Exit Strategies for Getting Your Money Out of the Deal
Let’s say you have decided to invest in real estate. You can find a good deal, but you’re not quite sure what you should do with it. How do you ensure that you make a profit? You may have heard several times already that you earn your money in real estate when you buy, but you are still curious how you are going to collect this money.
Getting started in a real estate investing business requires a few decisions to be made. For example, once you have a property in your sights, or even in your possession, what do you do with it?
Good planning involves beginning with the end in mind. As you enter into a transaction, what are your plans for the other end of the deal: in other words, what is your exit strategy?
The Importance of a Plan
So you do what you’re supposed to do; you go out and find a deal. You check it out, analyze it, run the numbers, and decide that there is money to be made here.
So, now what do you do?
One thing we know for sure. If you fail to plan, you plan to fail.
That being the case, we should think about planning ahead on your deals. This really is something you should do before you make your offers on properties, because what you do with the property will influence how you analyze the deal and how you structure your offer. As a case in point, if you are looking to acquire an income property, you will check out not only the market value, but also the cash flow value of the property. You would also look at a long-term mortgage rather than short-term funding for your money.
On the other hand, if you are looking for a house to grab and turn quickly, market value is your main concern, along with the rehab and repair costs. The financing will be short-term, or at least something that won’t cause problems because of an early pay-off.
One of the great things about real estate investing is that there are so many possibilities – so many ways to make money. This article will look at some of these possibilities.
So now you’ve gone out there, you have enlisted the help of real estate agents, talked to a lot of people, overcome your fears, stretched your comfort zone, gathered your comps, analyzed them and put together a solid future market value. After running your formulas, you know how much to offer, the offer is accepted and you sign a contract for purchase and sale.
“You Gotta Know the Territory”
This line from the Broadway musical, “The Music Man,” reminds of one of the first things you should do as you set out to do deals. There is no one-size-fits-all technique for making money in real estate. There are some fundamental principles that you forget at your own peril: this business is not about deals, properties, or funding, it’s about people. You don’t look for properties, you look for highly motivated sellers. Without a highly motivated seller, even a junker would cost you too much.
But let’s address the market you live in. You may live in one of those white-hot rapidly growing, rapidly increasing-in-value markets. You might be in the low-priced markets in the Midwest or in the South. You might be in stable, average markets where values increase about 4 –5% a year.
It will quickly become very clear to an investor working in San Diego, California, that attempting to buy properties at 65% of market value would be Quixotic at best. Who is going to discount it that deeply, given that normal starter-type houses go for $700,000 and more within hours of being listed – usually for more than the asking price because of the competition among would-be buyers? On the other hand, an investor in Knoxville, Kentucky, or in Kansas City, will find all kinds of deals at $20,000 that might sell for three times that value when they are restored and looking nice.
The truth is, it works in any market. A real estate investor can make money no matter what is going on in the market. If it is a sellers’ market, like most of Florida, you know you will never have a problem getting your money out of the deal, so focus on finding the best opportunities you can. In a buyer’s market, like rural Oklahoma, finding cheap deals is easy – so focus on how to move the property and get your money.
Know your market. Ask around. Check with the local Board of Realtors. What is the average value increase or appreciation in your area? What is a normal market time – how many days is a typical starter home on the market before it closes? Do your homework before you get started, so you know how to proceed.
Collecting the Money You Make when You Buy
There are four fundamental ways of disposing of a single-family residence profitably. We would like to take a general look at these, then follow that with a more in-depth investigation.
You may have heard several times already that you earn your money in real estate when you buy, but you are still curious how you are going to collect this money. The purchase contract gives you control over the property. Now what can you do to generate cash and profit, the reason you do this business?
Simply put, a contract can be assigned. That means that if you are the buyer under a contract to purchase and sell real property, you can assign your rights under the contract to a third party. Assuming that the contract represents a good deal for the buyer, giving up your buyer rights means you are giving up something of value. For that you deserve to be compensated. Conversely, the assignee — the person to whom you assign these rights, gains some of value, which must be paid for.
There is no set amount for the assignment fee. It can be considered as more than a finder’s fee, since you not only find the property but negotiate a contract. It has a lot to do with the value of the property involved, and might range from $1000 to $7000 or more. This might become more clear as we look at what you actually do with a contract turn.
