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Are Nothing Down Real Estate Deals Risky?

by Ben Leybovich on January 7, 2014 · 24 comments

  
Nothing Down Deals Risky

How many times have you heard – Buying Real Estate with Nothing Down is risky?  Let us examine the risk factor in nothing down deals:

Few Words About Insurance

I often write about the duality – the proverbial ying & yang that exists in life.  Well, let me tell you – nothing is more of a duality than the concept insurance.  I’ve never met an investor who likes insurance or likes paying the bill for that insurance, and yet everyone does.  Now, how is that…?

Let us understand the premise behind insurance.  In most basic terms, the function of insurance is to protect you from a catastrophic loss – a loss of such magnitude that expense associated with it would send you into bankruptcy.   For instance, you don’t need auto insurance most of the time, but on a day when you have an accident you really do because you’ve caused $200,000 worth of damage and have no means with which to pay up.  Same goes for health insurance, fire insurance, flood insurance, etc.

So – all that we are doing by purchasing any given insurance policy is we are transferring the risk of an over-seized expense some time in future away from ourselves and onto an insurer.  The more the actuarial risk of such an event, the more we can expect to pay in premiums.  That’s the name of the game – transfer the risk…

It seems to me that real estate is no different from any other circumstance in life in that if we can, as much as we can, it is desirable to transfer the risk of a future loss away from ourselves.  Let’s agree to define the ultimate loss in real estate as loosing the property – what can cause this and how can we offset the risk?

Basic Protection #1: Cash Flow

First of all, our capacity to hang onto property is a function of Cash Flow.  When we buy property, in most cases it is evident that we can not support the costs of ownership with earned income.  Yes indeed – the property must support itself.  Put differently, if there’s more money coming in than the cost of ownership, then you can hold onto property indefinitely, or until you find a way out.  The safety, then, is a function of the magnitude of Cash Flow.

By buying property with substantive Cash Flow, therefore, you effectively transfer the risk of a loss to the tenants who make your payments for you, so to speak.  Your cash flow – the quality of the tenants that your building can attract is the only reason the lenders would so much as consider your deal: Good tenants = Cash Flow.  This is why I don’t slumlord – I could never attract stable tenants and create stable Cash Flow which would in my mind as well as my lender’s constitute safety.  This is also why I don’t flip – there’s no tenant there to transfer the risk onto; the risk is all on the owner in flipping…

Basic Protection #2: Financing

This is also why it is important to finance property in ways that do not force the exit, especially if you are new at this.  There’s nothing worse than having to sell when either you are not ready, or the market is not conducive. Now – as you grow, specifically if you aim to become very sophisticated, you will most likely have to learn to play with things like adjustable rate mortgages, balloons, negative amortizations, blankets, ect. and there are some ways to offset the risk posed by these, but at the outset you should stick to vanilla financing…

Ultimate Risk Transfer

OK – so you have to agree that putting money on the table in any enterprise is by definition a risky activity – you could loose it.  Real estate is no different from anything else in this respect.  Therefore, logic would have it that the ultimate way of offsetting risk of loss in real estate is by not putting any money down!  Who are you transferring the risk onto in this case – the financier.

I know – I’ll get a lot of flack for saying this, but it’s the naked truth.  Having said this, let me outline some realities.  Since the lender(s) know that by allowing you to finance the deal 100% they are assuming all of the risk, certain thresholds will need to be met:

  1. The deal must be VERY STRONG
  2. The Cash Flow must be VERY STRONG
  3. The opportunities to force appreciation and therefore create equity must be VERY STRONG
  4. Your track record must be VERY STRONG

THE END
Photo Credit: Max-Design

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{ 24 comments… read them below or add one }

Michael Sadler January 7, 2014 at 1:50 pm

Thanks Ben!

It can help having a portfolio of property that cashflows to help soften the potential blow from losses in market value.

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Ben Leybovich January 7, 2014 at 1:57 pm

Hey Michael – nice to see you here indeed!

Yes – we don’t buy anything that doesn’t Cash Flow. As such, by default, we don’t too much care what happens to equity. OK – we do, but equity is the icing on the cake, while CF is the cake :)

Thanks so much Michael!

