Why You Can Sometimes Pay More With Good Financing: A Message to the Naysayers
In the comments section of my article “Your Guide to Uncovering the Best Seller Financing Deals,” one of the more experienced and knowledgeable investors in the BiggerPockets community called me out. This veteran told me that “to pay more with alternative financing is a mistake.”
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Why did he say it was a mistake? Because financing does not make a property more valuable. Because the practice could lead me to being upside-down in a property when I need to refinance or sell it.
These were good points from someone who has a large knowledge about real estate and finance, but I have found that this general guideline does not always apply.
So, in the rest of this article, I intend to show you how carefully trading a higher price in exchange for a particular set of good purchase financing is NOT a mistake. In fact, for certain deals, purchasing at a higher price with the right kind of alternate financing can be less risky and more profitable over the long run than paying less with less favorable financing.
First Principles of Real Estate Investment
This conversation will not make sense without some first principles. We need to discuss what makes a real estate investment worth purchasing or not.
The investors I admire most, like Benjamin Graham and Warren Buffett, share a common principle for successful investing: “Don’t lose money.” Accumulating savings or equity is difficult; therefore, the priority should be not to lose it.
So, you might say that our first principles for purchasing investment properties are to:
- Minimize the risk of losing money
- After #1 is taken care of, maximize our return on investment
In order to not lose money, it will always help to buy at a lower price. This gives us more options to sell or refinance if needed. But a low price alone does not completely solve our problem of risk. Most real estate purchases are made with financing, so the type of financing used for a purchase plays a large part in the success or failure of the deal.
For example, the most common real estate failure story I've noticed is when someone cannot pay off a loan that has come due or when an over-sized monthly financing payment uses up all of an investor's cash flow. Both of these are directly related to financing terms.
Why Financing & Time Horizons Complicate the Risk-Reward Equation
If I am buying with the intent to resell in a relatively short period of time, price is by far the most important term. Nothing else really matters because a lower price reduces your risk and increases your profits.
If I am using equity (my own cash) to purchase, whether to resell or to hold for income, price is also the most important term for the same reasons.
But if I choose to use debt or other forms of leverage (options, leases, etc.) to purchase an investment whose purpose is income production over a longer period of time, the equation is not so cut and dry. The analysis of risk and reward becomes more complex.
Why? Because not all debt or forms of leverage are created equally. The terms of each form of leverage can make a deal extremely risky or extremely safe.
To share what I mean, here is a brief list of a few key negotiable financing terms:
- Loan to Value
- Minimum down payment
- Source of down payment
- Minimum regular payment
- Start date of payment
- Interest rate
- Is rate adjustable?
- When does interest begin accruing?
- Maturity date (a.k.a. balloon date when all principal is due)
- Does borrower personally guarantee the financing?
- Are there prepayment penalties?
- Can borrower substitute the collateral?
- Does borrower have first right of refusal to purchase note?
- Is there a due on sale clause?
If these terms don’t make sense to you, I suggest that you start educating yourself by reading the mortgages you have already been signing you entire adult life. You may be shocked. The bank who lends you the money and their attorney probably understand the power of these terms better than you do.
Each of these financing terms affects the risk of the overall deal. In other words, more negative negotiated terms could make financing more risky for a borrower even if the price and amount borrowed were lower. And more positive negotiated terms could make the financing less risky even if the price paid was higher.
Let me illustrate this entire concept with two case studies.
Case Study #1: Lower Price, Risky Financing, Bad Results
A rental property investor in my town almost lost his multi-unit income property to foreclosure in the downturn of 2008-2009. This investor originally bought these units at a reasonable price (good cap rate), and he paid a substantial down payment. At the time of his problems, his loan to value ratio (LTV) was around 55% (i.e. $165,000 owed on a $300,000 value building is 55% LTV).
This investor never missed a payment, but he almost lost the property to foreclosure because the bank who owned the mortgage refused to rollover the loan at maturity. The balloon popped! He tried to refinance, but real estate credit was extremely tight at the time. He was forced to sell quickly at a HUGE discount to another investor (and lose money) because the bank controlled the terms of financing.
This investor followed the traditional rules. He bought below value. He paid money down. He got a bank loan. He amortized the loan aggressively. In the big picture, this was not the worst thing that could have happened. His risk reduction measures kept him out of bankruptcy because he was able to just sell quickly when problems arose.
But this situation shows the importance of balancing all of the financing terms, not just a low purchase price. If he had been given the chance to pay a slightly higher price with terms that did not force him to sell, is it possible he would have been much better off? I think so.
Let’s imagine what could have happened with an alternative case study.
