Eight Exit Strategies

Sorry. There isn’t an Exit 8 in Texas. Or, at least, I can’t find a picture of it. Photo by TBD

This post originally appeared in substantially altered form on the Hermit Haus Redevelopment website on 2016-06-17.
 

Seems to me

You don't want to talk about it

Seems to me

You just turn your pretty head and walk away

—Joe Walsh

I’ve mentioned “exit strategies” in a few posts. I thought it might be worthwhile to discuss the exit strategies we use at Hermit Haus Redevelopment, LLC (HHR). But first, let me define the term “exit strategy” as we use it in the redevelopment industry and more specifically at HHR. Simply put, an exit strategy is a way to get out of a deal once you’re involved in it. Each of the exit strategies I discuss here can be applied in various parts of the deal cycle.

Okay. Let’s get down to it. Here are the eight exit strategies we use:

Before Going under Contract

If you exit the deal before going under contract, you essentially have no risk, not even opportunity costs. You don’t tie up any of your funds. The worst that can happen is you find out a better negotiator got the house and made a killing. This has never happened to me. Yeah, right!

Walk Away from the deal.

Speaking of “walking away,” it seems like whenever we go hiking I spend a lot of time looking at receding butts. Am I just slow?

Believe it or not, walking away is the most important exit strategy you can acquire. Most of the deals you see won’t make you any money. You have to recognize these bad deals quickly and not just walk, but run away. And you can walk away at any point of the deal cycle. You just have to be aware of the consequences, especially if you have already taken title to the property.

Refer the seller to a Realtor®.

Many of the deals that come your way are really retail sales. There is little value you can add to the property, and the owners need more money than you can pay. Period. These deals can help you maintain a good relationship with your Realtor by referring the seller to your listing broker, who can help the seller get the seller get the most for their house. Since this is another form of walking away, you’ll only refer out a deal if you can’t do anything else with it.

Of course, if you are a Realtor yourself, you could always list the property as an alternate way of monetizing your time.

Under Contract but before Closing

Simply by going under contract you are incurring some risk. If you can’t sell the contract, you could lose your option money and your earnest money. Then there is always a chance the seller could sue for specific performance, however unlikely.

The contract is what makes a deal real. This is the beginning of a contract where we bought a house from a wholesaler. In Texas, anyone acting as an agent (except, I believe, a lawyer) for another person is required to use a standard contract.

Wholesale the contract to another investor.

You have to have an equitable interest in a property to sell it without a real estate license. In most states, the contract to buy the house is an equitable interest that you can sell for a few thousand dollars. At this point, all you have invested is your option and earnest money. So if you have $100 down and assign the contract for $10,000, you can make a tremendous return on your investment without ever owning the property. A couple of caveats:

• Wholesaling is not legal in all states.
• It works best when you already have a list of buyers who might be interested in the property.
• In the states where wholesaling is legal, you must have a valid contract to sell.
• I recommend you always use an attorney when wholesaling.

You’ve closed on it. Now you own it. What are you going to do with it? This question is what exit strategies are all about.

After Taking Title to the Property

After closing on the purchase, there is no doubt that you have embraced risk. You own the property. Now you have to pay for it and the needed renovations. Unless you use the double-close method of wholesaling.

Double close on the property.

Although this is technically a type of wholesaling, you actually take title to the property. Because of the cost of closing twice, you would only want to double-close in a few situations:

• Traditional wholesaling is illegal in your state.
• You’re making enough money on the deal that you can afford the double close.
• You don’t want one or both parties to the wholesale transaction to know how much you’re making on the deal.

"Prehab" the property.

Prehabbing is doing the extreme minimal amount of improvements to a property needed to sell it to another investor. (Yes, you could call this another type of wholesaling.) We haven’t had the opportunity to prehab a property yet, but the most common example I’ve encountered of other people prehabbing is with hoarder houses. A friend of mine bought a hoarder house for $45,000. He then spent $500 to have the garbage hauled off and sold the house to another investor for $70,000, making almost $30,000. The investor who bought it put another $30,000 into the house and sold it for $150,000. In my books, that a win-win-win.

