Chapter 8: Real Estate Exit Strategies
"Start with the end in mind." -- Steven Covey
Buying real estate is great, but no one gets into real estate because it's a fun hobby. Investing in real estate is a means to an end: wealth building. Over time, your property should gain serious equity and provide you with substantial income from cash flow and hopefully, appreciation. Some investors choose to hold on to their investments indefinitely. Some will simply hold on to cash flowing properties until the day they die - with no intention of getting rid of it. However, in your investing career, you will most likely choose to get rid of one or more of your properties for various reasons. Choosing the best strategy for exiting your real estate investment is just as important as deciding which one to buy. This chapter will give you a broad overview of the various exit strategies you can use in your investment career.
This Chapter Includes:
- Traditional Selling With a Real Estate Agent
- Selling FSBO
- Selling With Seller Financing
- Using Lease Options
- 1031-Exchanges: Avoiding Taxes On a Sale
- Your Next Steps
Traditional Selling With a Real Estate Agent
When listing your home with an agent, be sure to interview several agents to find one you are comfortable with and that you know will get the house sold. In the world of real estate agents, the "80/20 Principle" often seems to hold true - that 20% of the agents sell 80% of the listings. It's important to find that 20% and allow them to work their magic.
When you choose the agent you want to list your property, you will typically sign a "listing agreement" with the agent, giving them the right to earn the commission if they sell the home. The agent will discuss with you all the important features of the property and enter them into the "MLS" or Multiple Listing Service, which all agents have access to. At this point, you will decide what price the property should be listed for. Pricing is very important, as you do not want to list too high (adding months to your holding time) or too low (leaving money on the table.) A good agent should be able to look at other similar properties and determine the best price to list at.
The listing agreement also spells out the commission to be earned by the agent. The typical commission for a real estate agent is 6% (though that can change slightly, depending on price, property type, and location.) This fee is usually split 50/50 with the agent who brought the buyer. In the case where your selling agent is representing both you and the buyer, the whole commission is given to the agent.
Many individuals feel that this is the end of their duty in selling the property, and the agent will take it from here. However, this is not the case. There are many tricks and techniques that you, as the seller, can do to ensure the property sells for the highest amount, the soonest. Start with making sure the appearance of the property is desirable, including both the interior and exterior. Look around at competing properties, and aim to look better than the rest.
If selling a single family home, consider staging the home with furniture, artwork, plants, flowers, and other accessories to help the buyer imagine a home rather than simply an empty house. If selling a multifamily or commercial property, be sure all units are filled and operating at peak efficiency.
Once an offer is received, negotiations begin, and hopefully both parties can agree on a price and terms for the sale. Just as when you purchased the property, the paperwork for the sale of the property will be handled by either a local "title and escrow" company or an attorney, depending on the common practices in your area. Both parties will sign the documents, the money will be funneled through the title and escrow company or attorney, and the deal will close, leaving you with a large check to invest in more real estate and grow your empire.
Selling FSBO (For Sale By Owner)
While the majority of homes are sold with a real estate agent, you don't need to. Most often, a real estate agent is going to cost you an extra 6% to sell your property for you. For this fee, an agent typical will:
- List the home on the MLS, which is accessed by all real estate agents across the country.
- Put the sign in the yard to advertise the home.
- Show your property to prospective buyers.
- Market to the best of their ability, including through networking, Craigslist, and other online or offline media
- Manage negotiations with potential purchasers.
- Handle all the paperwork.
For some, the cost of a real estate agent is too high, so they choose instead to sell "For Sale by Owner," or FSBO. A major deterrent in selling FSBO is not getting your property listed on the Multiple Listing Service, or MLS. This list (or lists) is a collection of all the homes listed by all the real estate agents known as Realtors, across the country. When you look for homes online through sites like Realtor.com, you are looking at the MLS listings. Without being on the MLS, you'll lose the ability to reach the vast majority of individuals looking for a property.
One recent tool used by some to sell is known as a Flat Fee MLS Listing service, in which a seller will pay a "flat fee" to a real estate broker to list the house. This fee generally ranges between $150 - $400 and includes very limited help from that broker. The broker will simply place the home on the MLS and might even offer a sign in the yard, but will do very little other than this. This leaves negotiation, setting up title & escrow, and managing the closing in the hands of the seller themselves. Additionally, since a real estate transaction includes both the buyer's agent and the seller's agent, a commission is still paid to whatever agent brings a buyer to the deal. Instead of 6%, it usually will end up being around 3% out of pocket.
Selling Using Seller Financing
Seller financing (also known as "carrying the contract") takes place when an owner sells a property to a buyer but carries the mortgage rather than requiring the buyer to get their own mortgage. This is done by many investors all over the world for a variety of reasons and across different investment types. In a normal sale, the buyer will go to a bank to get financing for the house, and the seller will receive the total sale price (less selling closing costs) in one lump sum. With seller financing, the seller is the bank, so the buyer will provide a down payment directly to the seller and make monthly mortgage payments to the seller for the life of the loan or until the buyer decides to sell someday.Why Use Seller Financing?
