Real estate investors are exposed daily to an ever-changing market. Sometimes these changes are favorable, and sometimes they are detrimental. The only certainties related to the real estate market are that it will change and that investors should expect the unexpected. Given this fact, doesn’t it make sense that investors use this knowledge to their advantage when assessing an investment opportunity?
I have seen many investors approach a transaction with only one strategy in mind: buy, rehab and sell for cash. While this isn’t a bad approach to property investing, it exposes the investor to a huge amount of downside risk should the market change.
The real estate market can shift in dramatic fashion. Who would have expected that interest rates would shoot up to 18 percent in the ’80s or that the subprime lending market would collapse in a matter of weeks?
Economic and market conditions can change, and if investors haven’t developed contingency plans, they can get hurt. For this reason, it is necessary to have multiple exit strategies should the initial plan of buy-fix-flip not work out. As such, I suggest that every investor create a three-part plan to address to changing markets as follows.
PLAN A: BUY-FIX-AND-FLIP
This is a good strategy—provided you have done the market research, estimated remodeling costs with a contractor and determined that the purchase meets the Buy and Flip Formula criteria outlined in “The Real Estate Wealth Building System.” (See www.The Property Ledger.com for details). However, only having Plan A as an exit strategy unduly exposes the investor to the whims of a changing market.
The investing landscape is littered with investments in which investors entered the transaction thinking they could purchase, repair and sell the property within a defined period and took out a hard money loan—only to find that when the promissory note was due, not only had the property not sold, they couldn’t satisfy their obligations under the terms of the note. So the property went into foreclosure. In some of these cases, the investor is forced to file for bankruptcy protection.
You can see why you need other fallback strategies in case Plan A does not work out.
PLAN B: HOLD THE PROPERTY
If Plan A doesn’t work out, it’s imperative to know the purchase and the financing have been structured in such a manner to create options for yourself. It is difficult to go back to the lender and ask for a restructuring of the note when the market is turning, so it is best to negotiate flexible financing terms up front.
For instance, if you are dealing with a traditional lender, consider structuring the acquisition and construction loan with the ability to roll the loan into a longer-term (five or more years) permanent financing arrangement at your discretion. If negotiating with a private investor, you may want to set up the promissory note so that if the property doesn’t sell within a predetermined time, the financing will convert into an equity position in the property.
Obviously, you will also want to ensure the cash flow from the rental of the property is sufficient to cover the operating expenses of the property and the debt service on the promissory note. The key to the multiple exit strategies is to create flexibility in your financing so that it can adjust to a changing market.
PLAN C: LEASE WITH PURCHASE OPTION
Plan C is similar to Plan B, but in addition to creating flexible financing, it gives you the ability to enter into a lease-purchase agreement with a renter. That way, the combination of leasing revenue along with the option consideration is sufficient to meet the cash flow obligations of the property.
Having been in the real estate investment arena for a number of years, I will not purchase a property unless I have completed the market research, financial analysis and due diligence on the property and have structured the financing in such a manner to allow me to have all of the above plans working in my favor.
When negotiating with the lenders or sellers related to the financing, I let them know it is in their best interest for me to be successful since they want to repaid in full and don’t want to take back the property. I then outline Plan A, Plan B and Plan C and explain to them why it is important for me to have the flexibility in the financing I am requesting.
They don’t get offended by this discussion. In fact, they are relieved and impressed that I have thought through the worst-case scenarios and have contingency plans to protect their investments.
It is akin to the captain of a ship leaving harbor. Would you be more comfortable with a captain who outlines the safety and redundancy features of the ship and what the safety procedures will be if the ship runs into a storm or begins to take on water? Or would you prefer a captain who hasn’t thought of these emergencies, doesn’t discuss the safety procedures and blindly sets sail into the ocean?
What kind of captain do you want to be?