Real Estate 101

Essential Real Estate Investment Strategies

This short course is designed to introduce you to key real estate investment techniques and strategies that we will discuss in much greater detail in later modules.

These techniques and strategies are used successfully by investors every day and are a proven way to build your real estate investment business.

We’ll discuss the following techniques and strategies:

1.    Lease Options
2.    The Sandwich Lease Option
3.    Subject To
4.    Wholesaling
5.    Fix and Flip
6.    Foreclosures
7.    Pre-foreclosure
8.    Short Sales
9.    Real Estate Owned (REO)
10.    Virtual Investing

1.    Lease Options

Lease options are also know as Rent-to-Own. The terms are basically interchangeable although some people will split hairs and define them a little differently. For the purpose of this blueprint they are the same thing.

A lease option is exactly what it says – a lease with an option to purchase. When you acquire property under a lease option you are really concluding two separate agreements.

The first agreement is the lease. Usually the lease gives you the right to occupy the home for a period of time in return for which you will pay rent.

A practical example of this is where a tenant leases a property from the owner (the landlord) for a one year period and pays rent of $1,200 per month.

The second part of the agreement is the option. An option is an agreement that gives you the right to purchase the property within a given time period in return for the payment of a consideration called an option fee.

A practical example of this is where the owner of the property gives a tenant the option to purchase the property for $220,000 for a period of one year in return for payment of a consideration of $5,000.

There are three important things to note about options.

The first thing is that an option agreement is what is known as a unilateral contract as it gives the person who receives the option an option or choice to exercise that option. It doesn’t give the person giving the option any choice.

The second important thing is that the person receiving the option is not obliged to exercise the option. The optionee has a choice to waive their right, exercise their right or allow their right to expire.

The third important thing is that there must be a payment of a “consideration” in return for the granting of an option. A “consideration” doesn’t need to be cash. It can be anything of value, including a promissory note.

2.    The Investor’s Staple Diet – The Sandwich Lease Option

Investors will generally enter into a specific type of lease option called a “Sandwich Lease Option”.  In a sandwich lease option the investor is the “meat” in the middle of the two slices of bread.

In a sandwich lease option an owner enters into a lease option with an investor and the investor then enters into a sub lease and option with a tenant buyer in relation to the same property.

A practical example of this is where the owner will lease the property to an investor for $1,000 per month and provide him with an option to buy the property for $200,000 within a two year period. The investor will then sub lease the property to a tenant for $1,250 a month and provide the tenant with an option to purchase the property for $225,000 within a one year period.

There are a number of elements to the above sandwich lease option.

1.    The agreement between the owner and the investor must include the term that the investor has the right to sub lease the property.

If the investor can’t sub lease the property it will not be possible to enter into a sandwich lease option.

2.    The investor will usually sub lease the property to the tenant for more than lease amount that the investor must pay the owner. In the example above the investor leases the property for $1,000 per month and sub leases for $1,250 per month, giving the investor a positive cash flow of $250 per month.

3.    The option agreement between the investor and tenant must include the term that the option is subject to or contingent upon the investor being able to exercise his rights under his option agreement with the owner.

This is extremely important as there is no agreement between the owner and the tenant. The agreement is between the investor and the tenant and does not bind the owner. The owner is not obliged to honor an agreement in which he has no part.

If the investor can’t or doesn’t exercise his right or option to purchase the property then the tenant’s option is worthless.

4.    The investor will provide the tenant with an option to purchase the property for more than the option amount that the investor must pay the owner. In the example above the investor options the property from the owner for $200,000 and then options the property to the tenant for $225,000, giving the investor a gross profit of $25,000.

5.    The time period of the option is very important. The investor must option the property from the owner for a period that is longer than the period the investor gives to the tenant to option the property. In the example above the investor has an option from the owner for two years but only provides the tenant with an option for one year.

If the investor’s option expires the investor will not be able to honor the option agreement with the tenant.

3.    Subject To

Buying real estate using the “Subject To” technique involves acquiring title to the property subject to the existing mortgage loan.

