John continues his talk about the pitfalls and perils of nothing down deals with George Eaton in today’s podcast.
John Wilhoit: [00:00:00] Welcome to the podcast John Wilhoit on Real Estate. This is Part 2 on Nothing Down Deals, Pitfalls and Perils. I'm here with George Eaton. In Part 1 of nothing down deals we talked about good fast and cheap and how that's not always the best thing, about how the stars really have to align for a no money down deal to work well for the buyer.
[00:00:20] I want to recap here in Part 2 a little bit about exotic terms that become normal and emphasize within this discussion that with respect to no money down deals, there is a substantial amount of peril for the buyer. We will talk a little bit about the sell side towards the end of this program.
We want you to know if you're doing no money down deals that this program is to assist you in the assuring that you're not going in blind or under the pretense that everything is easy-peasy ready to roll. You must have quality real estate counsel. We always recommend having your own attorney looking at the deal from your perspective, on your behalf. With that George talk about some of the exotic terms that are the norm in no money down deals.
George Eaton: [00:01:08] There are basically two sides of it John. I think of the first side as the basic negotiation and that's when you're going to negotiate one of the things you can potentially lose by asking for no money down to you is the opportunity to have a concession in the price depending on whatever price you want to choose if you want to get a 10 percent discount it's very hard to go in and ask for less of a buying price if you're going to be asking someone to take care of your loan for the full amount of the time.
George Eaton: [00:01:44] The second part is somewhat the same thing. The seller sometimes may say well I tell you what I'll do it I'll take the financing back but I'm not fixing that plumbing I'm not fixing that roofs issue or something that might be a major issue for you starting off and we're assuming to some degree that you're starting out with no money down because you don't have a significant amount of the money that might be put down.
John Wilhoit: [00:02:06] That's right.
George Eaton: [00:02:07] And because of that there goes your opportunity to do your repairs. Also when you're paying a higher price figure you're going to have a higher payment amount.
George Eaton: [00:02:16] The third thing angle is; there really is no asking to make late payments on a mortgage; it's not like a rent. A lot of people get confused when they think payments on a no money down deal is just like paying rent. No. You don't get to go to rent court. You don't get any of those things where you can back off. So I just won't pay and I'll catch up and and the landlord doesn't have any options. So that's the first part on concessions.
George Eaton: [00:02:41] And then there's this; which is the real exotic term part: As an example, you'll pay for five years. You make your payments and after the end of the five years you have a balloon payment. That balloon payment has got to be paid. And it’s probably not going to be refinanced by the owner because the owner really does want to get out. And if it's not refinanced by the owner you're going to have to come up with terms and you have to hope that your opportunity for getting a loan then will be better than your opportunity for getting a loan today.
[00:03:15] The other thing that may happen is they (the seller) may ask to provide an interest only loan. With an interest only loan that means that all you've paid over five-years before the balloon payment is interest only. Now mind you you're not going to have a lot of principal pay down at an amortized loan over five years, but there will be some movement.
[00:03:34] Another part that I always think about is your property, if you get into trouble with your property, and the owner knows about it they may very well try to get it back from me because they're not a bank. They may take more interest in that loan than the standard banker will.
John Wilhoit: [00:03:56] Now the arduous terms that come with no money down deals can be ultra-complex. That means that, as an example, you could be signing onto the mortgage whereas if you miss even a single payment the property reverts to the seller. That's what we're talking about when we say exotic terms; things which bring peril to the buyer; things that wouldn't even be considered on the table in a normalized cash down mortgage based loan or transaction but can be arduous, to say the least, when it comes to a seller agreeing to a no money down deal in exchange for them applying whatever standards they so choose to you the buyer for getting that deal in place.
John Wilhoit: [00:04:45] And that's why in Part I we also brought up financial guarantees and how if there's a loss at the sale that the seller could actually come back and attempt to collect those from you if there's financial guarantees in place.
John Wilhoit: [00:04:58] George let's talk about how hard it is to get concessions when you're asking as a seller for a no cash in deal.
George Eaton: [00:05:09] Think about a triangle with three sides: fast, good and cheap. You've got a three-sided triangle and can you only have two at any one time. In other words, you can get something fast and good but it doesn't necessarily come cheap. You can get something cheap and good but you can't get it fast.
When you're asking for concessions what you're basically doing is entering into the normal negotiation arena that we're getting into all the time fort buying a car or buying a house and the first thing you want to ask for is what is the price of the house. Once it's established it's very easy to go down in that you know it's $150000. Well I'll offer you $130,000 - $135,000.
George Eaton: [00:05:47] That plays out really well in most cases especially when someone's trying to move real estate but when they're getting ready to take on some of the issues that they have to take on (as the seller does in a no money down deal) they don't want to negotiate that down. They're going to want to have a higher price.
