Advice on buy back loans for property investment

reddred · #1 05-25-2006, 10:59 AM

Let me preface by stating I'm new to property investment, so bear with me.
The situation is a friend of mine is liquidating a rental property business he has with his brother in law and is offering 3 of these properties to myself and my business partner. Here's the skinny:

The 3 properties are broken down into 2x4 rental units and 1x3 unit rental property. The total asking price for the 3 units is @1.1 million. The 3 properties are located in the Charles village area of baltimore (which is a good area now and looks to have a nice upside as well.....blocks from JHU).
The properties have all been upgraded in the past 5 years and look to have no major issues. The positive cashflow on these properties is modest.

Now.....needless to say, I don't have the money to buy this. I pretty much have zip. I own a house which has an excellent situation going on with it I don't want to jeopardize. Seller is offering an interest only loan to us for downpayment....basically, seller takes 2nd mortgage, lends us down payment, we pay 9% interest on a 200K loan for first 5 years, then owe the principal....if we can't pay, we do another 5 year interest only and so on. I know this is done all the time, but it's new to me, and being pretty conservative by nature, it's kinda scary to be on the line for that much money which I'm quite sure I won't have in the next 5 years. The prices for the properties are fair market and I believe will go up, but it's more of a long term investment than a flip it quick type of thing.
Anyway, I need some advice or opinions from you savy investors out there about these buyback loans and whether this a a viable way for someone w/ very modest income to move up the money ladder of life, or whether I would be tying a financial noose for myself.
Also, I believe it is an option for me to buy 1 or 2 instead of all 3 properties....thanks in advance for your thoughts/insight.

Groty · #2 05-25-2006, 12:39 PM

Create an LLC. Put the property in the LLC with you and your partner as the shareholders. The LLC will also obviously be the borrower. Be sure the loan is non-recourse to you and your partner. Do not provide a personal guarantee.

That's one way to structure it to try to protect your existing assets if things go wrong.

reddred · #3 05-25-2006, 12:54 PM

funny you should mention that....my business partner and I have filed for our LLC and are awaiting the paperwork to go thru the system, get our tax ID#, etc. Our plan is to transfer the title on the house we already own into the LLC, once it's approved.
My question is, what mortgage company, or person lending us the buyback loan, would do so w/out a personal garauntee or w/out any recourse to us personally? Doesn't seem that realistic. Now if we move our existing property to our LLC, then that property would be at risk if this deal went south. thoughts?

DesertCat · #4 05-25-2006, 01:39 PM

Why do you need to do this? Instead of committing all of your resources to a single roll of the dice on a so-so deal, why not wait for something much better? Do you really think you'll see much, if any, appreciation in period of rising interest rates? Why not find some properties with strong positive cash flow so you don't have to care about appreciation?

What's the cap rate on these properties anyways?

DesertCat · #5 05-25-2006, 01:58 PM

Also, sounds like your "friend" has decided to get out of the market when the getting is good. If he truly thought there was a strong potential for appreciation he wouldn't be selling.

Groty · #6 05-25-2006, 03:42 PM

[ QUOTE ]
funny you should mention that....my business partner and I have filed for our LLC and are awaiting the paperwork to go thru the system, get our tax ID#, etc. Our plan is to transfer the title on the house we already own into the LLC, once it's approved.
My question is, what mortgage company, or person lending us the buyback loan, would do so w/out a personal garauntee or w/out any recourse to us personally? Doesn't seem that realistic. Now if we move our existing property to our LLC, then that property would be at risk if this deal went south. thoughts?

[/ QUOTE ]

I was trying to point out that to protect your personal assets/property in the event the deal goes wrong, you want the LLC to be the party on the transaction documents. And to the extent possible you don't want to provide a PG.

Your lawyers can draft "carve out" language to exlcude the existing house you're about to transfer into the LLC from the mortgage. It's up to you to get the mortgage provider to accept.

My guess is that tax liens, mechanics liens, etc. against the LLC may put the existing house at risk. Consult a good real estate attorney before you get too far along.

Like DesertCat said, it looks like your friend wants out at the top. Be careful and good luck.

reddred · #7 05-25-2006, 04:41 PM

[ QUOTE ]
Why do you need to do this? Instead of committing all of your resources to a single roll of the dice on a so-so deal, why not wait for something much better? Do you really think you'll see much, if any, appreciation in period of rising interest rates? Why not find some properties with strong positive cash flow so you don't have to care about appreciation?