Practically this means that ownership of the property is transferred to the investor, usually by a quitclaim deed, but the mortgage loan is not transferred to the investor and the investor does not assume the liability of the mortgage loan. This doesn’t mean that the investor doesn’t have any responsibility or liabilities in connection with the property. Usually, in return for getting title to the property, the investor will take over the homeowner’s payments to the lender.

It is very important to note that the original homeowner remains liable to the lender as per the loan agreement and promissory note and the property remains encumbered to the lender as per the mortgage or trust deed. This has huge financial, legal and moral consequences.

The benefits to the investor are huge mainly because the investor can effective purchase the home without getting a mortgage loan. The investor is effectively invisible to the lender and doesn’t need to qualify for a loan, incur costs to register a loan or tie up credit.

Most new investors have a problem understanding this concept. The first question is usually, “Why would the homeowner pass ownership of the property but still keep the loan?”

The answer is usually because the homeowner is unable to pay the mortgage loan and risks loosing the home anyway. It is better for the homeowner to give title of the home to an investor because if the investor makes the loan payments this will save the homeowner’s credit.

As I mentioned there are huge financial, legal and moral consequences attached to buying a property “subject to”. The primary concern is that an unscrupulous investor may get the deed to a home but never make the mortgage payments. This will put the homeowner in an extremely bad position as the lender will eventually foreclose on the property.

There is also a question surrounding the legality of this real estate investment technique because most mortgage loans have a “due on sale” clause that allows the lender to elect to require that the full outstanding mortgage loan balance is paid when the owner sells the property. When a homeowner gives title to an investor in a “subject to” deal, ownership changes hands and the “due on sale” clause kicks in. However in practice, the lender rarely calls up the loan so long as the investor makes the monthly payments on time.

4.    Wholesaling

This real estate investment strategy involves “buying” real estate at X price and reselling it quickly at X plus Y price. I use the word “buying” in a very broad way because usually a wholesaler will never take title to the property. Most wholesalers will put the property under contract and then assign, broker or double close the property. The main reason for this is that by not closing on the property the investor avoids closing costs and makes more profit.

Wholesaling is a great way to build up the cash reserves that you need to be really successful investing in real estate. It’s a great “no money” down” technique that generate quick cash flow with little cost, hassle and time commitment.

I highly recommend this technique for new investors without the money to put down or hold real estate.

Most wholesalers use an assignment clause to wholesale real estate. A practical example is whereby a wholesaler contracts with a seller to buy a property worth $250,000 for $190,000. The buyer of the property is written up as “wholesaler and / or assigns” and gives the wholesaler the right to assign the contract. The wholesaler then assigns the contract to a new investor for the same price of $190,000 but includes a provision that the new investor will pay the wholesaler an assignment fee of $10,000. This means that the effective purchase price for the new investor is $200,000 and the wholesaler makes $10,000.

Note that the wholesaler never took title to the property and assigned the contract to the new investor before closing.

Note also that the wholesaler doesn’t sell the property to the new investor but instead sells the contract to the new investor.

A second way to wholesale real estate is to use a real estate license and act as a real estate agent. I use this technique extensively. In the case of our $250,000 example, the wholesaler, who has a real estate license, puts the same $250,000 property under contract for $200,000 and includes a provision that the seller will pay the wholesaler’s real estate company a commission of $10,000. Thereafter the wholesaler finds a buyer for the property and assigns the property to a new investor for the same $200,000 purchase price. At closing the wholesaler’s real estate company is paid $10,000 commission.

The reason that having a license is important is because it is much easier for the wholesaler to collect his fee as a $10,000 commission than as a $10,000 assignment fee as he will be paid at closing by funds advanced by the lender. Lenders are accustomed to advancing funds to pay broker commission but rarely cover assignment fees.

A third way to wholesale real estate is to double close or simultaneous close. This is a complicated technique that requires the co-operation of all parties to the transaction, including the lender and title company. It’s an advanced technique that we will discuss later.

The final way to wholesale a property is for the investor to put the property under contract, close on the property and then resell the property at a later date. The biggest obstacles to this technique is that the investor incurs the cost and hassle of closing the property, the cost and hassle of owning the property and the cost and hassle of selling the property. Also lenders don’t like having loans flipped too quickly and have problems funding loans with seasoning issues.

