IS FLIPPING WITH LITTLE OR NO MONEY POSSIBLE?

I am often asked if flipping with little or no money is actually possible.  I use to think that it was not really possible to flip a house with no money.  I felt that it was necessary to have some of your own money invested, either during the purchase or during the rehabbing.

Recently I have been working with another flipper who frequently uses a hard money lender.  A particular hard money lender he uses did not allow second mortgages on the property being flipped.  The lender wanted to see that the flipper had some “skin in the game.”  It is not unusual for a hard money lender to write into their note/mortgage that no second mortgages are allowed.  So, when this flipper found a great house to flip, and had his money with other projects, what did he do?

Well, we figured out of way of getting 100 percent funding for the flip.   We had to provide some security without putting a second mortgage on the property.  What did we do?  We found another investor who normally funded flippers, but he also usually wanted a first mortgage with no seconds.  After showing him the past experiences and successes of my flipper friend we made him an offer that he could not refuse.  

We offered to put his LLC on the deed as part owner of the property.  The property was quitclaimed to him after the closing.  He was then 50% owner.  Now, in order to secure his funding, and put him at lower risk, a note was prepared which indicated the amount of his investment and the interest rate that he would receive.  The investor was not participating in any income or loss from the sale of the flip when it was completed.   He was getting his principal back with an agreed upon interest rate.  Since that time I have worked with flippers who have also been able to do this.  So, as you can see, finding the right investor and using this tactic can lead to flipping a house.  This shows it can be done with little or no money of your own.  As long as the numbers work, it can be worth doing.

TRANSACTIONAL FUNDING FOR WHOLESALERS

Transactional funding for wholesalers has become more and more prevalent when a double closing is needed to wholesale a deal to an end buyer.  Essentially, transactional funding is a short term loan which funds a real estate closing for a short period of time.  This allows a wholesaler to actually buy the property from the original owner first.  Once that initial closing is completed the wholesaler then sells that property to the rehabber/flipper by having a second  closing within a short period.  This is usually referred to as a double closing.  Both closing take place with little time passing between the first and second closing.  Often they are done back to back.

The transactional funding party will generally take the appropriate steps to verify that the end buyer has been approved for closing and has the required funds in place before they will fund the first part of the deal.  The fee charged by a transactional lender is usually between 3 and 4 points (the percentage of the principal amount of funding).  Generally if the deal extends beyond a 24 hour period you will find that there will be a pretty steep interest rate charged to the wholesaler, in addition to the points, which will cover the number of days that the loan is outstanding.  Interest may be as much as 12 to 14 percent in many cases, which should inspire the wholesaler to get the deal done very quickly.

Transactional funding of a wholesale deal is not uncommon.  It seems like the concept of this type of lending has become more prevalent since the collapse of the real estate market.  Traditional lenders became more weary of certain types of funding once the real estate market situation changed.

The bottom line is this, if transactional funding is the only way to close a deal and you will make money by using this source of funding, do it.

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FLIPPING OR HOLDING MULTI-FAMILY PROPERTIES

A positive result of rehabbing a multi-family property is that you have an automatic “plan B.”  Once you are done you can decide whether to flip it for an immediate profit or hold it for rental income.  There are a number of considerations and calculations you must examine when making that decision.

There are calculations such as cap rate, cash on cash return, rent as a percentage of purchase price, rent percentage of purchase price plus rehab cost and the ratio of operating expenses to operating income.  Debt service coverage ratio becomes particularly important if you are thinking of conventional financing through a lender or refinancing after some experience with renting the property.  Be aware that any multi-family less than 5 units would not be viewed as commercial property by a conventional lender.  That generally means that you will have to show the lender that you are capable of handling the debt by disclosing your personal income and source of funds.  In a commercial transaction you can usually get the lender to consider the income producing property as a stand-alone business without you having to worry about what your personal income is.