This is done for a number of reasons, but typically it is used for buyers who don't typically qualify for a normal mortgage. The current lending atmosphere can make it tough for many buyers to obtain traditional financing. They may not be able to document all of their income, they may be self employed, or may have some blemishes on their credit reports.
Keep in mind that seller financing isn't only for the benefit of buyers who normally don't qualify for a mortgage. Many investors choose to sell off their properties using seller financing because they want to receive monthly income that doesn't involve maintenance, tenants, or rentals. When a property is sold via seller financing, the property is 100% the new buyer's responsibility, and with that comes all the rights and expenses that come with ownership (including taxes, insurance, and maintenance).
A seller may also choose to use seller financing in order to offset the taxes due at the end of their investment career, as the IRS classifies this as an "installment sale" and allows the seller to spread out any capital gains taxes that may be due. See your tax advisor for more information on the tax benefits of seller financing.How to Use Seller Financing:
When offering seller financing, the seller should require a large non-refundable down payment up front to protect their interest and to prevent against the the likelihood that the buyer will stop making their monthly payments. The higher the down payment, the lower the risk to the seller. For example, if a seller requires a $1,000 down payment, there is not a lot of incentive for the buyer to uphold their obligations. However, if the down payment required is $30,000, there is a lot more incentive to perform. Additionally, it is important that the seller goes through the same process as they would during a normal sale, using a title company, attorneys, and other legal paperwork to ensure the sale is done correctly.Who Can Sell With Seller Financing?
Seller financing is generally only applicable if the home is currently owned without a mortgage. If you have a mortgage through a bank or other lending institution and decide to sell the property to another party using seller financing, you will break the "due on sale clause" in the fine print of that mortgage, and the bank may foreclose on you. Seller financing is only viable for a free and clear house.
After a property has been sold with seller financing, the seller may choose to sell the mortgage, or note, to another investor. This opens up the world of "note buying," which is beyond the scope of this guide, but which is a very common strategy amongst experienced investors. For more on notes, search BiggerPockets.What Are Risks of Using Seller Financing?
The largest risk of selling with seller financing is having your buyer stop making payments at some point, whereby you, the seller, will have to foreclose. In this case, you are subject to the same laws and foreclosure process as any other lending institution, which takes time and money. Each state is different, but you will probably need to hire an attorney to get through the process. After the foreclosure is complete, you will get the house back and be able to sell it all over again, but you may have to deal with repairs and other issues before the home is ready to be sold again.
While the risks of having to foreclose can’t be completely avoided, they can be minimized if the note is managed properly. You do that by screening the buyer carefully, so that you are fully aware of any issues that might arise. Furthermore, as mentioned earlier, the best way to reduce your risk is to get as high of a down payment as possible. The more money you receive up front, the less likely you are to have problems.
Also be sure to check out:
Using Lease Options
Another Option used by investors as an exit strategy is known as the "lease option" or "lease purchase." This arrangement is actually two separate parts: the lease and the option.
The lease is just like any other rental lease, where the tenant moves into the home and makes monthly rent payments.
The option is a legal agreement that gives the tenant the legal right to buy the home at a pre-determined price in a pre-determined length of time. The option makes it illegal for the landlord to sell the property to any other investor during the pre-determined time period. In exchange for the tenant's sole "option" to buy the property, the tenant will pay an upfront non-refundable "option fee" that will typically be later applied toward the purchase.
Real World Example:
John and Sally would like to buy a house from Fred, the investor, but lack the down payment and credit requirements to get a loan for themselves. Fred has a mortgage on the property himself, so he cannot carry the contract and provides seller financing instead. Fred does a thorough background and credit check on John and Sally and decides they would be good candidates for this. The parties then sign both a lease agreement and an option agreement, giving John and Sally the right to buy the home for $100,000 any time in the next two years. John and Sally provide a $5,000 option fee and move in.
In the example above, there are several different endings that might occur:
- John and Sally are able to get traditional financing from a bank and end up buying the property from Fred sometime during the two years. The $5,000 option fee will apply toward their down payment.
- John and Sally decide they don't want to buy the house and leave within the first two years (or at the two-year point.) The $5,000, being non-refundable, is Fred's to keep. He then can decide to sell it, do another lease option (collecting another non-refundable fee from the next tenants), or do whatever he wants with the property.
- John and Sally may find, after two years, they cannot yet get a traditional mortgage. Fred may sign another "option" with them for another year or two, possibly increasing the purchase price and option fee.
A lease option gives options to the seller. The lease option is oftentimes a great alternative if you find yourself in a changing market and cannot sell a property, but don't want to simply discount the price. It gives the seller the ability to win in any situation - if any of the three endings above occur, the investor comes out okay.