Recommended Reading

5.    Fix and Flip

Fix and Flip refers to the process of finding a distressed property, fixing it up and then selling it for a profit.

The process of fixing the property is also called rehabbing.

The fix and flip process has been made famous by countless TV shows like “Flip this House” on Home and Garden TV. You’ve probably also seen ads and billboards by companies that say “We Buy Ugly Houses”.

The central premise in a fix and flip is that you can buy a house at a steep discount because it needs work to get it back to an acceptable condition., fix it up and then sell it for a much higher price.

The house may be damaged and needs to repaired. It may be out dated and needs to be modernized. It may lack some functionality, like an extra bedroom or a garage, and needs to be improved.

In a fix and flip you need to determine the “as is” value of the property. This is the value of the property in its distressed state.

You then need to determine the cost to buy, fix and hold the property.

Finally you need to estimate what the value of the property will be after the fix up. This is the “after repair value” or the ARV.

If everything works to plan you will buy the house for $X, fix it up for $Y and sell it for $Z, where $Z equals more than $X plus $Y.

A word of caution.

Fix and flipping works best in an appreciating market. When home values go up it doesn’t matter too much if you’re stuck holding the property as the value will usually increase over time. In a depreciating market there is normally tremendous pressure to sell the property quickly as its value will decrease over time.

This means that in a depreciating market only the savviest investors will be successful as fix and flippers. A down market is not the time to learn on the job.

Recommended Reading

6.    Foreclosure

A foreclosure refers to the process whereby a lender institutes proceedings to repossess a property as a result of a default in the loan.

When a homeowner borrows money to purchase a property, he must pledge the property as collateral on the loan. If he falls behind on the payments, the bank has the right to sell his property at a public foreclosure auction to pay off the loan.

Usually the lender will hire an attorney to manage the foreclosure proceedings on its behalf.

The foreclosure process usually starts after the homeowner has been in default for three to six months.  There is no rule or time frame for the lender to start foreclosure proceedings except that the lender is usually obliged to wait a minimum of one month.

A foreclosure starts with a default notice that is sent to the homeowner by mail.  The default notice is a warning to the homeowner to pay all of the back payments, or lose the house through foreclosure.  The default notice will have the exact amount that needs to be paid, and a list of all the missed payments.

The total amount that is owed in order to stop the foreclosure and make the loan on the house up to date is called the reinstatement.

If the homeowner fails to pay this reinstatement figure, then the foreclosing attorney, by law, must advertise the upcoming foreclosure auction in a local newspaper.

The foreclosure must be advertised at least once a week for a set number of weeks, usually between three and five weeks.  When a foreclosing attorney advertises in a local paper, the place, date and time of the auction is listed.  The foreclosure advertisement gives you most of what you need to know to be in the right place at the right time.

The last step in the foreclosure process is the actual auctioning of the property.  Once the foreclosure auction has taken place the homeowner has lost the property and the highest bidder at the foreclosure auction is the new legal owner. The exception to this is if the state allows for a redemption period. During the redemption period, a homeowner or junior lien holder may redeem the loan and acquire title to the property

Every state has a prescribed process that the lender must use to foreclose on a property.

Some states provide for judicial foreclosures whereby the lender must sue the borrower through the courts.

Other states provide for non judicial foreclosures and allow a public trustee to transfer ownership of the property to the lender.

Some states allow both judicial and non judicial foreclosures.

You can check the foreclosure laws for each state by going to Foreclosure Law.

The important thing for you to know is that a foreclosure creates a motivated seller and a motivated seller is usually willing to sell his property at a reduced price or with investor friendly terms.

7.    Pre-foreclosure

Pre-foreclosure refers to the time period before the property is sold at the foreclosure auction. It usually starts when the borrower misses his first mortgage payment and the loan goes into default. When the borrower misses a number of payments the lender will initiate foreclosure proceedings by filing a Notice of Demand (NOD) or Notice of Election and Demand (NED) with the court in a judicial foreclosure or the Public Trustee in a public trustee foreclosure. This is technically the start of the foreclosure action.

Until the property is actually sold at the foreclosure auction the homeowner has the right to sell the property. This means that you can do a deal directly with the homeowner.

