Can We Make BIG Bucks on Over Encumbered Properties?

When everyone is running North that might be a good time to walk South and see what they left behind. A. Lincoln

At each of my workshops I ask the question: “How many here enjoy buying houses for more than they’re worth?” Seldom does a hand go up, but when the occasional one does it is usually withdrawn in haste once the question registers with the respondent. “Oh, you said ‘more’ than they’re worth? Never mind...”

But is there in fact a scenario where paying more for something than its worth could create a windfall profit later? What about having bought a few thousand shares of Amazon.Com or E-Bay ten years ago for more than its market price at the time? Might one have made money in that deal? Of course, but who knew?

In the above scenario, what if you, the purchaser, had as much confidence in the performance of the stock market over time as you likely have in that of the real estate market? And what if the seller was willing to pay you handsomely to take it off his hands, and what if you had someone standing by to cover all the costs of the purchase? And too, what if you knew with reasonable certainty that the value of your purchase would in time far exceed its price (over-encumbered or not), not to mention its current value?

Over the years I have sought out many properties that were worth less than their loan amounts by from $5,000 to $20,000 or more. Later on, when I began disposing of those “dogs” I managed to accumulate a small fortune from them.

A few examples:

Olive Dr., Riverside, Ca. was worth a maximum of $90,000 with two loans on it of $120,000 in 1987; sold this year for $235,000;

Hatillo St., Canoga Park, Ca. was worth $180,000 in 1988 with a loan on it of $185,000: sold in 2005 for $410,000;

Blythe St., Canoga Park, Ca. was worth $140,000 in 1989 with a loan on it of $155,000; sold in 2004 for $290,000,

Northstar Dr., Palmdale, Ca. was worth $110,000 in 2000 with two loans amounting to $125,000 which has been sold and is closing, as I write this article, for $335,000.

Muscupiabe Dr., San Bernardino Ca. was worth $225,000 in 1988 with a loan on it of $225,000 (needing $10,000 in work); sold in 2004 for $395,000.

In these examples, it was not luck and Appreciation alone that fed my profits: it was several other, too oft overlooked, profit sources: 1) up-front cash from the sellers, 2) up front cash from the buyers, 3) positive cash-flow (derived largely by being able to transfer tax benefits to a tenant-buyer), 4) equity build-up from the mortgage’s principal reduction, 5) bumped equity (i.e. starting price increased due to the credit and/or cash challenges of the acquiring parties), and 6) contingency fund-deposits retained when tenant-buyers default (note that all of my properties are held in 3rd party trustee, co-beneficiary Illinois-type land trusts, each of which require a contingency fund deposit that most often is left behind in the event of default (i.e., initially posted to protect the trust by covering missed payments, minor repairs, evictions, legal actions, etc.).

Note that in each of the examples, if there were to have been absolutely no Appreciation what-so-ever, I still would have done just fine given the additional profit sources mentioned.

Question:

Which of the following identical houses is less costly over the long-run; least expensive to get into; easiest credit, easiest qualifying…and which seller of the two is most likely to pay you to take the property (either up-front or by participating in monthly payments).

A) An over-encumbered 3+2 valued at $200,000 but with a $209,500 loan on it. Acquired seven years ago for $245,000 at 7% interest. Now has 23 years remaining on the original 30-year mortgage. It can be yours with only minimal, if any, credit, no down payment, $5,000 in closing costs and a safe payment take-over. Your payment is $1,385 P&I (note: loan is over-encumbered by $9,500, which amount will be neutralized in just a year or two (or less) with as little as $5,000 in appreciation coupled with an average mortgage principal reduction of, say, $165 or $175 per-month for a couple years).

Or…

B) An identical $200,000 house available with good credit, a 10% down payment, a new 6.5% mortgage loan, $5,000 in closing costs. Your loan payment is $1,137 P&I (and the loan has a $9,500 pre-payment penalty if retired sooner than 5 years)

Answer:

A) 23 yrs X $1,359/Mo. = $375,000 + $5,000 Clos. Costs = Total amortized cost of house “A” - $380,000

B) 30 yrs X $1,137/Mo. = $409,320 + $5,000 Clos. Costs + $20,000 Dn Pmt = $434,320) then add another $69,000 for lost Future Value of the down payment (at even 5% simple interest) = total amortized cost of house “B” - $503,000.

The Recipe: Find a highly motivated seller with a big problem; carefully analyze the profit sources (without anticipation of Appreciation); point out the estimated likely costs of short-sale, foreclosure, renting, leasing, any subject-to or equity sharing arrangement. Then compare the risks and downsides of these schemes (due-on-sale violation, susceptibility to lawsuits, creditor judgments, partition, charging orders and tax liens; also of prime consideration should be the inability to evict any errant tenant-buyer who holds “Equity,” as is the downside in virtually all creative financing, including lease optioning (except when the property is held in a 3rd party trustee, co-beneficiary land trust…my own transfer vehicle of choice).

To find out more about Landtrust and Equity Transfers Using Landtrust, Click Here.