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This is part three of a three part series on How to get started in real estate investing. In the first article, we discussed some of the basics of where to start. In the second article, we looked at seven different ways real estate investors make money. Today, we want to discuss three advanced ways to make money in real estate.
Options are great way to dip your toe in the water and see if you like a property, without actually purchasing it. Let’s say you find a motivated seller with a property they want to sell. Instead of writing them a standard purchase offer, you instead give them money in exchange for the option to purchase. The option gives you the right to purchase the property at a later date for a specified amount. The money you give them now, may or may not apply to the purchase. However, if you choose not to purchase the property, the option money is kept by the seller.
Option to buy
I have a friend who is a general contractor who does this with properties all of the time. If he finds a seller who is moderately interested in selling, but needs cash now, he’ll offer them a few thousand dollars now. In exchange, he requests the option to purchase the home in six months to a year. If the property needs repair, he may even invest money in updating the property, doing all of the rehab as well.
When all of the work is done, he exercises his option, buys the property outright from the previous owner and then resells the property fully rehabbed. In some cases, he may also make monthly payments to the seller, just like he was a tenant. Most of the time, the upgrades he does to the property are the only lease “payments” he makes beyond the initial option money.
You can use a standard real estate purchase agreement for an option, or you can use a special options contract. With a standard real estate purchase agreement, you might have thirty days to purchase the property. However, depending upon the seller, you might be able to make it six months or a year. Simply by making the earnest money deposit non refundable and having six months to remove all contingencies, you have created your own option contract.
When tenants think about buying a home, they often look for rentals with an option to buy. In this scenario, the tenant rents the property from the landlord, often at an above market rent. A portion of the rent then applies to the tenants purchase price should they choose to buy the home. These scenarios can be difficult to find, especially in a good housing market. However, many tenants never exercise their option. This means the landlord collects more money in rents, and keeps the option money.
A word of caution. There have been many cases of landlords writing unscrupulous lease option contracts. The landlord may add conditions such as, the tenant can never have any late payments or have bounced checks, or their option is forfeited. In California, once the tenant gives the landlord their option money, they are considered to have similar rights as being an owner, since they now have a financial interest. The result is the landlord cannot just evict the tenant for lack of payment, but must foreclose on the tenant. Hopefully, as a landlord, you will have better ethics.
The term sandwich lease or master lease comes from David Tilney. In a sandwich lease, the investor enters into a long term lease agreement (master lease) with the owner of a property at a discount. The long term lease guarantees the existing landlord that they will always receive income, and not have to deal with tenant turnover or vacancies. The lease agreement may also include an option to purchase the property at some point in the future. The investor, then sub leases the property to tenants at market rents taking over the management and care of the property. Of course, the lease agreement must allow for the investor to sub lease the property to other tenants.
There are real estate investors who’s entire strategy is buying individual mobile homes and then reselling them, carrying the financing for the new buyer. Lonnie Scruggs made this model of investing in mobile homes popular. He would buy a mobile home from a seller, either for cash or asking the seller to finance the purchase. Let’s say that he purchased the mobile home with $2,000 down, for $10,000 and 5% interest over 10 years. He’d then resell the mobile home for $2,000 down, and carry back a loan to the new buyer for $12,000 at 7%, leaving the original loan in place. Meanwhile, Lonnie would continue to pay the mortgage of $10,000 to the original seller, while collecting payments on from the new buyer for $12,000.
The key in this model is the difference in interest between the two loans. Lonnie’s monthly payment would be $85 a month to the original owner. However, the new buyer is paying $139 a month to Lonnie. Using a process known as wrapping the note or a wrap around loan, he would wrap one loan around another loan and collect the difference. It wasn’t the difference in price that generated the $55 a month in income, it was the arbitrage between the two notes.
Mobile Home Parks
The big money in mobile homes is in mobile home parks. In this strategy, the investor looks for a run down mobile home park. Like multi family pricing, mobile home park prices are determined by the amount of rent they collect. If the park is poorly maintained or has lots of vacancies, then the lack of income will reduce the value of the mobile home park.
The mobile home park investor buys the park, updates the property to once again be a desirable community that attracts new tenants. The investor may then look to sell the mobile home park for a premium, or simply keep it for long term cash flow.
Mortgages, also called promissory notes or notes, are another way some investors make money in real estate. Some investors like to sell property while carrying the loan for the buyer. These might be older investors who are are tired of the headaches of property management. By selling their rental portfolio, they move from being a landlord to becoming a lender.
Let’s use an example. Suppose a buyer buys a home from the seller for $100,000 at 5% interest. To a seller, the value in the loan is not just the $100,000, but the monthly interest payments. At face value, the above loan, may be worth $100,000. However, the interest alone generates and additional $5,000 (100,000x.05) a year income for the lender. If it takes the borrower 30 years to pay off the loan, they will have paid $93,255.78 in interest. If the borrower sold or refinanced their loan in seven years, as is common, they would have paid $33,038.03 in interest.
Non performing notes
Investing in non performing notes means buying mortgages (notes) where the borrower is in default. The borrower may have lost their job, had health issues or simply stopped paying the mortgage. When this happens, the value of the mortgage drops, and the note buyer purchases the note at a discount. The mortgage example above, may only be worth $90,000 to an investor, due to the borrower’s payment history, even though the borrower owes $100,000. An experienced note buyer might purchase this note, for $80,000 to $90,000 from the original lender.
The new note buyer then attempts to make the note a performing note again. They do this by means of negotiating with the borrower to help them get back to a regular payment history. If this happens, the investor may keep the note and collect regular payments, including interest or sell the note for a premium.
If the investor is unable to make the note a performing note again, then the investor may be forced to foreclose on the property securing the note. In California, if the lender forecloses, they receive the property, but can no longer pursue the borrower for the loan. In some states, the lender can still pursue the borrower for any losses the lender incurs. If the property is in decent condition, the lender may be able to sell the property for more than they paid for the note and avoid any losses.
Well, there’s three more ways to make money in real estate. There are many, many more including REITs, storage units, land and other strategies. Hopefully, this three part series has given you some ideas of how to get started in in real estate investing.