A Quick Turn Example
Here’s an example of how a typical contract assignment might work.
Let’s say you find a vacant house, ugly and run down. It doesn’t even have a “for sale” sign in the yard. One thing you can depend on, though: whatever you offer the owner is more than he or she is getting on this house right now. With a little detective work you locate the owner and negotiate a “risk free” contract to purchase the property. The price you negotiate would be as low as possible – in this idealized case, better (i.e., lower) than 70% of the value the house will have after repairs are made. To give it numbers, let’s say the house will be worth $150,000 when it has been made pretty. We offer $100,000. The seller wants to maintain a shred of dignity, and counters at $110,000, so the two of you settle at $105,000.
The great thing is that the owner was not actively selling the house, so a minimum earnest money deposit should not create an argument, and since the house was just sitting and presenting no economic value to the owner, the price you offer can be low. As earnest money, you may want to offer $10. This will be enough to make the purchase contract binding and enforceable. If you must offer more, do so, within reason.
As soon as you get the signed purchase contract, you contact an investor that rehabs houses in the area and offer to sell the house for $5,000 more than your contract amount. That would still put it at around 73% of value, which will be very attractive. To transfer your right to buy the property at the contract amount to the investor, you fill out a one page “Assignment of Contract” form and get $500 in earnest money. A few days later the transaction closes at a title company or an attorney’s office and you get a check for $4500 PLUS the $10.00 earnest money you paid.
What have described here would be called a wholesale deal. You would be the wholesaler. You get the house directly from a supplier, then act as a wholesaler to an investor who will serve as a retailer to an end user.
A Review of Contract Assignments
In this role, you gain control of real estate with the intention of immediate resale for profit. You do this at well below the going or “retail” rate. This puts you into two roles, acting as both principal and middleman, buying at one price, then reselling at a higher price. From the seller’s perspective, you are a principal, but the person taking the property off your hands sees you as a middleman – a supplier.
If there is not a large margin between the agreed upon purchase you negotiate and what someone is willing to pay you, your profit is likely to be similar to what a real estate agent might make off the deal. But your overhead is a lot less than an agents, you do not take on the same kind of fiduciary responsibility for a client as an agent, and you only spend a few hours of your time, rather than days or weeks of effort.
In order to do contract assignment transactions, you need no license. You are not regulated by any government agency. You enjoy low overhead (work from home, if you wish, you only need a telephone with voice mail) and flexible working hours.
For people just getting started in real estate and looking to build your confidence and knowledge before moving on to other real estate ventures, this is a great way to start. You make money while you learn how investing works without incurring much risk at all. Finding properties for other people to buy means you’ll be able to earn while you learn the ropes in real estate and you don’t have to worry about risk if you do it right. All you do contract to purchase a property then sell your right to purchase to a third person. And, best of all, it is perfectly legal in all states.
The biggest advantage to a lease option is the quick turnover time. Your buyer need not qualify for financing in order for you to begin the income stream that offsets your cost and provides your profit. This means that as soon as you are comfortable with the tenants, they are in and paying. Of course, they pay more than rent, as well, and the lump sum profit waits at the end of the option period.
Closely related to lease option as another form of an Income Stream or Cash Flow transaction is selling the property “subject-to” the terms and conditions of an underlying wrap-around mortgage or all- inclusive trust deed along with an installment land contract. The primary difference is that the subject-to deal might command a higher lump sum up front, but you are likely to be in the deal longer before you transfer title to the buyers. A lease option might provide less up front money (though not necessarily so), but is likely to go for just a year or two.
There are other modules in this course that outline the details of these two types of transactions.
Buy and Hold for Rental
This provides long-term cash flow and growth of the investment portfolio, but is not the way to start out for most people. The problem with acquiring too many rental properties too soon is the lack of capital needed to support the properties (especially maintenance and repairs) and the eventual difficulty in obtaining mortgages for future acquisitions after you have reached a certain debt ratio. Critical for a good experience here is a positive cash flow after debt service, skill in property and tenant management, and discipline in handling the cash flow. We will elaborate on this below.
