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Pop Quiz: A Challenge in Creative Financing

by Ali Boone on January 12, 2013 · 34 comments

  
What Would You Do?

I need money! You have money? Where’s money? I need money. We all need money!

Although we are long since out of school, today I want to give you a pop quiz – an “exercise” if you will. I want to know what you would do? I no longer qualify for a mortgage since I’m self-employed. Sound familiar? Who even qualifies for a mortgage these days? Not a whole heck of a lot of people!

It’s easy to find a private lender for flips because the investor gets his money back in a relatively short amount of time. Assuming all goes well he may see his money plus a nice return in 3-6 months on average, earning probably 10-15% and up to 5 points or so. Not bad. Well what about rental properties? While rental properties (commercial or residential) are, in my opinion, the best long-term strategy due to the passivity of the income, the returns happen over a substantially longer period of time. This means that an investor who can help you finance a rental property is in it for the long haul which can severely limit your investor pool.

Past Creative Financing Methods

Here is what I have offered in the past to investors and it has worked out nicely. The investor puts up the cash necessary to buy the property, usually a 20% down payment and closing costs for the mortgage, and I take out the mortgage in my name and manage the purchase and ownership. He contributes capital, I contribute risk and management. In return, we split the net 50/50. The net includes profit or loss and a sale if we decide to sell. This has worked out great for me so far with the properties I currently own, especially since my ROI is technical infinite in this setup because I’m zero cash in. That is hard to beat.

However, this chapter of creative financing is officially over for me now. I left my corporate job four months ago meaning I won’t qualify for a mortgage again for at least two more years after I can show proven income (if even then). Now I can’t offer my half of the deal to an investor. I also don’t have enough cash on hand to fund an all-cash buy or a high down payment for private financing.

I have people email me all the time wondering new ways of creative financing. I can explain all day long the methods I know and that have worked for me, but what methods even I don’t know about?

Let’s talk about the property so you can see why I want this thing.

The Property

Property Details

Duplex, Built in 1945, Fully Rehabbed, Tenants in Place.

6 bedrooms total, 3 bathrooms total, 2246 square feet
Pic 1
Financials

Purchase price: $155,000

Market value: $180,000 (bonus!)

Total monthly income: $2,200

Total monthly expenses: $797

(Includes property taxes, insurance property management fee, vacancy estimate of 7% and repairs estimate of 5%, does not include a mortgage payment)

Estimated monthly cash flow: $1,403

Cap rate: 10.86%

The Challenge!

Are you as sold on this place as I am? What do you think? And how would you buy it, assuming you have no capital to put down on it and don’t qualify for a mortgage.

Experienced investors, where are you? Speak up! What creative financing options work in this scenario?
Photo: D Services

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{ 34 comments… read them below or add one }

kyle hipp January 12, 2013 at 6:01 pm

I think a similiar approach as you took in the past would be possible. The difference being that your investor takes out the mortgage. On a 15 yr note around 4% you are looking at about $915/m principle and interest payment. You can still manage but share ownership. You could split cashflow or sweeten it to 60/40 for them. With 20% down they will bring $31,000ish to the table. They will make about 10% plus cash on cash. 5 years into the loan you end your relationship and refinance in your own name and return their $31,000. With no value change you can cashout refi from $90,000 remaining to $121,000 after pulling out your cash to return and still have a LTV under 70%. You could also do it after 3 years and be able to be just under 80% LTV which will give you time to estabish business history in order to recieve commercial financing.

If you are committed to the longterm you could up the split to 80% – 90% and you can make up by managing yourself and keeping those costs and better manage repair and vacancy costs. This will give the investor close to 20% cash on cash return because you keep the equity with the long term focus.

I would discuss with a lawyer in order to set this arrangement up prior so when the property appreciates to $250,000 they don’t get upset because from the get go they understand they are in for “dividend” returns and you are taking the equity bet without the dividend return.

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John January 12, 2013 at 7:04 pm

Though, you have to ask, if the investor is putting up the down payment, taking out the mortgage, and the property is going to be managed by a third party property manager, why wouldn’t they just buy it themselves? Ali may be adding some value by taking care a lot of the legwork, but probably not enough to justify a 60/40 split.