What's the cap rate on these properties anyways?

[/ QUOTE ]

Good point, and certainly one I'm thinking about. I/we DON'T NEED to do this deal. It's an opportunity, and I wanted to explore how good of a deal it is. And your right, these guys got in at a great time, fixed up these places, and are trying to get out at the top. Not necessarily the best time for us to get in, and a good time for him to get out. Plus selling directly to us saves them alot of $ on realtors fees.
My thought was that if this was feesible , I/we could be sitting on a nice little retirement plan 20-30 years from now. But certainly not the only real estate plan we could get involved in......and most likely not the best. thanks for your input, and your assessment of the deal which is that it's a "so-so" deal. I agree.

Also, what exactly are you refferring to when you mention"cap rate"? thanks.

reddred · #8 05-25-2006, 04:45 PM

[ QUOTE ]
Also, sounds like your "friend" has decided to get out of the market when the getting is good. If he truly thought there was a strong potential for appreciation he wouldn't be selling.

[/ QUOTE ]

He actually is a genuine friend.....has done a lot of nice things for my partner and I over the years. I don't think he's intentionally trying to set us up for failure....he wants to see us do well. He is a lawyer(i know, your laughing right now) who is starting his own practice and needs cash for startup. But, yes, it is a good time for him to get out, and we all know this.

DesertCat · #9 05-25-2006, 06:46 PM

I'm not a real estate investor or expert (yet), so bear that in mind. A cap rate is one of, if not the, most important measures of a rental property. It's basically the cash flow generated available to pay for the mortgage, with what's left over your profit.

This guy goes into great detail and seems to know what he's talking about.

My shorthand is to start by estimating your annual rents. Deduct reasonable vacancy percentage. Deduct reasonable annual maintenance costs, any management costs, insurance, and annual taxes. Essentially deduct every annual expense that isn't your mortgage cost (I'm not sure what to do about depreciation). What's left is your net operating income (NOI).

Divide NOI by your purchase price. For example, the three units will cost $1.1M, assume your NOI is $80K. 80/1100 is a 7.3% cap rate. So, if you could get a 100% loan at 7.3%, you'd break even every year, and require appreciation to turn a profit on the deal. If you get an 80% loan for 7.3% and put 20% cash down, your cash will earn 7.3% per year. If you can get interest rates lower than your cap rate, then you should have positive cash flow and shouldn't be dependant upon market values for your profits. I.e. you won't be sinking money into it every month, and maybe get forced into a fire sale if you run out of capital.

Working backwards from your post on the 3 unit deal, and guessing you'll pay around 8% for an 80% loan, would mean your NOI is around $90k per year. If it's less than that, run away. Here are the risks you face

1) Interest rates. Try to get a fixed rate or very long term (7 years) ARM. You can't afford to have your rate adjust 1% or more within the first few years ($9k per year per percentage point). It would absolutely kill you. And try get your friend to guarantee he won't raise the rate on the 2nd if you have to renew.

2) No equity. You won't be building any equity in the second unless you generate positive cash flow. You'll be treading water and hoping appreciation will bail you out.

3) Negative cash flow through from bad events. Your interest costs will be around $7500 per month. If anything goes wrong, i.e. you have trouble replacing a tenant or lose two at the same time, you may have to fork out $2500-$5000 a month out of pocket to keep your mortgages current. How well capitalized are you to do that for 6 months at a time? What if a tenant damages a unit when they move out and refuses to pay for repairs? Will you be able to repair it out of pocket?

Personally I would only want to do the deal if I thought my cap rate was significantly higher than my interest rates. A cap rate of 9.5% would give you about $16k per year in positive cash flow to handle emergencies and build equity. On the three units, if they generate $90k, I'd want to pay less than $1.1M. Your friend will likely not agree with that price, but you should not enter a deal unless you do the research and are convinced not only is it a great deal, but that there is a big margin of error to cover your ass in case you make a mistake.

reddred · #10 05-25-2006, 07:42 PM

DesertCat...absolutely one of the most thorough replies I've gotten to a post in the years I've been on 2+2 (and my post wasn't even poker related...lol). Thanks so much for taking the time to explain these concepts to me. I'm going to crunch the numbers and just fyi, I'll let you know what we decided. Thanks again for taking the time. REDDRED.