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Ben Leybovich January 7, 2014 at 2:21 pm

Michael – tried to call you at the number you called from and could not connect. Give me a call please.

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Sharon Tzib January 7, 2014 at 2:02 pm

You’ve now officially met an investor who loves insurance. After a tornado in Indiana practically ripped the roof off my rental and destroyed the fence, and I got it all replaced for the deductible, I have no problem making the payment every month :)

Great points, Ben. There’s a big leverage discussion on another post right now, and frankly, I don’t understand people’s aversion to it. They either don’t understand how to implement correctly, are ultra-conservative, or very paranoid. Everyone should do what they’re comfortable with, by all means, but I’ve always put as little money down as possible, and I can’t imagine where I would be today if I had paid all cash for everything.

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Ben Leybovich January 7, 2014 at 2:05 pm

Hey Sharon – I agree with both of your statements :)

Talk to you soon.

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Brian Gibbons January 7, 2014 at 2:03 pm

There are nothing down traditional deals and nothing down creative deals.

U my dear friend are the master of traditional deals.

I have not shared my net worth statement, my tax returns, my EIN, or PGed any docs except for residential loan docs.

I buy on terms (sub2, master lease, lease option, master lease option) and rent out or sell on terms.

Much can be learned from Prof Ben’s course on Commercial Financing.

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Ben Leybovich January 7, 2014 at 2:07 pm

I know – it’s too funny how 2 guys can come at it from exactly opposite directions and arrive at very similar place :)

Thanks so much Brain!

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Lisa Phillips January 8, 2014 at 8:28 am

Hi Ben, good article!
I would like to know if you could expand on how you mitigate the risks of using adjustable rate mortgages, negative amortization, etc.? Thanks,

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Ben Leybovich January 8, 2014 at 9:20 am

Hey Lisa –

Once in a while I get a writer’s block and can’t figure out what to write about; this generally happens when I do a lot of writing here as well as my own blog. Usually, when I am in a rut like this, I check and see what Brandon Turner has been writing about and usually I am able to find something to pick a fight with him over lol – I was going to do exactly that here in a day or two unless I had a revelation. Thank you for causing a revelation Lisa – look for some answers in up-coming posts from me :)

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Roy N. January 9, 2014 at 3:37 pm

Lisa,

The “Adjustable Rate” mortgage – known commonly outside the U.S.A. as a “Variable Rate” mortgage – is not a fearful beast as regularly depicted here on BP!

Truth be told, in the realm of conventional mortgages here in Canada, my preference is a 5-year term, variable rate mortgage, with an amortization of 25 or 30years. The interest rate is far lower than a fixed-rate mortgage of the same duration {currently: 2.6 – 3.0% for a 5-yr term, variable rate versus 3.9 – 5.34% for a 5-yr term, fixed-rate}.

There is risk if interest rates head skyward, but rates would need to almost double to put me on par with a fixed rate mortgage. Furthermore, if I’m 2-3 years into my mortgage when rates start to climb, they would have to rise significantly higher than the 5-yr fixed rate to preclude me from coming our ahead. There have been statistical studies in the Canadian residential market, looking at conventional mortgage rates port WWII until the mid/late-1990s, which have demonstrated that if you were to take any 25-year interval {the most common amortization in Canada}, variable rate mortgages always cost less than fixed rate mortgages.

BTW: The long term fixed-rate mortgage is an anomaly only present in the U.S.A market. If other parts of the world can invest in real estate with short-term and variable rate mortgages, I’m sure it’s possible within the U.S.A as well. :-)

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Ben Leybovich January 9, 2014 at 5:00 pm

Right on Roy – I wrote what I think is a killer post for next Tuesday on the subject…

BTW – the anomaly you speak of is otherwise known as social engineering :) Personally, I think that these low interest rates are going to hit the fan before too long and the folks who can only invest via a 30-year at 4% are not going to be investing any more. Perhaps I’m wring but this is what I see coming possibly…

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Sharon Vornholt January 8, 2014 at 11:15 am

Nice post Ben. I love creative deals where you don’t put anything down. You are indeed a master at doing that. So long as the property can still cash flow I personally don’t see anything wrong with not putting money down. Now if you do that and your are upside down, well that’s just plain stupid.