George Eaton: [00:06:03] And part of that reason is, and we haven't talked about the seller's risk, but they have to worry about the repair of the property, making certain assumptions about how you will upkeep the property, the roof repairs the basement repairs, etc. And since seller has that in mind the seller is certainly going to make sure that he gets full value for his or her offer.
John Wilhoit: [00:06:27] So that's right. And that would be what I would consider the seller's premium. We'll talk about salaries a little bit more here in a bit. One of the other perils to no money down deals is significant changes in market value. People only want to think about the upside but of course in the last 10 years we've been through both. We've seen the highest of highs, the market top, the bubble did burst.
John Wilhoit: [00:06:53] I utilized Atlanta in our example. With respect to single-family homes, Atlanta had values of x. They were different in the north and the south. But let's pick the exact same house that had the exact same value in Atlanta pre-recession. Well since then, that exact same house in the northern part of Atlanta is back to a similar value but a house in the southern part of Atlanta has nowhere near re-gained that pre-recession value.
John Wilhoit: [00:07:28] So markets change. When they come back, even if they're roaring back, even in the same market, the values can be different in different submarkets and within different zip codes or in different parts of the same city. So you can't presume that if you're in a no money down deal that if something occurs to the negative that you will have time to bring it back to previous market value. Bringing it back means before that mortgage note is due and due and payable in full you're very often hoping for a refinance opportunity, right? Some way to exit out of the short-term no money down financing.
John Wilhoit: [00:08:08] Well, market changes don't allow you to do that if they don't go in your favor. They can of course, but they don't always. And one of the reasons that the seller get that seller's premium is because there is a substantial default risk in no money down deals.
John Wilhoit: [00:08:25] That's why you don't get negotiate price. Back to good, fast and cheap; you don't get all three. You don't get price in a no money down deal. So, with market changes there's added peril to nothing down to you, the buyer.
John Wilhoit: [00:08:38] George. Talk a little bit about refinance opportunities with respect to no cash, no money down deals.
George Eaton: [00:08:46] Most lenders aren't going to give you an opportunity to refinance unless they feel secure in the amount of value that they have in their collateral. When you buy a property for 100 percent of the value you don't give them much of a cushion to protect themselves. What they have to worry about is the same things as the seller who gives you the initial financing. But the difficulty they have is they don't have the property now they don't necessarily want the property back. What they want is their loan paid. So they're going to want some collateral to be able to refinance your property and that depends on how much you are willing to pay as a penalty for refinancing. We all think of refinancing and lowering our payment but there are loans out there where you can refinance but because of your credit risk you have a higher interest rate than you may be happy with.
George Eaton: [00:09:43] One of the things we talk about with no money down, when you don't have a reserve account is that its very difficult for you to keep the property (or house) in repair. Repairs can get behind really fast.
[00:09:54] Plus once you purchase this house and you’ve paid the full amount or you paid the higher amount, maybe even a little bit over market, the first thing that’s going to happen is your taxes next year are probably going to go up and along with your taxes your insurance rates are going to go up. So for the benefit of the seller getting more money you're going to increase your tax rate and you're also going to increase your insurance cost.
John Wilhoit: [00:10:18] Let's talk about an a-typical no money down deal and let's just make the presumption it's a rental property, it doesn't have to be a single family or large multifamily. Lets say it's a $500000 property but it's a rental property. And one of the issues with no money down deals is they usually have a short-term bullet with respect to the financing. There's a balloon note that's coming due and we'll say in five-years for the sake of argument.
John Wilhoit: [00:10:44] George you've agreed to pay $500,000 for this deal. Market values have increased 1 percent per year. Well let's even say 2 percent per year. So at the end of five-years the value of the property is now $560,000 maybe $570,000 (actually $552,000 with 2% appreciation). The seller wants their cash and they want all their money out and you've got six months to refinance this deal. You owe $500,000, the deal was worth $570,000. What has to happen for you to refinance out $500,000?
George Eaton: [00:11:16] Well you've got to find a bank that's willing to play. And they are always tougher when they deal with rental properties or income properties than dealing with home-ownership.
George Eaton: [00:11:27] Secondly, you have to remember that closing costs are going to be significant for you; getting in and getting out. And when you when you take a look by the time you close the closing is again 100 percent refinancing again because you're paying all these extra expenses.
John Wilhoit: [00:11:52] That's if you could even find a lender to do that.
George Eaton: [00:11:54] That's right.
John Wilhoit: [00:11:54] The atypical lender is going to want twenty-five percent cash down or equity with respect to the refinance. If the value is $575,000 then the lender may be willing to do a loan for $425,000. And you're still $75,000 short from paying off your originating seller. So in a no money down deal, just like death and taxes, there is a day when it comes due. And when that day comes the seller has all the cards and you do not unless you have the cash to take out the originating financing which was your 100 percent of value, or value at the time. If you can't do that five-years after the purchase price, the originating purchase price, then you're going to have to come up with cash.
