The Importance of “Skin in the Game” in Real Estate
A couple of weeks ago I wrote an article about offering terms as a selling tool. In follow up to that discussion, I thought it would be worth exploring the different types of financing scenarios that arise as a result of listing a property with the option of owner financing.
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As I mentioned in my previous article, offering terms on one of my personal properties resulted in a great deal of activity from interested buyers. In fact, I listed the property for almost $20,000 above market value because of the owner financing option, and there was still more interest than I had anticipated. As a result of this activity from potential buyers, I entertained a number of different offers and financing scenarios.
Ultimately, I ended up accepting an offer that was lower than the other offers. In fact, the offer I accepted was lower in sales price and accompanied by a lower interest rate than the other offers. Why would I do this? Simple, this particular buyer was willing to put down over 20% whereas the other offers were in the 3%-5% range. Don’t get me wrong, it wasn’t an easy decision. I liked the idea of the higher cash flow with the other offers, but in the end, I liked the idea of “skin in the game” even more.
At initial glance, I could have made a higher return had I chosen to sell to a buyer with a lower down payment, but a higher sales price and a higher interest rate. However, in analyzing my options closely, I felt like there were two key principles that steered my decision to the buyer with the larger down payment:
1) The cash that I receive from the buyer as a down payment can be reinvested in other deals. It was important for me to not only look at the returns for the property I was selling, but also the ability to invest in other deals as well. Truthfully, the 20% down payment I receive from this buyer will get invested and reinvested multiple times before the end of this owner financing. While it’s hard to calculate a return on future deals, they will more than likely net a higher return than selling to a buyer with a lower down payment.
2) The risk of the buyer defaulting on my financing is greatly reduced by the fact that the buyer has over 20% of his own cash invested in the transaction. It’s a lot easier for someone to walk away from a house when they only have 3% invested as opposed to 20%. While it’s not easy to assign a concrete value to this, up-front cash invested should weigh heavily in the decision making process.
Interestingly, the term “Skin in the game” was originally coined by Warren Buffett. He knew that in order to create a successful company, it was important for interested parties to have a legitimate financial stake. In the same way, when dealing with tenants or buyers, the more financial stake they have in the transaction, the higher the likelihood that the transaction will be a success.