In last month’s article, we reviewed financing options for investors to use in their businesses. The two options discussed were traditional financing and asset-based financing (also called a hard-money loan). This month, we will review additional options, including seller financing and lease options, debt partners, and equity partners.
The whole point of both of these articles is to show you that there are financing options that will allow you to capitalize on some of the best real estate deals you will see in your lifetime. Now is the time to be creating a portfolio of real estate that will pave the way for financial independence. Applying these principles will make getting out of the rat race easier than it ever has been.
Seller Financing/Lease Options
Seller financing and lease options are very viable strategies in today’s market as it allows investors an option to bypass financing altogether. Usually when we discuss creative financing techniques, like seller financing or lease options, people usually wonder if these techniques are commonly used and accepted by sellers. The answer to that is yes and no. Let us explain…
Yes, the techniques are commonly accepted. In fact, seller financing is commonly used with commercial properties and other types of real estate that are not easily financed through traditional means (mobile home parks, commercial buildings, etc). Although it is less common with single-family homes, it still happens when it is explained the right way. And that brings us to the “no” part of the answer.
No, they are not common because it is usually explained the wrong way. Most investors will simply ask the seller if they would be willing to carry the financing. Most sellers are not sophisticated enough to know what that means, so they will say “no,” simply because they do not understand. As an investor, part of your success will be based on how you present this to sellers. You would be better off saying something like, “If I were to make your payments on the home until I could find a buyer and cash you out, would that work for you?” or “Would you like cash, or more cash?” Either of these questions will open up the door for the conversation to go further. At that point, you can explain how seller financing or a lease-option works and they can make an educated decision.
When you are presenting seller financing, always frame the discussion around the benefits for the seller. These benefits include monthly cash flow from your payments, more money because of the interest on the loan, no more hassles of being a landlord, and the tax benefits. Tax benefits are a huge reason for people to consider seller financing. If the seller is selling a property where they are making a gain and it is not their personal residence, or if they have lived in the property less than two of the last five years, the seller must pay capital gains taxes. If the seller is receiving a lump sum of money from the sale, they have to pay capital gains taxes. When they are taking monthly payments from you on seller financing, they only pay taxes on the payments received and greatly reduce their capital gains tax. Or, if you are using a lease option, the title of the property has not transferred and it is not subject to capital gains until the property is purchased and title is exchanged.
The whole point of creative financing is to find a win-win scenario. When you construct deals that benefit both parties, you can produce great results by investing and you can also sleep well at night knowing that you have benefitted someone else.
Most people think that a partner is a partner and there is not much difference between a debt partner and an equity partner. The truth is, that they are very different.
A debt partner is someone that partners with you by owning the debt of the property. In other words, they put up the money, and you are paying them a return in the form of interest on the loan. For the sake of clarity, let’s explain it this way…
When you buy a property through a bank and use traditional financing, the bank is your debt partner. They own the mortgage and expect you to pay them interest on the loan. They make money as the payments are made each month, regardless of how well (or poorly) the property performs. They make money by financing you and you repay them the interest. If the property goes up in value or receives more positive cash flow, they do not receive a greater return.
When you have a partner that puts up the money and they only want you to pay them interest on the money you are using, this is a debt partner. They do not have any ownership in the property. They own the financing behind the property. The property is their security in the event that you do not pay them. If payments are not made, they would have the right to foreclose and secure the property to recoup their investment.
What would make someone want to be a debt partner? It is all based on the return that they would get. Consider the options from their point of view. They could put their money in a CD at the bank and get a return that won’t even keep up with inflation. They could put it in a mutual fund or the stock market and get a lower return. Generally speaking, most mutual funds and index funds offer low rates of return. As a debt partner, they could finance the money on a property, get a fixed return in the 5-9% range, and have the property as security for their investment. That is a pretty safe deal for them when you consider their other options.
The equity partner is different from the debt partner. Instead of owning the debt on the property, the equity partner owns a percentage of the property based on splits that are predetermined. Since there is not a fixed return (based on an interest rate on the loan) there is no guarantee that the partner will make money.
However, as the property increases in value or cash flow increases, their return increases as well. You will find that most people will prefer to have an ownership interest as it will also provide them a greater return.
When you are raising capital from other people, there are rules that you must comply with or you can get into trouble with the Securities and Exchange Commission (SEC). You will want to read up on Rule 506 for Regulation D on the SEC’s website. It will walk you through exactly what you have to do to be in compliance when raising capital for an investment.
The presentation to potential money partners is one of the most important aspects of raising capital. The presentation should ideally cover market conditions, the type of properties you will be purchasing, why you are able to provide a return, and how the return will be shared. If you do not adequately address all of these issues, then you will not be as successful raising money as you could be.
When you are working with money from your investors, you must be conservative and handle their money the way it should be handled. Provide them with an accounting of each fee, expense, and return. The worst thing you can do with a money partner is to not communicate with them. They will get the impression that you are trying to hide or run away with their money. That does not inspire a lot of confidence.
Raising capital is one way of being able to finance almost any kind of deal. Investors that are successful with equity partners will be able to take their business to the next level without investing any of their own money into the deal.
That is the whole point of these two articles on financing options. There are so many possibilities out there. It is just a matter of finding solutions for your deals. When you open your eyes to the possibilities, you will see that there are so many more options than just traditional financing.
from Rich Dad Education Newsletter