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Ali January 12, 2013 at 8:50 pm

Hi Kyle, thanks for the thoughts! I got distracted once you mentioned the qualifying for commercial financing as I hadn’t thought as much about lending in that arena and now I’m intrigued. But back to the topic, I was actually going to say the same thing as John. If the investor puts up the cash and takes out a mortgage, and a property manager is handling the property anyway, what role am I playing to justify me keeping a cut? If he’s doing all that already, why not just keep the property in full for himself?

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kyle hipp January 12, 2013 at 9:13 pm

I would manage it myself if I were you and establish a standard fee schedule for the managing setup. You would prolly have to offer a higher percentage share for them for the split of the cashflow. I know this wouldn’t be the most ideal situation for most people but the guy that is hesitant on jumping in might love the idea of making 15% – 20% cash on cash return in order to learn the business. Or the partner just wants a good return and doesn’t want the hassel of any of owning a rental property.

I just started into commercial financing and I see a lot of potential as it seems to rely on your business results as opposed to your traditional financing requirements of a job for 2 years and this and that. If a deal is good and you have proven you can make it work then it can be possible.

I don’t know for sure and am gonna check this week. If you have another property with decent equity you could combine them into one loan in an LLC and use the equity in the owned property as a down payment in the purchase of this property. I am not sure on this but am gonna look further into using this in the near future.

Keith Schneider February 28, 2013 at 12:33 pm

You may find that if you were to seek private equity capital partnership that your leverage in acquiring larger projects would be boosted. Also there are accounting manners that can be creatively structured between debt and equity, and since the money is private capital it can be tailored to meet your business needs. In this manner if you wish for a partner who will invest, and then let you operate, with the ability to negotiate an equitable split in revenue and percentages of debt and equity, this is a phenominal way purchase commercial real estate, with an investing partner, and as the number of properties grows, so does your portfollio, leverage in the industry, and assets, all with the partnership of investment equity capital. Equity financing is often available when commercial banks that are closely regulated will not be able to sign on to projects. For more information contact me at [email protected]

Ali February 28, 2013 at 2:10 pm

Thanks, Keith, I’ll do that!

Ali January 12, 2013 at 8:56 pm

Hi John, I agree with your point exactly. When I could put the mortgage in my name, it worked great. But if I can’t contribute that or cash, what else can I contribute more than a referral cut for handing the property to an investor? The million dollar question.

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Ali Boone January 12, 2013 at 9:56 pm

Thanks again, Kyle. I appreciate the thought you are putting into everything. However, there is no reason for an investor to give me a cut for managing the property when he can hire a property manager for much cheaper. Also, I don’t live in Chicago so wouldn’t be able to manage it anyway, and I have no desire to be a property manager. Doing that is work, not investing.

Yes, you can definitely use equity from one property to help fund another. LLCs, however, don’t necessarily qualify you for a commercial loan. Be careful about mixing those two terms up.

kyle hipp January 13, 2013 at 7:22 am

I was speaking to finance two properties with one commecial loan and package them both in an LLC. This makes it simplier than have to refinance an existing property to pull cash out and then use that cash to purchase another. This becomes very important especially when time is of the essence.

I still don’t mind a good dose of work to go with my investing. I have always heard “work smarter, not harder”, but I have found that the traction is incredible when I work both harder and smarter ;)

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Brian Gibbons January 13, 2013 at 12:24 pm

@AliBoone, this is what I learned over the last 10 years and have implemented.

Find busy professionals that have no time, have cash, and want a great rate of return.
Say they want 20% in 4 months.
They have cash and will give you control.

Say your market has alot of cheap $100K properties in good school districts.
You have the green light to buy rehab, pay for costs of rehab, and sell it.
See a CPA first with this for taxation. An S or C corp might be better.
You create an LLC with a Joint Venture agreement.
You do all the work, JV partner funds everything, down to paying for some of your Project Managing expenses.
The JV Partner/Funder owns everything.
You own nothing.

BUT you have an option to buy 50% (or some %) equity of the sold rehab profits after all costs are returned to JV Partner for $1. You can have Escrow Instructions for this with all money kept in Escrow.

Funding Partner knows you have to sell it to make a profit, and you have to be profitable to make any real money for yourself.

Ex)
Buy for Cash $50K
$10K Rehab
$5 Sales costs
$65 total
Sales Price $100K
Net $35K
div by 2 or 25% 75%, or whatever.
Figure taxation with a CPA.