Buy, Fix and Sell
The main risk here comes if you don’t know who will be buying the house from you after you fix it up and pay carrying costs for the fix-up and marketing time. The factors that could interfere with profitability are:
Too much rehab time: can you get the job done (or do it yourself) in a short time period. Must cosmetic rehab jobs should require no more than two weeks for a handyman working full time.
Too much rehab cost: For most people, $10,000 – $15,000 for labor and materials together should be an absolute ceiling. A handyman who can do the work him/herself can take on a larger project, if the numbers support it.
Unless you like to do this kind of work as a hobby, always find a professional who can do it for you. That way, you make sure it gets done well, quickly, and will pass code inspection. This does not necessarily apply to painting or basic clean-up, but most other things are best left to someone else while you manage the project and find more deals for the future.
The solution is to be careful of whom you entrust with the labor. Get referrals from people who have worked with contractors or handyman. Check with members of your local real estate investors club for names. Make sure everything you agree to with the handyman is in writing.
The upside of a buy, fix and sell project is that there is more money to be made quicker here than elsewhere. Why? Because you are doing more and providing a greater service. You do no fix-up with the flips, and you are delaying the closing with the lease option. Over the long run the rental may return more income (long term cash flow plus the residual business income), but the buy, fix and sell brings more immediate cash.
However, there is no rule of investing that states you must engage in fix-up. If you don’t feel confident in your rehab abilities or knowledge of construction, it is certainly much easier to just buy and sell. We know that the seller’s motivation is key to a great deal, and that is not always tied to the condition on the property. In other words, a property in excellent condition sold by a highly motivated seller might be just right for you. If all it needs is some paint and carpet, that is hardly a rehab project, but it certain increases value and gets you a better price for the property.
The Final Analysis: Rent or Sell?
What you do with a property acquisition depends upon what you want to accomplish. Holding onto a rental gives you long-term cash flow and provides growth for a real business entity with assets and net worth equity. Selling the house brings in immediate return on your investment and builds capital needed to create a strong and profitable business.
In other words, both are extremely important. You need both. Where to start depends not only on where you want to go with it, but what your capital situation is at the beginning. Someone starting out without much cash in the bank should probably look to contract flips and buy, fix and sell situations to generate capital. That way you either need no financing at all or else you will use hard money, which is short-term lending from private parties. Mortgages, on the other hand, have a major impact on your credit history and standing. You might have excellent credit and a superb payment history, but after you have a mortgage on your residence and another on a rental, your debt ratio may get close to the limit that lenders will allow.
There are two ways to deal with this:
Do a number of flips and quick sales to put money in the bank. Then when you purchase a rental property (preferably multiple units) your business has its own money to put down, which means your debt will be less relative to your assets, and your cash flow will be greater.
Do things as a business. This doesn’t mean you need to incorporate right away, but even a sole proprietorship can keep books like a business. Then you can show the lenders a business financial statement with a balance sheet and a profit and loss statement. The balance sheet shows a photograph of your company’s financial situation at the end of an annual or quarterly operating period, the profit and loss statement shows the financial operation over the course of that operating period. To put it in other words, the balance sheet shows everything the business owns and everything it owes. The profit and loss statement (also called a cash flow statement) shows all the income and outflow of monies to the company. This allows the lender to analyze your loan request without having to guess at where all the money goes. If your company buys food, it shows up on the profit and loss statement. Now the lender can look at things like cash flow and profitability. The judgment on the loan is made based on whether the new asset (the rental property, for example) can improve the company cash flow. If it does — well, contrary to popular belief, banks want to lend money, and now they can justify doing so.
In summary, a good strategy for building your investment business is to do a number of short-term deals—flips, quick sales, to accumulate capital to support the acquisition of long-term assets. Once the company can take care of itself, then it is good to mix long-term and short-term purchases. If you do one at the exclusion of the other, you will limit your progress. Doing nothing but quick sales means you accumulate no fixed assets, therefore no long-term business organization that you could sell off in the future and move to the Bahamas. Buying nothing but rental properties means that eventually you will be cash-poor and unable to acquire any more, therefore unable to grow. The stunted growth would leave your business unable to generate the income to support the life style you desire.
In short, be flexible, be balanced, be smart. All four of the above income activities are good, and should be used in concert with the others to create a strong, growing and stable business.