Let’s look at some of these numbers.  Cap rate (capitalization rate) is calculated by dividing the annual net operating income by the purchase price of a property (or possibly market value).  So, if a property net operating income is $20,000 (which does not include any mortgage or debt used to finance the purchase of the building) and the building is selling for $200,000 then the cap rate is 10% or 10.  $20,000 divided by $200,000.   For smaller rentals I personally do not pay attention to cap rate.  If there are 6 or 7 units in the building I will ponder it, but if it may not be a deal killer.  In areas like Manhattan or Fairfield County, CT you will find very low cap rates 2, 3 or 4 may not be uncommon.  Buyers of these properties are often looking more toward appreciation then what their return in current income is going to be.  Cap rates in less affluent areas will normally be in the double-digit ranges for good deals.  But again, it is not the only thing to consider.  Generally it is felt that the higher the cap rate the better the deal you are probably getting.

I think cash on cash return should be a consideration in a multi-family buy and hold situation.  After all, if you only get a 3 or 4 percent return on your money then there are probably better secure investments for you.  I calculate the cash on cash by taking the actual cash flow on the property and dividing that by the actual cash you use to purchase the property.  So, if the net operating income on a cash basis is $20,000 in the first year and you then deduct your loan payments, let’s say $10,000 for the year, you have $10,000 of cash flow.  If you had to come up with $40,000 cash to get the building, then your cash on cash return is $10,000 divided by the $40,000 you needed to get the building, or 25%.  That looks like a pretty good use of your cash.

I consider rent as the percentage of the purchase price and the purchase price plus rehab to be a “must compute” type of calculation for analysis and holding rental property. At a minimum, I am looking for the monthly rent to be equal to or exceed 1 percent of the cost of the property.  At one percent I am not crazy about the deal, but if the current rents are too low and I think they can be raised or increased by getting new tenants I would consider the building.  If you can get a 1.5 to two percent rate I think you are doing very well.  So, let’s look at the calculation.  Again, we will say the cost of the building is $200,000.  Let’s say we get $3,000 in rent each month.  The rent as a percentage of the price of the building is $3,000 divided by $200,000 or 1.5%.  This, for me, is acceptable.

I do not like to see operating expenses being more than fifty percent of the operating income.  I include it that calculation a reasonable estimate for vacancy loss as well as a reserve amount.  This calculation with the rent loss estimate and reserve amount included in expenses is probably too conservative for many multi-family investors, but that is a personal preference and I am always willing to consider the pros and cons of this calculation given current market considerations and longer term projections.

The last calculation I will mention is the debt service coverage ratio.  As I mentioned before, if you are looking for conventional refinancing or a bank loan this is an important calculation to a lender along with the cash flow.  Most lenders that I have talked to are looking for a 1.2 or 1.25 ratio.  Some may go with a lower ratio, but plan on a 1.2 or1.25 minimum requirement.  The debt service coverage ratio is the net operating income amount divided by the loan payment amount.  So, if we have $20,000 of net operating income, (which must consider vacancy loss, which should automatically be accounted for when using actual numbers), and our annual loan payments total $15,000 the ratio is $20,000 divided by $15,000 or 1.33, which is acceptable. Presented on a monthly basis, the monthly net operating income is $1,667 divided by $1,250 which is 1.33.  This would be considered an allowable ratio.  So, if the lender was confined to a 1.2 ratio or better, and wanted to see what the maximum monthly allowable loan payment is, the lender would take the $1667 monthly net operating income and divide that by 1.2 to say the maximum allowable loan payment allowed would be $1389 per month.  In this example the monthly loan payment of $1,250 is perfectly acceptable.

Using a spreadsheet when considering multi-family properties before you make a deal allows you to properly estimate your annual income and expenses and then calculating these rates, ratios and numbers. This will help you make a more informed and intelligent decision when considering your alternatives before purchasing a multi-family property that needs work.