Many busy people want 12% on their money.
You can get them more than that on 12% in 4 months.

You can present to doctors, professionals this kind of JV.

To do this in an IRA or SEP,
See http://www.trustetc.com/new/real-estate-ira/

Terms to Know
A custodian is a company that is approved by the IRS to allow people to use their IRA to be a non traditional custodial set up.

A prohibited transaction is some transaction prohibited by the IRS for a self directed IRA.

The best book I know to understand IRAs and using them to get JV Partners is Patrick Rice: IRA Wealth. He worked for Pensco, another IRS approved custodian for self-directed IRAs.

Some custodians have presenters that if you have a meeting of IRA holders, they will explain how self directed IRAs work on a Powerpoint.

Another great custodian is Entrust http://www.theentrustgroup.com/locations. Hugh Bromma has written amazing books, who heads TheEntrustGroup. See Amazon.

And lastly, a Buyer can borrow money at a modest interest rate from a relative, but there are restrictions. Uncles and Aunts work better than blood parents, but step-parents are ok! Go figure.

Get IRA Wealth, its the easiest to understand.

Brian Gibbons

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Ali Boone January 13, 2013 at 2:30 pm

Brian, Thanks for taking the time to write all of that out! It will be very helpful I’m sure for any investor reading this article. Very articulate and well-spelled out. I am definitely going to pocket your suggestion for potential future deals I work with. However, it is still relevant to flips rather than holds, so the original problem still exists- how to fund buying rental properties. Flips are easy because investors get their money back in a short amount of time. But with rentals, there isn’t a lot of margin and it’s a long-term deal. So unless an investor is willing to pay the full purchase price in cash and I put the property in my name and manage the purchase and maintaining, then we split 50/50, what can someone offer to investor if not cash or a mortgage?

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Tim Czarkowski January 13, 2013 at 3:56 pm

I have something similar I am working on with an investor now. Basically we are going to be flipping properties to ourselves. The value I add is finding profitable properties we can purchase that need work and handling the rehab. We split the equity created from the property 50/50. So for a $100,000 property with $100,00 in rehab that has a $300,000 ARV my equity share would be 50,000. Then I will receive the portion of cashflow and eventual sale that my ownership would provide, so 16.6% in this case. We could also refinance after rehab and split the proceeds along the same ownership percentages to help cash him out.

I will also manage the properties but that is a completely separate agreement and could be changed in the future. I think maybe what you should look for is properties in need of rehab instead of ready to rent properties. This way you provide more value than say a real estate agent would.

I have also heard of agents taking their commission as equity in the project although I have never seen it personally. I think that would work better in large commercial deals where although the commission would only be a couple percent it is still a very large amount. Think $100,000 plus commission for shopping centers, apartment building, offices buildings, etc.

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Ali January 13, 2013 at 6:37 pm

Thanks for the structuring idea, Tim! That is actually one of the first 50/50 split on flips I’ve heard. Not bad. I know a guy who teaches flips and in return keeps 50% of the profits on the first one, then the new flipper is on their own after that and they keep everything. I’ll definitely keep your idea in mind if I decide to flip. I’m still looking to avoid the rehabs though. I’m really just in it for the passive income.

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Tim Czarkowski January 13, 2013 at 7:50 pm

What split do you usually see for rehabs, whether for long term hold or for flips? From my reading it seemed like 50/50 was the usual.

If I had the money to do these deals on my own I certainly would but I don’t. I have enough money to do some small projects but nothing close to this size and one deal at 50/50 would certainly not put me there. The idea is to have a money partner so that I can do more deals and bigger deals than I otherwise could thereby increasing my income. Even if I had the money to do a project of that size there is always more deals that can be done of you have the financial backing.

I can understand not wanting to flip it is a lot of work particularly if you have another business. However, I love idea of flipping to yourself and then refinancing if you can. You can have both high equity and a high cash on cash return that way. It can allow you to grow your portfolio faster than you otherwise might also.

If you can offer you investor a decent long term return on there money these days you should be able to find investors no matter the exact structure. Try to find people making one or two percent and offer the ten with real estate as collateral. I know there are plenty of people doing it.

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Ali January 13, 2013 at 7:59 pm

Hi Tim, I don’t do rehabs so can’t answer that question. I have a ton of available financing structures that I know of to do flips. I’m really looking to see if anyone can suggest financing strategies *not* involving flips.Even if I was rehabbing though, refinancing won’t work if I don’t qualify for it, so holding the property is a harder option then too.