Rehab or redevelop the property.

This is our bread and butter. At this point, all of the properties you see described on this site is a rehab or a redevelopment project.

Buy-and-hold (and rent) the property.

Holding rental properties are a great way to build wealth. You use someone else’s money (mostly) to buy the property, and your tenant makes the payment for you. HHR doesn’t hold rental properties. We do, however, sell redeveloped properties to our sister companies to hold.

Owner finance the sale.

To owner finance the sale, you must have sufficient capital to absorb the risk. I have to say this is one of the riskiest exit strategies you have, and it is fraught with drawbacks. First, you have to pay taxes on the capital gains without having the income from the property to do so. Then you have to assume the buyer will continue making the payments you rely on either for income or to make wrap payments yourself. And finally, it eats the capital you would need to continue your investment business.

So that’s it: Eight different exit strategies to keep in mind on any deal. We use one of these strategies every time we look at a property. By far, the one we use most often is to walk away.

Cloudy Title

We found out about a bogus $14,000 lien against one of our rentals today. Bogus liens are a multi-million dollar industry. Photo by: WUNC

This post originally appeared on the Hermit Haus Redevelopment website on 2016-02-04.

It is ridiculously easy to put a lien on someone’s property in Texas.

This morning I was talking to our banker at First Texas Bank about a Home Equity Line of Credit (HELoC) we are in the process of taking out in the company name using a house Suna and I own free and clear. This is a strategy to help build credit in the Hermit Haus name. The company is responsible for paying back the loan, but Suna and I are still on the hook. It’s like cosigning for your kid’s car.

During that call, I found out that a bank put a lien on our Lloydminister property—the one we own free and clear—in the name of Susan Kendall and her husband. The bogus lien is for roughly $14,000. That’s no pittance in anybody’s book.

Apparently, having a name that sounds like someone else is good enough. Someone at that bank decided that Susan Kendall must be the same person as Sue Ann Kendall and filed a lien on our property. Texas has no mechanism to check the legitimacy of these liens. The state blithely assumes that anyone filing such a lien must be correct and homeowners are guilty until proven innocent.

I have known about the possibility of these bogus liens for years, but I have never encountered one before. In checking with a couple of Realtors, I was told situations like this one happen “all the time.” The problem apparently amounts to millions of dollars each year in legalized fraud or robbery, depending on how you want to look at it. The good news is that the lien holder can’t force us into foreclosure. They have to wait until we find out about their scheme or sell the property.

Many people don’t find out about one of these bogus liens until they have a contract to sell their property. Then they are under too much time pressure to fight the fraud and end up paying for someone else’s debt just to be able to sell their own property. But on the positive side, it’s the title company’s job to clear these things up, and, given time, they are pretty good about clearing them up.

Luckily we found out with time to fight. Keep following this series to learn more as I do.

 

Streams of Income from Rental Properties Part 3: Tax Reduction Through Depreciation

Try to think of depreciation on rental properties as an income stream instead of as your money going up in smoke.

This post originally appeared on the Hermit Haus Redevelopment website on 2016-01-08.

This is the third of the articles I’m writing on the financial advantages of owning rental properties. A couple of recent posts have pointed out some of the hazards of owning rentals, and everything said in those posts is true. Owning rental properties is a business, and there are risks in any business. If you don’t manage your properties well, you could lose money. Let me restate that. If you don’t manage your properties well, you will lose money, sleep, and peace of mind—the last being the most important.

That said, the US tax code is written to encourage people to invest in real estate, from individuals who own only one home to investors who own many. It contains so many tax benefits for rental owners, you’d need to be a real estate tax specialist to understand all of them. And if you’re playing this game, you definitely need a good CPA and a good lawyer. I have them, and so does every professional investor I know. Further, I’m not going to pretend to be an expert in tax law or strategies. I’m writing these articles from my own experience, and your experience will definitely be different. You’ll do somethings better than I did, and you’ll do somethings worse. You’ll make or lose more money that I did, and I’ve done both.