Investors are interested in two things – price and terms.

A homeowner in foreclosure is motivated to sell the property below market value so as to avoid losing everything at the foreclosure auction. If there is equity in the property this is usually pretty easy to do. If there’s no equity in the property it’s possible to create artificial equity if you can short sale the property. In a short sale an investor offers less than what is owed to the lender and the lender accepts the offer.

A homeowner may be willing to offer the property on very attractive terms. Many investors buy foreclosure properties using “subject to” terms. “Subject to” means that the property is sold subject to the existing mortgage. This allows the investor to buy the home and take over the homeowner’s payments to the lender.

The homeowner may want to stay in the house and may lease the property back from the homeowner. This is called a lease back.

The homeowner may want to lease the property and get an option to purchase the property back from the investor. This is called a lease option.

The main thing to understand is that the homeowner is motivated to avoid foreclosure and will agree to a price and terms that make the property an attractive deal.

8.    Short Sales

A short sale occurs when a lender accepts a pay off of a promissory note for less than the amount that is owed on the note.

This situation regularly occurs when a homeowner goes into foreclosure and can not sell their home for the amount of the outstanding loan.

An investor will make a short sale offer to the lender for an amount less than the outstanding loan balance. If the lender accepts the lesser offer, then this is called a short sale.

A simple example looks something like this:

A homeowner buys a house for $200,000. The homeowner got a 100% loan and owes $200,000 on his home. The loan amount is made up of a $160,000 first mortgage and a $40,000 second mortgage.

The value of the home depreciates to $190,000 and as a result the homeowner can’t sell the home without bringing about $25,000 to the closing table. The homeowner doesn’t have $25,000 and is now facing foreclosure.

An investor makes an offer of $170,000 and the homeowner accepts subject to the lender approving a short sale.

In this example the first mortgage holder will be paid off as the offer of $170,000 covers the amount of the first mortgage.

The second mortgage holder will not be paid off as there is not enough money in the offer to cover the second loan.

If the second mortgage lender approves this offer this will be a short sale.

Short sales are an extremely important technique in a housing crisis. Record numbers of foreclosures mean that many homeowners are “upside down” in their property and owe more to the lender than the property is worth.

The Short Sale Packet

Each lender has its own requirements for the submission of a short sale application. The rule of thumb is to submit a short sale packet exactly as required by the lender.

The short sale packet will contain a number of consistent items required by every lender.

•    Authorization to release loan information
•    A cover letter that provides a summary of and motivation for the offer
•    A hardship letter explaining the reasons for the borrower’s financial predicament.
•    A purchase contract for the property (or a document or contract that gives the person making the offer the right to make an offer).
•    A HUD 1 net proceeds statement that specifies the bottom line to the lender
•    The listing agreement. Most lenders will insist that the property is listed.
•    The balance sheet and personal income and expenditure statement of the borrower
•    Borrower’s latest two pay stubs
•    Borrower’s latest two monthly bank statements
•    Borrower’s last two years tax returns
•    Proof of funds or loan approval for the new purchaser.

Short sale experts will warn you that the process is not easy, that it differs from lender to lender and even from processor to processor within each lender. The process can take up to 120 days and there is no obligation on the part of the lender to accept the offer.

A few tips about submitting a short sale application:

•    Only submit a complete application
•    Confirm that your application has been received by the lender and appointed to a loss mitigation processor.
•    Get the processor’s email address and try to maintain as much email correspondence as possible
•    Mark each page of every document in the application with the loan number in bold print.
•    Always meet the broker and appraiser appointed by the lender at the property.
•    Research and submit foreclosure statistics for the relevant area.
•    Never, ever lose your cool with the processor
•    If you don’t know what you’re doing, outsource the processing to a third party expert.

In many cases a short sale is the only viable exit strategy for the homeowner.

It’s very important to note that a short sale doesn’t eliminate the homeowner’s debt to the lender. When the lender agreed to lend money to the homeowner to buy the property, the homeowner signed both a promissory note and a mortgage or deed of trust. The promissory note is a promise by the homeowner to repay the loan to the lender. The mortgage or deed of trust is a security instrument that the lender uses to secure the loan. A short sale results in the cancellation of the mortgage or deed of trust. It doesn’t extinguish the promissory note and the homeowner will still be liable to the lender for the short fall from the short sale, called the “deficiency”.