The no money down deal scenario isn't no money down; it’s no money down in closing.
But there is a point where there is cash required. And saying that's five years out, in some instances, that's very generous. It can often be one year or two years that the seller is willing to carry back until they can turn around and say well you did miss one payment therefore you've given up all your rights.
John Wilhoit: [00:13:14] Or the arduous foreclosure process starts because they didn't really want to sell anyway. They were giving you a chance and you aren’t able to pay them the cash out. So one of the things that I often say is that it really doesn't matter if it's a stranger or your favorite uncle; your uncle wants his money. He did the deal with you under the pretense that you could get him cash out at a certain period and you didn't perform. So, uncle or stranger, they want their money or they want their property back.
George Eaton: [00:13:48] And John as you mentioned earlier, I think in the last session, if you go into this (a no money down deal) and you don't have significant reserves there is no money for you to catch up on any concessions that the seller may have asked for (such as immediate repairs requiring dollars).
And that's a problem...
If you're not keeping the property in repair when it’s time for the appraiser he's going to be looking at and subtracting things off (like noticeable deferred maintenance). Lastly if you have any kind of tenant problems during that short one-year, or five-year window, (the eviction process) they can run not just 30 days; they can run 60, 90, 120 days depending upon local regulations and who you are renting to.
John Wilhoit: [00:14:30] What George is saying is that you have a 4-plex (in this example a $500,000 4-plex) and things go bad and two of your renters are no longer paying rent, it may not be just 30 or 60 days for you to exit them from the property. It may be 90 or 120 days.
John Wilhoit: [00:14:46] So in the no money down deal, back to what we talked about before, the stars really have to align.
Everything has to go perfect every month or you have to have cash.
And if you don't have cash for the no money down deal how do you address chronic vacancy or a lack of payment for a season if that season is one two or three months? How do you address any deferred maintenance that may keep your rents lower than they would be otherwise if you could address the deferred maintenance?
John Wilhoit: [00:15:14] That gets to our last point (before we started talking about sellers) and that's a lack of an operating reserve. If you're doing a no money down deal the premise is that you don't have a lot of cash. And if you don't have a lot of cash if you've acquired the transaction then how are you going to address deferred maintenance?
John Wilhoit: [00:15:33] Well most people will say I'm going to do it with sweat equity. That's all well and good but the pretense is that you're actually going to perform, you're actually going to do it. Whether it's painting, roofing, electrical, plumbing. These are ways to lower your expenses (using your own labor). Maybe you do your own landscaping and lawn care maybe do your own cleaning. There is ways to lower some of your expenses with sweat equity. The question is; is it enough?
John Wilhoit: [00:16:01] You're already taking a significant risk and on top of that now you're talking about putting in your very own time on a consistent basis for more than just management ut management and upkeep of the asset.
John Wilhoit: [00:16:16] George let's let's finish this session with talking about no money down deals from the seller's perspective. And I mentioned earlier that many sellers that do a no money no money down deal, they are expecting the seller's premium in exchange for agreeing to those terms.
George Eaton: [00:16:34] That's absolutely right. They do expect the premium and sometimes sellers, when they start this, they believe well this is a great deal. I'll get more paid for (a higher price) and I'll get the mortgage paid to me consistently for a year to five years and then I'll be out of the take the full bulk of my money away from property sale in a few years. Well that's all good and true, but you run into situations where you're now dealing two people you mean I think you are a you are you dealing with the buyer who's bought the property and how they will retain and maintain the property and you're also dealing (indirectly) with the tenant.
George Eaton: [00:17:21]
Tenant selection is one of the most important things you do when you run a property
If you get a bad tenant and they get unemployed, they suffer a divorce. These are the vagaries of life that happen to us every day. You'll find they can't keep the property up. You run it all kinds of issues like that; basements flooding unreported, a small kitchen fire that may take place. All those things are going to impact the value of the property. And if it comes at that time when your when your balloon is due (payment due to you- the seller) and the buyer looks at it and says, you know, if I have a personal guarantee, or if I don't have a lot of money to begin with the personal guarantee really isn't worth that much. I'm just going to escape this and give it back to the owner. So the owner has to be very serious when he agrees to make a commitment to own refinancing. That's why he asked for the concessions.
John Wilhoit: [00:18:20] I think we are confusing the terms when we say owner. We need to focus on the seller of the asset. The one that sold the asset to the person who asked for and received the the property in a no money down deal. We want to talk about the seller who's agreed to the terms and and what a no money down the means to that person.