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IRC Section 1031 Like-Kind Exchange For Real Estate Investing

Real estate investors should be somewhat familiar with the IRC Section 1031 like-kind exchange rules.  It is important to talk to your tax professional if you are considering selling investment property and getting (replacing it) with another property. The IRC Section 1031 rules allow favorable tax treatment when a like-kind exchange of certain assets occurs.  You are allowed to defer gains on the sale of an asset if it is replaced with like-kind property.  It is a tax deferral, not a tax free exchange.

This exchange must be done within prescribed time periods.  Basically, there are two time periods you must follow.  The first requires you to identify a replacement property within 45 days of disposing of the first property.  Identifying means a written agreement that should be delivered to the seller.  The second time element is the requirement that you must acquire the replacement property within 180 days of disposing of the initial investment property.  There is a bit of a catch to the 180 days.  It must be acquired within the 180 days or before you tax return for that year is due, whichever is less.

Depending on the way the exchange is done, your transaction may require a third party intermediary or facilitator. Per an IRS release,  “It cannot be someone that you have used within the past 2 years.  You cannot act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) cannot act as your facilitator. ”

When you do qualify for the IRC Section 1031 like-kind exchange you must report that on your tax return using IRS Form 8824.

I am attaching a link to an IRS document which provides clarification and publications references pertaining to this issue.

https://www.irs.gov/uac/like-kind-exchanges-under-irc-code-section-1031

 

Rehabbing a Bathroom

Rehabbing a bathroom is an important step in a fix and flip situation.  Generally, if you want to get the best results you will find yourself replacing toilets, sinks, bathtubs, tile, flooring, tubs and showers.  You have to be careful about how much you spend in a bathroom makeover.

Prices for tubs, showers, sinks, tile and toilets vary tremendously.  When flipping you want the bathroom to look great.  You also do not want to use products that look cheap.  You need to find decent materials that will look great and will last for a reasonable amount of time.

Kitchens and bathrooms are probably the two rooms that need the most attention when flipping.  Sometimes you will find a bathroom with porcelain tubs and tile that may look worn but really doesn’t have anything wrong with it.    These items may even be a better quality,  when originally installed ,then the products that you intend to use for the flip.  Instead of ripping it out the old items consider refurbishing the tub and tile through a glazing process.  Redoing the coloring and glazing in a tub and on tile will make the bathroom look as new as replacing those items.  You can also change the colors.  There are a number of people who do this, and a good job could save you some cash, which means more money in your pocket.

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Calculating the Maximum Allowable Offer

CALCULATING THE MAXIMUM ALLOWABLE OFFER

 Calculating the maximum allowable offer (MAO) on a rehab project can be the beginning of a great return or the beginning of the end.  Knowing what your maximum allowable offer is will probably be the most important thing you do prior to your purchase.  That being said, you have to know that all of the components  going into the maximum allowable offer calculation are independently as important.  If you don’t get all of the parts right then you obviously don’t get the big picture right.

There is a quick and dirty calculation that many flippers use to calculate their maximum allowable offer.  That calculation starts by determining the after repair value (ARV) and multiply that by 70 percent.  It is often advisable to use a 65 percent calculation rather than 70 percent.  How you do it depends on how conservative you want to be and what is happening to the real estate prices in your area.  After doing the multiplication you then take that answer and subtract the rehab expenses.  The resulting amount becomes your maximum allowable offer.  This figure basically becomes your top-end offer, not your starting offer.

I have always used a spreadsheet instead of  this type of calculation.  If your spreadsheet is set up correctly you can do a fairly quick calculation without losing much time before you make your offer.  With a spreadsheet, you are able to see both the raw dollar amount of your projected profit as well as the amount as a percentage.  The spreadsheet allows you to put in specific amounts for buying expenses, rehab cost, holding cost and selling expenses.  You get a more precise picture of where the money is and you are able to make a more educated and confident offer.  Without a doubt, a spreadsheet is the best way to go.