Again, looking solely for recommendations *not* for flipping.

Andy Teasley January 13, 2013 at 4:16 pm

There is an old book I have called ‘How to Finance any Real Estate Any Place Any Time’ by James Misko. It’s available on Amazon and the other sites. Lots of quick chapters laying out lots of different deal structures. But I must warn you, every time I read it, I find a deal structure that I have to go try and use!

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Ali January 13, 2013 at 6:38 pm

Oooooooh, thanks Andy! I’m going to order it right now. I’m always looking for a new book and that one sounds amazing! Thanks!

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Michael January 13, 2013 at 4:39 pm

Hi Ali,
You can raise 100% of the money & offer a 50/50 split on cash flow and appreciation. I would suggest a 5 year plan where the projections are based on cash flow and appreciation. You would want more instant equity than the example you mentioned. You may have to find markets that this will work in. It will not work in my market but will in other’s. What you bring to the table is finding the great deals, negotiating the rehab costs to be far less than the average person or passive investor could ever do which adds significant value right away, stabilizing & getting the place rented with a property manager. Just because you don’t manage it doesn’t mean it will not work. You still have to find a great manager, hire them and make sure they are doing their job.
Just to be clear I don’t believe this will work on full turnkey properties as the Investor that went through process to get it to turnkey to sell as investment to other’s would in essence be what you would be doing.
There is tremendous value in that providing you do all right.

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Ali January 13, 2013 at 6:41 pm

Hey Mike! Glad to see you on here as always :) You are my first official ‘regular’ I think! You are right, I can definitely raise 100% of the money and do the 50/50 split from there. In that case, I would even consider giving the investor a shave off the top of the net before the split, until his initial investment is paid back, just to make it more appealing and rewarding for the amount of money. Depends on how the numbers work out.

I’m not sure I understand your statement about why it wouldn’t work with a turnkey? My deal would be based solely on cash flow and any equity that came out of it if any, so it’s a different pot than what the provider goes through. Any clarification would be great.

Talk to you soon!

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David Driscoll January 13, 2013 at 4:40 pm

Good sources for money, I’m sure you’re healthy but like most healthy people they see doctors on a regular basis. What Dr.’s do you know? They know you because they see you on a some what regular basis. Docs have been a good source of money for me. They are too busy to do it themselves and have been slammed with the stock market. The other benefit of Docs they love to talk to other Docs. Be honest upfront and do what you say and you will have a lot of referrals. This should be easy for a rocket scientist.

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Ali January 13, 2013 at 6:44 pm

Ah man, David! Just as I lose my health insurance! Lol. Although this is now a good motivation to keep scouting out personal insurance policies (blech). Anyone know of a good individual policy available in southern California? ;)

But seriously, great recommendation! I am definitely going to look a little harder at my doctors when I see them and feel them out for investing desires. Especially my Los Angeles doctors…. they probably don’t even know $100,000 houses exist :)

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Kevin Sapp January 20, 2013 at 9:47 am

Ali,
Another option for funds are your old “seasoned” engineering colleagues. Most engineers are savers and conservative by nature, you will have to target your pitch appropriately, but as an engineer you have an advantage. Older engineers have cash, usually more outside of IRAs than in. Most have great credit ratings too. Itis all about the pitch. I’ve turned several into passive investors, usually holding onto old homes and renting, all are hesitant, but later are thankful and look for more.

That said, I’m taking a different route. Keeping the day job, and passive investing with several properties and as a private lender.

Keep living your dream!
Kevin Sapp. BS ChE 1985… Old seasoned engineer…

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Ali January 21, 2013 at 2:40 pm

Thanks, Kevin! You are definitely right about the engineers. They hardest part about them is usually getting them to understand that real estate investing can be less risky than most make it out to be and not over analyzing the numbers to death (analysis paralysis). I can talk about “them” because I used to be one (engineer) :) But yes, definitely a good group to promote real estate too. Doesn’t solve the creative financing problem, but may be able to find one who wants to put all of the cash and forget leveraging.