The lender has the right to sue the homeowner for the deficiency caused by the short sale. This is a judicial process which means the lender will be required to file suit in a civil court.

It’s common practice for the lender to simply write off the debt and not proceed with legal action.

When a lender writes off the debt it will issue a 1099 to the homeowner for the amount of the write off. This has important tax consequences as the IRS views the amount of the write off as imputed income to the homeowner and this amount is taxable.

The good news is that recent legislation, the Mortgage Forgiveness Debt Relief Act of 2007, allows qualified homeowners to avoid taxation on the imputed income.

This relief does not extend to second homes, investment properties and has a limited time window.

Why would a lender accept a short sale?

This is the question that many people ask – what’s in it for the lender?

The second lender will accept a short sale as it allows them to recover some money from the sale of the property. More importantly, by accepting the short sale the lender can close the books on a bad loan and write off the loss. This has very important accounting and compliance ramifications for the lender. There is almost nothing worse for a lender than to have a bad loan stuck on the books.

What’s the benefit to the homeowner?

Short sale advocates proclaim that the main benefit to the homeowner is that it allows him to sell his house and save his credit. This is partially true as there is some credit benefit. Unfortunately the borrower’s credit score is still severely harmed as the credit bureaus penalize the borrower for 30, 60 and 90 day late reports as well as upon the initial filing of the foreclosure action.

Another benefit is that a short sale helps rehabilitate the borrower in a much shorter time than a foreclosure. Fannie Mae released guidelines in May 2008 that make a homeowner with a foreclosure ineligible for a new mortgage underwritten by Fannie Mae for five years. This is different to the two year period that Fannie Mae requires for homeowners who sell through a short sale.

You can look up Fannie Mae’s guidelines at www.efanniemae.com/sf/guides/ssg/annltrs/pdf/2008/0816.pdf.

If the homeowner simply lets the house go into foreclosure this will have a long term negative effect on his credit and will severely limit his ability to buy another house.

Personally, I think the greatest benefit is the piece of mind that the homeowner gets from a fresh start. A condition of all our short sales is that there will be no deficiency judgment against the homeowner. The lender simply files a 1099 and goes away. The 1099 is not viewed as income by the IRS as the Mortgage Forgiveness Debt Relief Act of 2007 protects the homeowner against taxation on the loan write-off.

A short sale is not a cure all fix for the homeowner but it does make the best of a bad situation.

Recommended Reading

Josh Cantwell has written the Sort Sale Manifesto 2.0 and you can download it here for free.

9.    REO (Real Estate Owned)

A REO is a property that a lender owns as the result of foreclosing on a homeowner. Lenders refer to these repossessed properties as Real Estate Owned or REO’s.

It’s important to understand that the lender owns the property and can sell the property.

REO’s are a huge problem for lenders. How many times have you heard your local banker ay “banks are in the business of lending money, not …..”. In a housing downturn lenders foreclose on large numbers of loans and end up owning equally large real estate portfolios. This is extremely bad for a lender as the lender has a non performing asset that it doesn’t want to own. This creates an opportunity for investors to buy REO’s from lenders as the lender is a motivated seller.

REO’s have a number of advantages over pre-foreclosures.

The main advantage is that property has been through the foreclosure process and all junior liens have been wiped out. This means that you can buy a property that is not encumbered by the previous owner’s debts.

The second advantage is that when you deal with the lender it’s easier to structure a quick, discounted deal because the lender will make a purely business decision. The bank knows that it loses money every day it holds the property. The quicker it can sell the property the less of a loss it will incur.

A homeowner is emotionally attached to their home and this always complicates the process.

Most REO’s are handled by the bank’s asset management department or they contract an outside asset manager. The asset manager will usually instruct a local real estate agent to list and sell the property. The real estate agent will conduct a BPO (broker priced opinion) to help the bank determine the fair market value of the property. The property is usually listed at below market to ensure a quick sale.

10.    Virtual Real Estate Investment

The internet has fundamentally changed the way we invest in real estate. Why? Because the internet offers an incredibly efficient vehicle to distribute information.