Depreciation

So lets talk about depreciation. As an investor in rental properties, you are required to depreciate the improvements on your rental properties—just the buildings, not the land. For the sake of argument, let’s assume depreciation on the example house worked out to $5,000 per year. It doesn’t, but that’s an easy number to work with. At this rate, you will have written off your initial $25,000 investment in five years.

In the negative cash flow situation, there would be probably little or no impact to your annual taxes, but the depreciation and other loses would affect the bottom line when you sell. This minimal impact is because most of us can only use real estate losses to shelter real estate income, and conservative accountants will only allow you to carry forward the loss to shelter next year’s income, if any. The IRS publishes guidelines for being certified as a Real Estate Professional, which changes the rules substantially, but I’m not qualified to publish anything that might be considered tax advice; so I won’t. Talk to your CPA.

In the positive cash flow scenario, depreciation would more than offset the $4,800 dollars the rental put in your pocket. If you’re in the 40% tax bracket, that would be the equivalent of reducing your tax burden by $1,920—a return of almost 8% on your initial $25K investment.

The Downside to Depreciation

The downside to depreciation is that it reduces your basis in the property. Basis is basically what you paid for the property plus any improvements that are not deductible as expenses. When you sell a property, you subtract the basis from the sales price to calculate your profit on the property for tax purposes. When you sell the property for more than your basis, you have to recapture the amounts you depreciated as income on the sale. But that comes much, much later—if ever.

My mom, a Realtor^®, used to joke that cemetery plots were good investments. “People are just dying to get in there.” Photo by:

If you leave the property to your heirs, their new basis is the value of the property at the time of inheritance; all of your deductions for depreciation don’t count after you die. If the property is worth $200,000 when you die, the new basis for your heirs is $200,000. That makes depreciate an almost infinite return on investment, but it doesn’t help you when you’re dead.

There are also tax advantages associated with equity growth, but that’s the subject of the another article in this series.

Are you starting to get excited about owning rental properties? Writing this series of articles has reinvigorated me, and helped reshape my investment strategy. As my friend and mentor Phill Grove says, “How many rent houses should you buy? All of them!” Just make sure you buy them right, and they’ll make money for you.

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Posts in this series:

1. Streams of Income from Rental Properties
2. The Two Examples and Cash Flow
3. Tax Reduction Through Depreciation
4. Equity Growth

It’s Not Always a Nail

If all you have is a hammer, pretty soon everything starts to look like a nail.

This post originally appeared on the Hermit Haus Redevelopment website on 2015-12-31.

This post is my take on the situation that spawned Sue Ann’s post yesterday. We came across a prime example of a deal that is not a good deal for everyone, but we were still able to find a good solution for a distressed seller.

Carol knows a frustrated landowner whose last tenants left his house unlivable when he was forced to evict them. He wants out of the renting business but is willing to owner finance the house.

There is a reason it’s called “property management.” Despite my series of posts extolling the benefits of rental ownership, renting houses is a business. It’s risky, and it’s not for everyone.

Russell, Carol, Sue Ann, and I all evaluated the house to determine what we would be willing to pay for it. At the same time, the owner asked Carol to show the house to another investor who had approached him. Sounds weird, huh? We’re looking to buy a house, and the owner asks us to show the house to a competitor. And we did so without hesitation. Carol is a Realtor®, so that gives us one more tool to help distressed owners find an acceptable solution. So, no problem.

It turns out that the other investor was willing to pay slightly more for the house than Hermit Haus was, because he focuses on that particular part of town. But he still wasn’t willing to pay what the owner wanted for the house. The owner didn’t see either our offer or the slightly higher offer from the other investor as beneficial enough for him at the time.