Sharon

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Ben Leybovich January 9, 2014 at 8:00 am

Haha Why would anyone think it’s a good idea to buy a property that doesn’t Cash Flow. I mean what – for losses; I can get those and put money in my pocket at the same time.

Thanks very much Sharon!

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Shaun January 10, 2014 at 1:12 pm

It is pretty simple to break down.

If you are leveraged then you are at a bigger risk of losing a property since you have more obligations that the property needs to be able to support and you have more people that can take it away from you. The more debt you have the bigger this risk.

If you have more of your own money in a deal the more likely you might lose that money. Not a very desirable situation. At least if you pay all cash as long as you can pay your property taxes there isn’t really any risk in losing the property.

I feel you want to be sort of all of nothing with financing. Either pay all cash or try to get as close to 100% financing as possible. Basically want to eliminate one of the risk factors of the risk factors.

If you really think about it the most common, and riskiest (stupidest?) ways to invest is to put a big down payment into a place and then also take a big debt obligation as well. So the risk of losing the property is quite high if it eventually can’t support the debt payments and if that happens the risk of losing the money you put in it is pretty high as well.

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Ben Leybovich January 10, 2014 at 4:24 pm

EXCELLENT!!!

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Brian Gibbons January 10, 2014 at 5:28 pm

As Shaun said, but from a different angle…

Do you want to be an equity rich, wealthy commercial landlord with a “SUE ME I HAVE MONEY” target on my back?

A common strategy for landlords of Multis for ASSET PROTECTION from lawsuits, is Equity Stripping, or getting as highly leveraged as possible.

See Equity Stripping http://www.rjmintz.com/equity-stripping/overview/

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Shaun January 10, 2014 at 9:51 pm

Well certainly from an asset protection standpoint there isn’t anything better than having a totally unencumbered that looks like it has no equity. :)

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Shaun January 10, 2014 at 9:52 pm

*property

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Brian Gibbons January 10, 2014 at 10:05 pm

Go Pats!! lol

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Ben Leybovich January 11, 2014 at 3:07 am

Yes gentlemen – 100% financing is indeed best from an asset protection point of view. Now, equity stripping is illegal, but there is nothing illegal about financing no money down – welcome to my life :)

There are caveats. Some attorneys work by the hour and are so unscrupulous as to take their client’s money knowing that there’s no equity to be had. Also, they could come after future Cash Flows. But on balance, reason would tell us that it certainly takes the bulls eye off our back not to have equity, which is why I try to re-leverage any equity that becomes available into acquisition of additional CF.

So, Shaun – while you are right that either 100% or 0% is best, on balance 100% leverage wins out in my book.

Brian Gibbons January 11, 2014 at 3:18 am

Hi Ben,

2 definitions of equity stripping:
1 is equity skimming, like foreclosure rescue, bad news.
another is 100% finance, no equity.

Great article! :)

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Ben Leybovich January 11, 2014 at 3:21 am

What the hell are you doing up man? My dog woke me up by throwing up in the living room at 4 AM – what are you doing up you crazy person. Stop working now – it’s an order… :)

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kendra January 11, 2014 at 7:05 am

Hi Ben,

I want to thank you for your several articles which I have read over the last few months. They have helped me think of how to not pay so much at closing. I’m new at this. The first SFR I got last May, I just bought without thinking much of how to reduce my cash expenses at closing. I paid about $5600 at closing. For the second one in September, I asked the seller to contribute to closing costs and paid about $2400 at closing even though it was a more expensive house. Now I am looking at a couple more owned by one person. Today I will be looking at them in person and have already thought, if they meet my requirements, of an offer for both together that will let me walk away paying nothing at closing, and even getting some monies to take home with me and use for initial work I’d like to do–if the seller agrees. I really appreciate your insights because they help me accomplish my goals quicker. I want to have a large cash reserve, but I also want to have a certain number of units. Your comments are helping me achieve that.

thanks
kendra

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Ben Leybovich January 11, 2014 at 9:04 am

Thanks for your comment Kendra!!! I am excited for your continued success and happy to be able to help in a small way.

Ben

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