As an investor you now have unprecedented access to critical information and data that you previously would not have been able to access. This access to data allows real estate investors to buy, sell, develop and manage investment properties with more confidence and far more efficiently because we have all the information we need to manage our real estate investment business.

Virtual real estate investing means that you can be a real estate investor from the comfort of your home. It doesn’t matter whether you want to invest in property in your neighborhood or out of state, you can be a virtual real estate investor.

The size of our market has grown to the point where the whole world is our investment playground.

The National Association of Realtors (NAR) released data that shows that almost 80% of homebuyers will start their search for a home by going online. That’s eight out of ten people – unbelievable. That means that you must be absolutely crazy not to advertise your investment properties on the web.

What’s unique about the internet is that it allows use to both receive and send information. A whole new industry called internet marketing has emerged to provide us with the resources and expertise to effectively distribute our marketing message.

It’s my opinion that the new “rock stars” of the real estate investment industry are virtual real estate investors. The key is that they’ve found a way to make huge money by using the internet. They can use the internet to find and analyze deals, evaluate local markets and sell their properties. All at a fraction of the time and cost of traditional real estate investing.

In effect, this course is really a Virtual Real Estate Investment Blueprint. It lays out all the tools and resources you need to be a successful real estate investor.

Some Essential Real Estate Investing Terms

I’ve created a list of real estate investing terms that you will need to know for future modules. This is not a glossary of terms, just a short list of essential terms.

Assignment

An assignment of contract allows an investor to pass his legal rights within the contract to another investor whereby the new investors “steps into the shoes” of the original investor. Effectively, the contract remains the same, with the same rights and duties, except that a new investor has replaced the original investor.

As a general rule, all contracts are assignable, unless assignment is expressly excluded. But be aware that most contracts do expressly disallow assignment without the written consent of the seller.

Assumption

Some mortgage loans include a provision that a mortgage can be assumed. This means that the mortgage holder agrees that the original borrower can be replaced by a new borrower. The original borrower may or may not be released of his contractual obligation to the lender. These loans are increasingly rare but can be hugely beneficial.

Double Close

A double close occurs when an investor purchases a property from a seller and then immediately resells the property to new buyer. The key is that the closing takes place at the same time or the second sale to the new buyer closes before the first sale to the investor. Sound complicated? It sure is! Technically the funds for the second sale are used by the investor to fund the first sale.

A practical example will really help here:

Homeowner X sells a property to investor Y for $190,000 who, before closing, resells the property to New Owner Z for $200,000. Investor Y arranges for a double close whereby both transactions will close on the same day with the same title company. Investor Y doesn’t apply for financing. New Owner Z gets a $200,000 loan from a Lender. At the closing table the title company will effectively manage the transactions so that the $200,000 loan that New Owner Z gets from his lender is used to fund the purchase by investor Y from home owner X and subsequent resale to New Owner Y. At closing, homeowner X will get $190,000, investor Y will get $10,000 and New Owner Z will get the house.

Seasoning

Seasoning refers to the amount of time a loan has been in issue. It’s like marinating a steak – the longer you leave it, the longer it will be seasoned.

Contingency Clause

A contingency clause is a term in a contract that makes the validity and enforceability of a contract subject to the fulfillment of a future event. What this means is that the contract will only be valid and enforceable if a certain event successfully occurs (or doesn’t occur) in the future.

The most common contingency clauses include a clause that makes the contract subject to the buyer being successfully approved for a loan or the property being appraised for a minimum value.

Hard Money

Hard money is the generic term used for money that is lent by non-traditional lenders. As a general rule hard money is lent subject to different terms as concerns the cost of the loan, length of the loan and the security provided by the borrower. Most hard money loans will be shorter than conventional loans, cost more than conventional loans and will include a minimum of two points, go to a maximum of 75% of After Repair Value and the security will be primarily asset based.

Although hard money is more expensive it is usually more convenient and quicker to close. Most hard money loans can close within 48 hours and often are done without a credit check on the borrower.

As an investor, if you find a home for sale at 60% of its fair market value, you will easily get a hard money loan but you may not easily get a conventional loan.

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