Real Estate investments have a finite life cycle and there comes a time when you need to sell your investment to realize the profit of all the value add work you have done as an investor. A value-add investor can add value when selling their property as well in this final disposition phase of the real estate value-add life cycle.
The Disposition segment of the investment life cycle is the last phase where you can accrete cash value from your investment by balancing income buyers biggest concerns and providing them unique value add acquisition financing options.
Real Estate Value Add Life Cycle
Income buyers are primarily concerned with two main things: the amount of capital they need to invest (down payment/equity) and the amount of their net cashflow (NOI – Debt Service Payments). Given these two concerns in mind, you as an investment operator can improve the resale price of your asset.
A lot of real estate books advise investors to sell their properties at higher sale prices by taking back a mortgage with below market down payment and interest rate terms. Now this is where the value question is subjective as you can technically increase resale price but not value in my opinion.
My view on this topic is that you may have increased price but not value as you have not realized the additional price increase in the form of hard cash in your pocket. Remember cash is king.
Sell to a Note Buyer = Cash. Yes you can sell the note to a note buyer directly or through a note broker to realize the cash. How much cash is the key question?
Note Buyers are a part of the real estate investment marketplace as they are motivated to buy newly originated notes to hold in their portfolio for monthly cash flow. Hence it is important to call and speak with Note Buyers to see what they would be willing to pay for notes and on what terms- FICO, LTV, DTI, Seasoning etc. Most real estate books recommend taking back mortgages/notes with buyer on below market terms to help sell the property to them at higher sale price. So what is your net cash if you utilized this technique?
Increasing Resale Price but not Value
Lets take a hypothetical example. You sold a property for $110,000 by taking back below market terms mortgage and the resale value of the asset was going to be $95,000 if a buyer got his or her own mortgage. You must be thinking “I am a value-add-investing genius, as I just made $15,000 more from the disposition value.”
However, did you really just make $15,000?
|Note- Face Value|
|Note to Cash Sale @ 20% discount|
Assumptions: The example above includes no transaction costs so that the example can be made clear. Also, the Note to Cash Sale was at 80% of the face value of the note.
Utilizing the table above, we will break down what happens if you took back a mortgage at below market terms. Typically, whenever you take back a mortgage at below market terms you need to sell it at a discount from its face value so that the note buyer can make an equivalent yield to notes being originated at market value. For the sake of the example, it is assumed that you called around and got a bid at 20% discount to the face value of the note. Utilizing the 20% discount rate, it is visible that you lost money compared to just selling the asset on the open market without taking back a mortgage.
Adding Value at the Disposition Phase
Below market terms do not work as we have seen from the example above. To increase the value at the Disposition Phase, I want you to keep in the mind
Rule 1: Buyers care about down payment, Monthly Net Cash flow, and Balloon Payoff date.
Rule 2: Do not make your equity the loan instrument, but rather get it from third parties like Note Buyers, Mezzanine Investors, or Institutional Capital.
Keeping the rules above in mind, lets look at a hypothetical example to better understand how to create value through financing instruments and techniques at the asset disposition phase.
Asset Type: 6 units
Market Value: $500,000 (without a seller held mortgage)
Market Value: $550,000 (with a seller held mortgage)
Asset NOI: $2,114 (per month)
Equity Available: $100,000 to $110,000
Target Cashflow: $400 (per month)
Target Hold: 7 years
Capital Market Facts
1st Mortgage: 70 LTV; 5% Interest Only for 10 years; Balloon in 10th year; 1.25 DSC
2ND Mortgage/Mezzanine: 80 CTLV; 10% Interest Only; 1.25 DSC
Lets see how the buyer would fare if they got the asset with open market financing terms:
|Net Operating Income||$2,114|
|First Mortgage @ $350,000||$1,458|
|Second Mortgage @ $50,000||$417|
|Net Cash Flow (per month)||$239|
|Deficit from Target Net Cashflow||-$161|
If the buyer purchased the asset at the asking price they would be making $161 less than their target cashflow. The buyer only option here is to discount the purchase price to $455,000 to be able to achieve his target cashflow of $400 per month. As a seller we do not want to loose $45,000 of resale cash value given that there are creative ways to help the buyer achieving the target net cashflow without taking a huge discount from market value.
Here are a few win-win financing instrument strategies to help both yourself (seller) and your prospective buyer:
1) Buy Down: Buyer at the current asking price has a deficit of $161 per month. You can offer to buy down the rate with the second mortgage lender by paying points, which in effect helps the lender reduce their interest rate as while their yield rate is still maintained. For example, if the second mortgage lender wanted to make a yield of 10% then you could figure out how much to pay into the lender as points. The annual deficit of $1,932 divided by lender yield of 10% equates to $19,320. $19,320 is the amount that must be paid into the lender to help them maintain their yield while making a $50,000 loan. So how do you as the investor wind up?
Open Market Sale
Offering a Buy Down
|Net Sale Price|
Utilizing a buy down you as an investor can help the buyer achieve their target net cashflow while adding $25,000+ of cash value to your bottom line.
You can get more creative given that you know what buyers in the market are seeking in Net Cash Flow and offer to sell the property for $525,000 with $25,475 in buy down credit which would hit allow the buyer to hit their hurdle net cashflow and allow you to achieve a net sales price of $449,525.
2) Annuity: To help the buyer make up the deficit from their target net cashflow, you can offer to buy him a monthly annuity that paid out $161 per month. Using an annuity calculator and using a very conservative growth rate of 1% per annum, you can buy an annuity for $13,067 that will pay out $161 per month for the next 7 years.
Open Market Sale
Offering a Buy Down
|Net Sale Price|
3) Zero Coupon Bond: If the buyer does not need the monthly coverage in the cashflow and is willing to take a balloon payment of the deficit cashflow in year 7 (the year he or she wants to sell the property,) then you can utilize a “zero-coupon bond instrument” to help satisfy that need. In our example above, the seller can purchase a $15,000 zero (another name for a zero coupon bond) that would balloon close to the buyer target resale date. In persuading the buyer to accept a bond as an alternative to a buy down, you want to get the buyer to agree to acceptable credit rating risk and the best way I have seen it done is the bond of the municipality where the property is located within as that is the implicit risk that the buyer is already taking by buying the physical property regardless.
As an investor, you can create value at the disposition phase by using creative financing instruments to help provide a net asset sale value rather than a straight sale. If you as a reader have other other financial instrument techniques to increase your net sales price, please share them in the comments below so that we can learn from each other.
Photo Credit: SalFalko