So what is the best win-win solution?

This trashy image from HuffPo symbolizes the house we evaluated. It isn’t that the problems were so bad, just that there were so many of them.

Let’s step back and look at the house. It’s a four bedroom 2.5 bathroom brick two story with a two-car garage. After renovation, it will be a perfect home for a growing family. Unfortunately, there is that thing about the house not being livable right now. That means a family will have trouble finding a bank willing to finance the house in its current state. But that’s okay because the owner doesn’t want to sell the house outright; he wants to finance it. We can also help the right buyer find funding to rehab the house and increase their equity in it—kinda like what they do on Fixer Upper, but we don’t to the rehab. Luckily, we can put the right buyer in touch with the right contractors, as well as the money to fix it up.

In investor language, that’s called having “multiple exit strategies.” In Hermit Haus terms, it’s called “having the right tools to find the right solution for the problem.” The old saying is holds that if you only have a hammer, everything starts to look like a nail. At Hermit Haus Redevelopment, we pride ourselves on being able to look at the actual situation and find the right solution, not just the one that fits the tool at hand. Depending on the situation, we will take one of six positive actions to help any distressed owner:

• Buy the house ourselves and renovate it to sell
• Buy the house and renovate it to as a long-term hold (rental)
• Wholesale the house to another investor
• Refer the house to Carol to list as a Realtor^®
• Advise the seller on other methods of getting out from under the property
• Walk away from the house and nothing but good wishes for the seller

In this case, our solution was for Carol to list the property as an owner-financed fixer upper. When she finds the right buyer, we will have a good set of solutions for them, too.

Villa Park Nanny Suite Update

It's almost a house again.

This post originally appeared on the Hermit Haus Redevelopment website on 2015-12-23.

Those windows look so much better than what was there before. This won't even REMOTELY resemble its before state!

-Suna

The Villa Park nanny suite is starting to look like a building again. As of this morning, it is officially dried in. Our GC will finish wrapping the building in Tyvek (or a similar plastic) to prevent any damage to the OSB siding. Then the city inspectors will give us the go-ahead to continue building the structure. What a wonderful Christmas present that will be.

If all goes well, the nanny suite will be on the rental market by the end of January.

Streams of Income from Rental Properties: The Two Examples and Cash Flow

Cash flow is not the same thing as return on investment.

This post originally appeared on the Hermit Haus Redevelopment website on 2015-12-20.

Ten days ago, I told you I would give you two examples of how to make money from rental properties and that I would use these examples in a series this series of articles. Things got busy after that, but here is the article laying out the two examples. We’ll also talk about how these two examples cash flow.

I could use real-life examples for this series, but the math would not be consistent between the examples, which could be confusing. So I’m going to use hypothetical examples for clarity. It will be much easier to get the basic principles across if the underlying assumptions are the same.

First, a couple of definitions. Investors talk of two kinds of cash flow:

Positive cash flow

Your rental brings in more money each month than your mortgage payment, including taxes, interest, and insurance (You don’t usually consider maintenance and depreciation at this point.)

Negative cash flow

Your rental brings in less money than its mortgage. (We’ll talk about why negative cash flow is not necessarily a deal breaker as this series progresses.)

	Positive Cash Flow	Negative Cash Flow
Purchase price	$100,000	$100,000
Down payment (25%)	$25,000	$25,000
Monthly payment	$550	$550
Monthly rent	$950	$540
Gross cash flow	$400	$-10

It should be fairly obvious that these examples make a couple of unrealistic assumptions.

• Why pay 25% down? You don’t have to, unless you’re getting conventional financing, which is probably the only way you’d get a 5%, 30-year mortgage today.
• What about other closing costs? We’ve conveniently ignored them to keep the math simple.
• Why would anyone take on a property with a negative cash flow? Like I said, we’ll get to that.
• Negative Cash Flow
• Cash flow can be the least important reason to buy a rental property. In some cases, it can even be advantageous to buy a property with negative cash flow—that is, at least initially. In our example, losing $10 each month on rent returns about -1.9% on your initial $25,000 investment. Kinda scary, huh?