Three Advantages of a Lease Option Strategy
A Great Short-Term Exit Strategy for a Slow Market. Flipping a property in the current real estate market can be difficult and costly. Doing a lease purchase can provide positive cash flow ,while giving the owner the opportunity to wait for the market to improve and lock in a possible buyer.
Lease Option Tenants Usually Take Better Care of Your Property. Tenants who have a lease option often feel more like "buyers" than "tenants" and, as such, often take much better care of the property than a typical renter. Tenants can also be made responsible for small repairs in preparation for their becoming homeowners.
No Real Estate Commission Required. Unless you find the lease option "tenant/buyer" through a real estate agent, you won't owe a commission when it comes time to sell via your option contract. Besides being able to market the home slightly higher due to the flexibility you are offering your tenant, you can save up to 6% when the tenant buys your property.
Three Disadvantages of a Lease Option Strategy
While lease-options often present a terrific "win-win" for all parties involved, there are some downsides to be aware of before jumping in.
The Dreaded "Due on Sale" Danger. While technically no sale took place, many argue that a "lease with an option to buy" can indeed trigger a "due on sale" clause because it transfers an interest in the property. The language in the law that determines when a bank can trigger the due on sale clause is cloudy at best, and while this may be a gray area, it is ultimately up to the bank to decide if they want to call the note due and force you to pay back the entire loan within 30 days. Should this happen, you could challenge this in court, but that also would require significant financial resources.
You Can't Sell the Property to Anyone Else. During the option period, the tenant has the exclusive right to buy the home. If prices suddenly rise, you are locked in at a certain price with the tenant and cannot sell for more. Also, if the market begins to drop and go downhill, you cannot sell to get out of the deal, either until the "option" is no longer binding.
You Could Be Sued. There is a story on the BiggerPockets blog about an investor who was sued by a tenant, who claimed (after being evicted for not exercising their option to buy) he had "equity" in the home. While the tenant had very little (or no) legal grounds to stand on, the tenant still cost the investor time and money in court fees, hoping for a settlement.
One final note about lease options: Very few lease option tenants ever actually utilize their "option" and purchase the property. As a result, some unscrupulous investors have used the lease option strategy to take advantage of tenants, offering a lease option to individuals who will never qualify for a mortgage and charging outrageously high option fees and short terms, just hoping the tenant doesn't buy. These investors then re-churn the process over and over again. This usually leaves the tenant in a worse position than when they began the process. BiggerPockets does not approve of this practice and instead asks that you to treat your tenants with respect and dignity. Taking advantage of others for profit is what gives real estate investors a bad name. Don't do it.
For more information on Lease Options, check out:
- Rent to Own Homes
- Lease Options as a Tool to Rock Out Your Rental Properties
- BP Podcast 041: How to Profit Through Long Term Flipping and Lease Options with Douglas Larson
1031-Exchanges: Avoiding Taxes On a Sale
As with any business venture, when you are successful, Uncle Sam is there to collect his share. When it comes time to sell a property that you own, chances are you will have significant taxes due, especially if you followed the advice in this guide and bought a great deal. Thankfully, if you are paying taxes in the United States, the government provides a way to "defer" those taxes to a later time.
There are a number of rules that need to be followed, but if done correctly, you can possibly re-use the money you would have paid towards capital gains tax, and you can use it as funds for your next property. Essentially, this is the government's way of "partnering" with you on your investment deals. There are a lot of complicated things that go into a 1031-exchange, so be sure to talk to a qualified tax specialist before making any decisions.
Your Next Steps
At the end of this chapter, you should have a clear understanding of how to eventually get out of your real estate investment. When you begin with the end in mind, you make it much easier to unload your property and clear a nice profit.
In this guide, we have covered nearly every facet of getting started in real estate investing. In chapter 1, we looked at what investing is, what it's not, and what you need to get started. Chapter 2 looked at the proper way to gain a good educational foundation before jumping in to the real estate game, while chapter 3 examined the many different strategies and niches you can get use to build wealth with real estate. Chapter 4 laid the groundwork for a successful real estate business plan and chapter 5 looked at the best way to prepare and shop for your first investment property. In chapter 6 we dove into the important world of real estate financing, and chapter 7 covered marketing. Finally, chapter 8 dealt with the importance of beginning with the end in mind and how to plan your exit strategy for each property you buy.
While you have reached the end of The BiggerPockets Ultimate Beginner's Guide to Real Estate Investing, your journey is just beginning. You now should have a very clear understanding of what real estate investing is and how you can begin to profit from it. Now it's time to put it into practice. If you have not yet done so, please head over to BiggerPockets.com and sign up for a free account.
BiggerPockets is a community of over 550,000 real estate entrepreneurs who are here to help build each other up with knowledge and support. They are also using the site to network and to find partners and clients. We want you to be a part of our community. Ask (or answer) questions on the forums, read the recent blog posts, create a company profile for your business, or just hang out with other investors. You are the average of the five people you associate with most, so if you are not currently associating with successful real estate investors, let BiggerPockets help you with that.
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