Cheap homes and terms that favor both buyer and seller are sowing profits for wise urban investors
Because real estate values have depreciated due to the tightening of mortgage guidelines, many prospective home buyers are being left out in the cold when it comes to receiving financing for a home purchase. This problem has created opportunity for many real estate investors who are buying dirt cheap homes in urban settings and providing seller financing to their buyers. This article explores how this relevant exit strategy of seller financing in low income communities can be profitable for you.
Would-be homeowners in urban areas face three problems
It’s important to note that the foreclosure crisis started in urban areas across the United States in 2007. In some cases, mortgages that had been created for lower income and/or credit inhibited urban families were unaffordable from the start. Other urban homeowners, with adjustable rate mortgages, lost their homes when they could no longer afford their payments when their interest rates adjusted upwards. These homeowners could not refinance as banks tightened up their lending standards. A large percentage of urban homeowners were renters before mortgage credit was extended to them by the banks, and they have gone back to being renters again. Urban renters generally face three problems that inhibit their ability to become homeowners:
- Many live on low, diminished, or government subsidized income, which often inhibits this genre of home buyer from saving a down payment need to purchase a home, or prevents them from being able to obtain a mortgage.
- Some urban dwellers have poor credit as a result of recently losing a home to foreclosure; many have always had poor credit histories.
- Urban home values are very low due to the foreclosure rate (commonly called “F-score” by mortgage lenders).
While these three factors inhibit an urban dweller’s chance at becoming a homeowner, these very same factors are creating opportunity for real estate investors.
If banks won’t lend to today’s urbanites, who will?
Savvy real estate investors are aware of the problems that urban non-homeowners face and have come up with a helpful and profitable solution: seller financing. Investors are buying homes for as little as $500 – $15,000 in cities all across the US. These investors then set move in terms of as little as $500 down and $500 per month with the buyer to make all property repairs. These terms are crafted to be affordable for the buyer and protect the seller at the same time. Savvy investors know that if they rehab an urban property prior to sale, it is likely to be vandalized or broken into while vacant. It also requires more cash to do this, which would cause them to ask for more aggressively priced move in terms. By having the buyers make all the repairs, they are less likely to default on their monthly payments down the road. It also allows the seller to keep the down payment small, which is a great marketing advantage in a tight credit market. Finally, buyers are likely to live in the subject house while they are making repairs to it. This prevents crooks and vandals from destroying the deal for both buyer and seller.
Most sellers are using a traditional land contract, drawn by their attorneys, as the method of sale. Accompanying the land contract is a mortgage, signed by the buyer and recorded as a lien against the property. If a buyer defaults on the mortgage during their occupancy, the seller can foreclose. The foreclosure process can take up to a year or longer in some states, so it may be a wise idea to talk with an attorney before practicing this investment strategy. The seller is usually not damaged too badly in a buyer default situation as accrued payments offset losses, and usually the buyer has made upgrades to the home using their own financial resources.
Some investors have cash or available credit lines, while others are forming partnerships that pool cash or credit lines together to acquire low priced urban homes. Investors know it’s hard to get hard money funding in urban areas because of low property values and high foreclosure rates. Because banks have been withholding foreclosures from the market, many investors are seeking sellers who are in foreclosure and buying the home in a short sale situation or at sheriff’s sale. Other investors who are strongly funded are knocking on the doors of hedge funds and banks, buying large pools of homes. Still, there are many investors who keep their eyes open and buy deals right off of REO (foreclosure) agents. The cities offering the cheapest homes are in the Midwest; Detroit, Cleveland, Pittsburgh and Indianapolis to name a few. Remember that the cheaper the home, the harder it usually is to find reliable buyers who have cash in hand to meet the seller’s terms. Ultra cheap homes are usually found in areas with high crime and high unemployment.
Patience is a virtue
Urban investors, who sell homes on cheap terms in which buyers make all repairs, have two ways to make money. One way is to simply maintain the role of “being the bank” indefinitely; collecting payments for the full term of the mortgage, usually 15-30 years. A home purchased for $10,000, would financially replenish a seller in two years, assuming $2,500 in closing costs and buyer terms of $500 down and a mortgage payment of $500 per month. Every month beyond two years is profit for the investor as long as the owner is paying on time every month. Remember that the buyer, who is the owner of the home through the land contract, has to pay homeowner’s insurance and taxes on the house, therefore the seller can maintain a true $500 per month cash flow on the home. If payments cease for whatever reason, the investor can foreclose and start the process over again with a new buyer. The first buyer paid the house off and upgraded it in this example. Even if the home gets vandalized during or after the first buyer moves out after foreclosure, the investor just resets move in terms and gets a new buyer to make upgrades and start paying by the month.
The other way for investors to make money using this strategy is to refinance the buyer into a mortgage with another bank, or discount the face value of the mortgage and sell the “paper” (mortgage note) to a note buyer, hedge fund, or real estate investment trust (REIT). Whichever mechanism is chosen, lending guidelines are very tight right now and most banks and note buyers who routinely buy mortgage paper will shy away from low income urban areas to hold paper in. Therefore, most investors practicing this strategy are opting to hold and play the role of long term financier to their buyers.
Urban land contract sales have various risk factors to pay attention to. Investors who practice this technique must truly accept the responsibility of acting as a mortgage provider. If the owner does not pay the taxes or the insurance on the property, the investor must step up and pay these, then charge the owner for these expenses. If an insurance policy lapses and there is a fire or other disaster, then the investor may lose the property. The same holds true with taxes that go unpaid. Bills and notices for tax delinquency go to the current owner, not the investor who sold the property to the current owner. This means that the investor must stay on top of tax and insurance issues and pay them for delinquent owners.
Investors that want to place buyers, create a mortgage, then sell that mortgage or have their buyers refinance later on to a mainstream bank need to screen their buyer the way a bank would. Nobody is going to buy paper that was created for a buyer who has a high debt to income ratio, low credit scores or poor work history. Today’s banks want credit scores above 620, a <41% debt to income ratio, along with a <2 year continuous work history and a perfect residential payment history spanning 2+ years. This leaves two choices for investors looking to sell their paper: either screen buyers using their current standards or be prepared to work with a buyer until their loan file looks good to banks. Remember that in very blighted areas or in areas with a high foreclosure rate, investors will never be able to sell their mortgage or have their buyer refinance it.