to that mortgage.
John Wilhoit: [00:13:20] And unlike a bank when you're talking about real property and no money down deals deficiencies based on personal guarantees can carry on past when a property is given back to the original seller. So that's the issue that most people don't realize or are not aware of with respect to no money down deals; if the transaction which is already at a high level of value, if the transaction doesn't go according to plan and the buyer reverts the property back to the seller if there is any deficiency and there is a personal guarantee then you the buyer are also liable for that. And that's the part that I think most people are missing with respect to no money down deals.
George Eaton: [00:14:08] I think you're right. I think one of the things that a few years ago, back in the early 2000s, when we had to foreclose on some houses we were actually foreclosing on houses and offering people the opportunity to get a realtor, sell the house, and then pay us back the note because you've lost your job, you're not employed anymore. Things have happened, you've gotten a divorce. So many things could happen outside of the house itself that you have to be prepared to carry that also.
[00:14:35] If we would foreclose on a house and get a hundred thousand dollars and they would have a note for $92000. Well we can't keep more money than what belongs to us. So they'd get a bit of money back. But as you said, as the market changed people were ending up with deficiencies instead of money back from the foreclosure of a house even when they had paid and established some equity in the investment.
John Wilhoit: [00:15:06] What George is referring to is when the state was involved as the mortgagee. Is that a fair statement?
George Eaton: [00:15:13] Well it's the state and the other banks we worked with because many times, we talked about exotic lending, there's a first and second and third loan in many cases.
John Wilhoit: [00:15:22] But out here in the real world when people are doing no money down deals they're usually dealing with just a single seller or maybe a family that's selling the asset and that seller is not going to be nearly as forgiving as a potential government entity.
George Eaton: [00:15:39] That's true. But there were a lot of folks that did buy earlier on and had 10 or 12 years into what we think is a great deal. No money down. You remember many people got equity loans so they'd get an equity loan and almost run their mortgage back up to where it was originally. And then when it was foreclosed by the first Bank, the second Bank said wait a minute I've got a note on this too where the second bank would come in and foreclose and take a small amount just to get something out of the deal.
John Wilhoit: [00:16:12] Let's turn now to multi-family with respect to no money down deal's. Give us an example of a high-leverage deal that almost worked.
George Eaton: [00:16:28] First off, some of them did work because timing is everything and one of the things I say about the economy you just mentioned how local real estate can differ just across one city from the other side of the city.
[00:16:40] In situations where it did work normally what happened is the value of the properties went way up. Many people took their investments and resold their investments while the value was very high. Then your second investor who now had the property and had gotten favorable deals while the first person got their money out, was turning around and saying wait a minute I can't make these payments because the rental market has changed and I no longer have the income stream that I had before.
[00:17:13] So if you lose your income stream because of the economy you're in a lot of trouble in a multifamily because you've got to worry about your vacancy factor plus what the rents are that you're able to command.
[00:17:31] In our conversation we've talked about no money down deals and they sound really great. And I think you've mentioned before that yeah they are really great if they work out. But if anything changes, and there's so many variables, depending upon the terms that you get, we talked about balloon or interest only loans. We've talked about the market or the economy changing, the rental market changing.
[00:17:57] If these things change drastically with no money down and no real ability to pay for these blips in the road they're not going to work out for you. They're probably going to end up putting you in a position where you're going to shorten your real estate career by that one property.
John Wilhoit: [00:18:14] I think what most people don't realize that everyone should know at the very beginning when you go into a no money down deal is that it doesn't mean that you can go in without cash reserves. Cash reserves are a requirement just to have a shot at it. And then further than, that to assure that the deal is going to work beyond the target time when the deal has to transition from no money down into an actual purchase where there's a new loan, you have to be prepared for market eventualities or changes in the marketplace because things do not always go up in value. We are now certainly very well aware of that in the last 10 years.
John Wilhoit: [00:18:55] Wwith that I'd like to conclude part one of the pros and cons of no money down deals. And stay tuned for Part 2 on John Wilhoit on real estate.
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