Positive Cash Flow

But let’s take a more common example, one with moderate positive cash flow. If you could rent our example house house for $950 (or $400 more than your payments), you would make $4,800 profit on that house every year, assuming no expenses other than the taxes, insurance, and interest wrapped into the mortgage payment. (It can happen easier in Central Texas than in some other markets.) That’s a 19% annual return on the $25,000 you invested to buy the house.

For some investors, that return is good enough.

Results

This negative cash flow example, could be a perfect example of applying the martial arts concept of winning by losing. Over time, the other advantages of ownership can overcome the initial cash flow deficit.

Wouldn’t it be worthwhile to lose $480 (or even $1,200) per year for five years if you would realize a $10,000 profit at sale? While we can’t say with perfect certainty that a given property will appreciate, history says it will if you can afford to hold it long enough.

What if you inherited the low rent with the property but you could increase the rent at the end of the lease? Maybe next year, the property would be able to generate $600 month without spending any more money on it. Then you’d be making $60 a month instead of losing $10. And what about inflation? Over time, inflation will probably push up the rent, but your mortgage payments won’t go up except to cover the inflationary effects on your taxes and insurance. Your cost of money is locked in for 30 years.

So the important thing is not necessarily positive cash flow today, but a cash flow you can comfortably live with knowing that it will probably improve with time.

I’ve been guilty of looking only at cash flow, and I have erroneously sold properties because of that shortsighted view. I’m focusing now on buying in growing areas where population density will increase the value of my holdings. That will improve my bottom return on investment even before I take tax reduction, appreciation, and debt reduction into account.

I’ll talk about these income streams in future articles.

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Posts in this series:

1. Streams of Income from Rental Properties
2. The Two Examples and Cash Flow
3. Tax Reduction Through Depreciation
4. Equity Growth

Streams of Income from Rental Properties

Rental properties build your wealth through four different income streams: cash flow, tax reduction, equity growth, and appreciation.

This post originally appeared on the Hermit Haus Redevelopment website on 2015-12-05

I seem to always be talking about redeveloping distressed properties, but I also have a portfolio of rental properties. Owning rental properties is the surest way to build wealth that will outlast your lifetime and ensure your family’s well being should something stop your ability to earn a living.

Notice in the last paragraph, I said, “wealth building” and talked about legacy. I specifically didn’t say, “Cash Flow” because that is only one benefit of owning rental properties, even if it’s the one most investors focus on.

Rental properties can provide the following ways to create wealth:

Cash flow

The amount of money the property takes in over the cost of ownership on a monthly or annualized basis

Tax reduction

The amount of income you can shelter simply by owning properties

Equity growth

The increase in the net worth of your properties over time through debt reduction (paying off the mortgage)

Appreciation

The increase in the value of your property through inflation or market dynamics

Over the next few posts, I’ll talk about each of these benefits. We’ll use an oversimplified example of a rental property you purchase for $100,000 to show how simply owning and renting a house can make you much, much more money than you’d think—certainly more than by leaving $25,000 in the bank. The next post in this series sets forth the two examples I use and talks about cash flow. You may not believe it, but I’ve had these conversations with my tenants. Unlike many “landlords,” I really don’t want long-term tenants in my houses. There are sensible reasons to rent for a year or two, but I really believe in the win-win situation. I prefer tenants who have a long-term plan to secure their future. I realize not everyone wants to be a home owner, but I want my tenants to understand their options. I believe they respect me and my properties more if I tell them the truth and try to help them succeed.

If, after reading this series of blog posts, you don’t believe you should be finding ways to invest in rental properties, talk to me about buying your house.

Posts in this series:

• Streams of Income from Rental Properties
• The Two Examples and Cash Flow
• Tax Reduction Through Depreciation
• Equity Growth