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Tom January 13, 2013 at 7:58 pm

There are creative ways to get the cash for the deal–and you’ve spoken of many–but with all due respect, it is not creative at all to limit your question to “how do I find the cash?” I can’t believe with all these replies, nobody mentioned the first thing I thought of: Seller financing. Be it Subject to, CD/Land Contract from seller, Lease-Option…why have to line up cash and pay through the nose for it when your seller might appreciate getting monthly cash themselves? I get sellers–including of MLS listed properties–to finance my deals all the time. Some own their properties free and clear, don’t assume they don’t. This can even work with REOs (esp. if seller is smaller local/regional banks. You may be able to get them to finance a whole portfolio of REOs.

Honestly, the numbers for your deal don’t look that great to me compared to what I’ve been buying lately, but my market’s better than most for cash flow. Regardless, you should always ask for seller financing, make it one of your three offers (always make three offers, all terms, terms plus some cash, and all cash…the latter is a very low price). I’ve bought many properties at 0% interest. The highest interest rate I’ve ever had to pay is 6%. The key is offering a higher monthly payment than they might expect otherwise. Example: Three years ago I bought an older duplex for $55k. Gave seller $5000 down, payments are $600, principal only, interest = 0%. Up unit rented $550, lower $615, tenants pay all utilities. Place rents itself, and is half paid for already, which can happen when there’s no interest.

Always think of how the seller can help you buy the property before resorting to cash. Maybe they can’t or won’t carry paper/terms, but you’ll never know until you ask. Cash offers are always my last choice. Cash is fun, and Kind, and all that, but whenever I have to use cash to buy I feel dirty, and lazy, like I didn’t try hard enough to get terms from the seller.

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Ali January 13, 2013 at 8:13 pm

Hi Tom, thanks for responding. You have a very valid point about the option of seller financing. There are definitely sellers out there who would enjoy the passive income every month and definitely some room to make those deals work. Seller financing is great to have, and you make a great point about not doubting the potential of finding it. I will keep that in mind for sure.

In this case, this property will not allow for seller financing. Most of the sellers I work will not do seller financing because they are groups who sell unlisted, not available to the public properties, and most of their buyers are fast-moving cash-paying investors. The purchase prices aren’t negotiable either because the sellers don’t need the business bad enough to have to be willing to lower anything…they sell out every week. In fact, a lot of the properties I see end up getting bought for up to $20k higher than listed.

What market are you buying in that has such good numbers? I also work with several markets with numbers better than these, but there is always a trade-off in every market. Some markets have insane cash flow but are such stable markets that the potential for growth is almost non-existent. Or vice versa, some people are willing to take a lower cash flow than even I’d be comfortable with because of the supposed growth that is going to send the values flying up. This property is decently in the middle of the spectrum. Of course it’s not going to have the highest cash flow you’ve ever seen. It’s Chicago! One of the most economically powerful cities in the world and considered to be one of the more “sexy” markets. It’s impressive enough that you can find good price-to-rent ratios at all, so for the idea that it gets as much cash flow as it does is impressive. You won’t find that in Los Angeles or Miami (at least not unless it’s a rehab job).

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Brian Gibbons January 20, 2013 at 11:50 am

“There are creative ways to get the cash for the deal–and you’ve spoken of many–but with all due respect, it is not creative at all to limit your question to “how do I find the cash?” I can’t believe with all these replies, nobody mentioned the first thing I thought of: Seller financing. Be it Subject to, CD/Land Contract from seller, Lease-Option…why have to line up cash and pay through the nose for it when your seller might appreciate getting monthly cash themselves? I get sellers–including of MLS listed properties–to finance my deals all the time. Some own their properties free and clear, don’t assume they don’t. This can even work with REOs (esp. if seller is smaller local/regional banks. You may be able to get them to finance a whole portfolio of REOs. ”

This is terrific.

This thread Ali started about Creative Financing is coming from the category of an Investment Group, not an Individual REI working on old fashioned Creative Financing Strategies.

I wanted to talk about Being the Doctor working with The Seller.

If you are interviewing the seller directly, it is really helpful to know what they are going to do with the money and what their plans are over the next 2-5 years.

If you are going through the Realtor agent, it is almost impossible to do this interviewing the seller properly.

Think of going to a GP MD office visit.

You fill out a sheet of paper, name, address, medical history, symptoms of problems today, allergies, etc.

So we have the next steps: examination, diagnosis, prescription.

