The infamous 3 Ts: Tenants, Toilets, and Trash! Without a doubt, they are the biggest turnoff when most people consider investing in real estate.
Let's face it, nobody likes the idea of a late night phone call from a bad tenant complaining about a leaking toilet or busted pipe. I can tell you first hand that it certainly isn't what you want to experience on a Friday night. For many people, being a hands-on landlord just doesn't fit with their desired lifestyle. And while the benefits of owning rental properties are tremendous, that is certainly understandable.
Is there a way to generate substantial passive income using real estate without these late night phone calls and the headaches of dealing with less than desirable tenants?
What is truly amazing about real estate investing is there is absolutely no need to try and fit a square peg in a round hole. There are many different ways other than owning rental properties to generate significant passive income while still being secured by a hard asset. One of my favorite investment strategies that I have utilized extensively over the years is owner financing.
In this article we will look at the benefits of owner financing and see if this could be a good fit for your financial and lifestyle goals.
Substantial Passive Income:
A real estate secured note is generally going to produce a strong monthly payment to you that is vastly superior to more traditional investments like stocks or bonds. For retirees facing the "yield crisis," this high level of consistent income can be extremely attractive.
Secured by Tangible Asset:
It is hard to find many other assets that offer the tangible security of real estate. Having lived in Houston when Enron collapsed, I saw first-hand the devastation that can occur when stock holders are wiped out. It was absolutely catastrophic for many families as life savings vanished overnight. With a real estate note, if your borrower should default then you would foreclose on the property. Property laws in Texas are very strong, and generally strong throughout the United States, from a lender's perspective.
Other than collecting a check from the mailbox, with a real estate note there really isn't much management at all as long as the borrower is living up to their end of the agreement. You are free to travel, vacation, or do whatever you please without much responsibility from your side. Should the borrower fail to honor their obligation, you will most likely need to hire an attorney to begin the collection / foreclosure process.
Great for Properties That Don't Fit Your Rental Standards:
I spend a significant amount of my marketing investment on finding tremendous deals on Off-Market Properties. Often I come across extremely attractive deals on properties that I am not interested in keeping as a rental property. Perhaps the property is too old or needs too many repairs or simply the economics just don't justify the headaches. These properties are great candidates to sell via owner financing and allow you to create a terrific stream of passive income.
Creating Phantom Money and Charging Interest on It:
Owner financing is probably the closest an ordinary person can come to emulating the tremendous benefits a bank enjoys. Not only do you get to create money "out of thin air," you also get to charge interest on it. What a system! (See Example 1 below)
In addition to the interest you receive off of phantom money, you can also financially benefit from the spread between the rate you borrow money at and the rate you "lend" money at. (See Example 1 below)
Delay / Reduce Tax Impact on Rehabs:
Rehabbing properties can be tremendously profitable. One major drawback however is that the profits are typically going to be taxed at the ordinary income tax rate (which can exceed 35%). By utilizing owner financing, you may be able to substantially defer and reduce your tax rate because it is an installment sale. Please consult with a qualified CPA to understand the full tax advantages and implications.
No Tenants, No Toilets, No Trash:
Without a doubt one of the most appealing aspects of owner financing. After the sale, you have no responsibility for the maintenance of the property. All repairs are now the responsibility of the new owner.
As you can see, owner financing has some extremely attractive benefits. Substantial passive income, secured by hard asset, and none of the typical hassles associated with tenants, toilets, and trash make this a very appealing option. If you are looking for secured, consistent monthly income without the responsibilities of rental ownership, owner finance may be a great strategy!
Let's assume using all cash that you buy and rehab a single family house that has an after-repair value of $ 100,000. Following the standard 70% of ARV rule, your total investment in the house after repairs is $ 70,000. You now market the home directly yourself and a find an owner finance buyer at $ 100,000. You require a $ 10,000 down payment and agree to split the $ 1,500 closing costs 50/50.
Sales Price: $ 100,000
Down Payment: $ 10,000
New Note Created: $ 90,000
Note Terms: 30 years @ 8.0%
Monthly Payment: $ 660.39
Your Initial Costs: $ 70,000 acquisition / rehab costs + $ 750 closing costs
Less Down Payment Received: – $ 10,000
Your Investment: $ 60,750
You have now just created $ 29,250 in "phantom money" or equity and are charging interest on it. In the first year you will receive $ 7,924.68 in note payments with $ 7,172.81 being interest and only $ 751.87 being applied to the principal balance.
For emphasis, you are receiving $ 7,172.81 in interest on a $ 60,750 investment. That's an 11.8% interest-only, cash throw-off on an unlevered, hands-off investment!
Continuing with the example above, let's assume you were able to refinance another property and borrow the entire $ 60,750 at 5% on a 30-year note. Without having invested any of your own money, you would now be receiving:
8% on the $ 29,250 in new equity that was created as well as the 3% spread on the $ 60,750 you owe (the difference between the 5% you borrow at and the 8% you lend at). Your annual cash flow is $ 4,011.24 ($ 7,924.68 you receive less $ 3,913.44 you pay the lender) and you are receiving an "infinite" rate of return because you have no money invested in the deal.
[The example above is "pretty plain vanilla" and is just meant to illustrate the concept. There are many more exotic and advanced structures with owner financing (wraps, etc …) as well. As always, it is highly advisable that you contact a local real estate attorney as laws regarding owner finance vary tremendously from state to state.]
Note: I highly recommend reading my article "14 Reasons You Must Consider Owning Rental Properties" as a point of comparison on investing strategies. Every investment strategy has both pros and cons.