Case Study #2: Higher Purchase Price, Lower Risk, Better Results
I don’t know all of the details when this investor originally bought his income property, but for this exercise let’s assume the following:
- $300,000 was the seller’s asking price
- $3,000/month was the gross rent
- $1,650/month was the net operating income
- $19,800 was the yearly net operating income ($1,650 x 12)
- 6.6% was the cap rate at asking price ($19,800 / $300,000)
- Location is in a college town, stable or rising rents, no major location problems
- Seller is a retiring landlord who does not plan to do a 1031 exchange
As I've told you, this investor used a bank loan to purchase the property, and it led to the near-foreclosure and loss of his equity. Based upon his numbers in the end, it's plausible he originally negotiated a pretty good deal that looked something like this:
- $247,500 = negotiated purchase price
- 8% = purchase cap rate ($19,800 / $247,500)
- 20% or $49,500 = down payment
- $5,000 = closing costs
- $198,000 = original loan balance
- $1,362/month at 5.5% on 20 year amortization
- Balloon in 5 years ($168,054 = principal/interest owed at 60th month)
- See amortization schedule here
- Positive Cash Flow = $288/month ($1,650 – $1,362) or $3,456/year
- ~6.34% = cash on cash return ($3,456 / $54,500)
What if instead he had offered the seller another option and received terms like this:
- $270,000 = negotiated purchase price
- 7.33% = purchase cap rate ($19,800 / $270,000)
- $50,000 = down payment
- $2,000 = buyer paid closing costs, inspections, etc
- $220,000 = seller carry-back financing balance
- $1,362/month at 3.0 %
- Fully amortizes to $0.00 by month 207
- See amortization schedule here
- Positive Cash Flow = $288/month or $3,456/year
- ~6.65% = cash on cash return ($3,456 / $52,000)
The down payment, monthly payment, and cash-on-cash returns are similar for each deal, but doesn’t the extra $22,500 in purchase price and leverage make the seller financing deal more risky? Maybe.
If the investor had to sell or refinance at year #3, for example, the answer is yes. He would owe only $180,000 to a bank, but would owe $189,000 to the seller.
But that is not the whole story.
The point of paying a premium in price was to negotiate terms that allowed the investor to not have to sell or refinance in the first place. The goal is to use the income from the property to amortize the debt over a longer period of time.
In either case, by the end of year #5 the principal balance of both scenarios is around $167,000.
So, by the time the bank was forcing the investor’s hand, an investor who had bought with seller financing was sitting with the same balance and no risk of having to refinance or sell at the wrong time.
That, my friends, is an example of why we sometimes pay more to get better financing.
Unlike the bank financing, the seller financing has no balloon payment, no adjustable interest rates, no payment changes, or other risky terms built in. During a downturn, the investor with seller financing may have to tighten his belt and struggle to get through, but once the storm clouds subside the investor can lick his wounds and keep sailing towards his investment goal.
In case you’re not convinced, we could also negotiate for seller financing terms that reduce our risk and increase our profits even more. They might include:
- No personal guarantee. The property is the sole collateral for the note. In disaster scenarios, this may give me more leverage to sell the property, deed it back to the seller, or renegotiate a new deal.
- Substitution of security. Even if I had to sell at a small loss on this property, I could use the closing proceeds to pay off a higher interest note on another property I own and keep the seller financing in place. I would substitute the collateral for the original note and give the seller a new mortgage on my other property.
- No due on sale clause. Unlike traditional mortgages, it is possible to remove the due on sale clause with seller financing. If I want to eventually move from property management to more passive interest income, I could sell my building, receive a down payment, and “wrap” the underlying financing with a second position note at 6% from my buyer while still paying 3% for the remaining term of my seller.
All of these terms are negotiated at the time of the purchase and sale agreement. A higher price could be a very worthwhile bait to exchange these terms that lower risk, increase flexibility, and allow for easier exit strategies.
Caveats and Big Picture Reality
This article is about a very specific tool, seller financing, in a very specific situation, a long-term buy and hold rental.
I hope you noticed that I still did NOT say it’s ok to pay ridiculous prices for properties. Even in my case study of a higher offer price, the cap rate was still 7.33%, which is at or in some cases below market value in my investing area. My price was just high relative to my cash offer, which is often lower than other investors in my market.
Be careful not to take the general concept (pay a higher price) and use that as a license to generally overpay for investments without careful negotiation and analysis. In a majority of cases when you buy real estate, a lower price is still the number one consideration. “Buy low, sell high” is a maxim for a reason, so if you only remember one rule, follow that.
At the same time, I hope this article encourages you to consider the nuances and complexities that financing can bring to the analysis of your longer-term deals. For every 9 investors who know how to buy a property at a low price, maybe one knows how to also negotiate other terms which can make or break the deal. This is a clear competitive advantage if you decide to master these tools.
Remember also to keep your big picture investing goals in mind. The tools of real estate and financing are just a means to an end. The end goal for me, for example, is a destination of financial independence. The chunks of equity and streams of cash flow created by real estate and financing are simply tools that help me get to that worthwhile place.
Do you have anything to add? Where do you fall in this debate?
I’d love to hear your feedback and comments (including or especially the naysayers:)).