Most salesy REIs do it wrong….They spend all of their time telling the Seller about their company, services, and how great they are, instead of finding out what the Seller wants or needs.

The Sellers do not care about you, your LLC – S Corp, your experience, your knowledge about techniques and abilities,

they care about
ARE YOU FRIGGIN’ LISTENING TO WHAT IS IMPORTANT TO US AND OUR SITUATION?

So let’s start with being a Doctor, and the Examination Step.

Ask great questions,

You’ve got to discover the financial impact or economic value of the problem.

You’ve got to get the Seller to tell you how much it’s costing them or how much sleep they are losing because something isn’t right with their house situation.

WHERE IS THE PAIN?

Do not guess here.
They feel pain now, but where is it?
How did it come about?
You need the Sellers to feel YOU the REI understand their point of view. Don’t rush this.

“To clarify my thinking and understanding here, you feel __their concern_____ is your number one concern right now?” Listen. Find their hot button or buttons about their housing situation.

Lastly is the Prescription Phase.

By the way, some sellers will fool you in first sounding motivated, but are not really. But if they are and you have a possible solution, then you need to prescribe it.

I use a letter of intent. I give it to them and sign it. It is hand written and signed and dated.

If they need cash badly and there is equity, I will offer 2 – 3 offers on the letter of intent,
1) a low offer for cash, and
2 for terms (cfd, lease option sandwich, lease option assignment, etc.)

This gives them something (a bird in the hand).

If I know they can wait for the money, I will do the same.

The big things about Creative Financing is….
– See the Sellers by yourself, no agents
– Listen and ask great questions
– Let the Sellers buy, do not sell
– Be a reluctant Buyer, ready to walk away always
– Have private lenders ready now for cash deals to close fast
– Have Tenant Buyers and Vendees ready to go now for Lease Options and CFDs

And remember, It’s about the Seller, stupid! Listen! lol

Brian

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Ali January 21, 2013 at 2:47 pm

Brian, excellent thoughts. You must be in sales? Basically what you point out is one of the #1 things about selling… listening to your ‘buyer’ and truly understanding their thoughts. So many people don’t do this step and it’s really the most crucial.

I will remember this sales application to seller-financing options I run across, no doubt. The turnkeys don’t allow seller-financing unfortunately, so won’t work for this case but I will keep it in mind.

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John January 15, 2013 at 9:11 pm

It’s worth noting that this property is in the Englewood section of Chicago, one of the most dangerous neighborhoods in the United States. If things go bad for this property, they can go really bad.

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Ali January 16, 2013 at 9:34 am

You are correct, John. Englewood is pretty rowdy and can definitely put some major risk into the investment. I have access to a lot of these properties in better areas as well. I just grabbed one to use for the financing challenge. Some people like the rougher areas, some people don’t. I don’t lean that way as much personally, but there’s no risk in using it as my example property :)

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David January 20, 2013 at 10:16 am

CIS(Cut In Stone) rule #1, Small REIs never buy a property in an area they can’t drive to within an hour.
CSI rule #2 Never trust a Realtor to value a property, unless she’s your mother.
CSI rule #3 All real estate is LOCAL. The same trends in you neighborhood may not apply across town, across the county, across the state.

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Ali January 21, 2013 at 2:50 pm

David, I definitely don’t agree with CIS #1 as every property I own is on the other side of the U.S. from where I live (and some not even in the U.S.), CIS #2 may be true but quite frankly no one can value a property much better and at least the agent has the tools to at least make an educated attempt, plus my mother would be the last person’s value I would trust and #3 you are correct. Ever market for themselves.

David January 20, 2013 at 10:09 am

Check out self directed IRAs. The people who have the standard IRA can convert to self directed IRAs and use the money for REI and the profits are put back in the IRA tax free. Take a look at the low rates the normal IRAs are earning, you can do better

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Ali January 21, 2013 at 2:51 pm

Absolutely, David, IRAs can be very helpful in funding a real estate investment. Doesn’t help solve the creative financing problem here, but definitely good for people to remember their options when it comes to where to pull money.

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Brian Gibbons April 2, 2013 at 10:05 am

@Ali Boone, creative finance is alive and well, using AITD – wraps in TX. See http://wallytingley.com/wallywrap/ , thought I would share. It has a really good explanation of DOS clause violation.

Best Wishes,

Brian

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