George Eaton: [00:18:44] It means that they'll do well if they get all the terms but if they don't get all the terms and they end up with a property then the seller is not going to be happy with the owner. I think we muddy the water when we said there's really two people the seller has to deal with now although not directly with the tenant. The results of what the tenant will do to the buyer who was financed the property.
John Wilhoit: [00:19:11] So the issue for the seller is if the new owner doesn't take care of the property in a manner which they should then whether it's one three or five years later when the balloon comes to the originating seller may get the property back in much worse shape than when they sold it.
George Eaton: [00:19:30] That's correct.
John Wilhoit: [00:19:31] That's a fair statement?
George Eaton: [00:19:33] I think that's a fair statement especially considering when the buyer takes a look at a property that he paid a premium for that's now been run into the ground via roof, water and any other vandalism situations. He may say well I'm walking away from this property because it's no longer worth anything near what I pay for it even though it's the action of the buyer and himself that's caused because of neglecting to the tenants and property.
John Wilhoit: [00:20:01] Another part that comes into play on the sell-side with a no money down deal is just plain out greed, right? The thought that I can sell this property for five or 10 percent more than the actual current market value. Fine I'm going to take a shot at that. But there is risk and the risk is that the new owner doesn't keep the property up the way they should. And you already know they have limited access to cash. The seller already knows that. So, you are going into the deal with eyes open but maybe part of your eyes have been hit with some sunshine. Maybe part of your view is constricted by the higher price that you couldn't believe you were going to get (that you did get).
John Wilhoit: [00:20:45] The downside is that the probability of that property coming back to you in a no money down deal is substantially higher than it would be in a standard sale situation.
George Eaton: [00:20:59] That's correct.
John Wilhoit: [00:21:00] Think about this as a seller. If you're selling into no money down deal, consider at least requiring five to 10 percent in cash making the new owner have some skin in the game. So, it may not be a 100 percent no cash down deal. If they (the buyer) have some cash in at least you have some cushion if you reserve those funds in case you do get the property back and have to put it back together based on the disrepair that's occurred since the originating sale.
John Wilhoit: [00:21:34] There is peril on all sides, most of all for the buyer of a no money down deal, Yes, even still for the seller of no money down deals.
[00:21:45] We talk about these things here because on the Internet you can get great information that says no money down deals are the best thing since sliced bread and there's nothing better than sliced bread we're selling. And George and I are trying to present to you another side of the no money down deal for your consideration. Doesn't mean you shouldn't proceed with them but at least go in with eyes open recognizing that you need good counsel.
Realize when you go into a no money down deal even though you may have no money in the deal initially but if the deal goes bad and there's financial guarantees, or something similar, there is great potential for litigation and litigation hardly ever makes money for anyone other than for the attorneys. So, we want you to avoid that at all costs.
George Eaton: [00:22:31] It reminds me of a story. I was always a big fan of the Indy 500 for years as a child. Growing up I saw when they actually had to stop the race. They went to a fellow by the name of Bobby Unser who was one of the more famous drivers and they said to Bobby; Bobby they are getting ready to restart this race, aren't you afraid you're going to get really hurt out there the way it’s been so dangerous so earlier with fires breaking out?
Bobby looked at them said; "No. If thought I was going to end up in a wreck or get hurt or killed I wouldn't go back out there." We sitting back listening to that story recognize that the Indianapolis 500 and race cars can be extremely dangerous. Here you have a man who's saying I'm not going to be harmed out there otherwise I'm not going back out.
George Eaton: [00:23:19] It's the same thing in how we make decisions about investing. We don't think we're going to be the ones that have the bad tenants; we don't think we're going to be the ones that run into these storms. We don't think we're going to be the ones that can't keep a job or that our spouse may leave us. We need to protect ourselves from our own positive thinking to some degree and do have a reality check.
John Wilhoit: [00:23:52] And a reality check with no money down deals is?
George Eaton: [00:23:54] Is that you can end up in a situation where you lose the house, not have enough money to take care of things and ruin your credit history.
John Wilhoit: [00:24:02] And that would be the most of all unfortunate for everyone including the buyer and the seller.
George Eaton: [00:24:07] Everyone loses, John, everyone loses. One of the big issues of why we're having this discussion is so you do recognize these things and understand when you're the buyer you understand the seller's mind set and vice versa.
John Wilhoit: [00:24:21] Not that this has been the happiest of episodes but at the same time we want to present reality. And I want you to go in with eyes open. We want you to be prepared to perform when you do acquire an asset for the long-term not just for the short term. We hope you picked up more than one or two things within this episode. Please circle back and download Part 1 and Part 2 so you have our full range of thinking on the topic. Thanks for listening today this is John Wilhoit on John Wilhoit on real estate.
John Wilhoit is the Author of five books, including: "How to Read a Rent Roll: A Guide to Understanding Rental Income". Join the conversation at JohnWilhoit.com for updates, blogs, books and podcast.