Oftentimes people want to purchase rental properties, but they may be having a hard time finding a property that positively cash flows. Negative cash flowing properties create a problem because ultimately it results in cash leaving the buyer's pocket and destroying any potential profit. Many time the negative cash flow occurs because the property is purchased with bank financing, which offers fixed terms and little flexibility for the buyer or the seller.
One viable solution to help alleviate negative cash flow, that I talk about from time to time, is seller financing. Seller financing is a great tool for both buyers and seller of real estate. To briefly describe seller financing, it is simply an installment sale for a property, much like when one buys a used car from a dealer and the dealer takes payments over time rather than taking all of the cash in one lump sum. This same concept that applies to cars also applies to real estate.
What makes seller financing such a great tool is that it gives the buyer and the seller the freedom to negotiate the terms of the sale in a manner that meets both parties’ needs because they are no longer restricted by the bank’s terms. I will give a brief example of what I mean.
Let’s assume that our friend Joe is looking to buy a 4-plex as a rental property and he contacted the owner/seller directly about selling their property. The property has gross rents of $4,000 and an expense ratio of 50%, meaning that 50% of the gross rent (or, in this case $2,000) goes towards repairs, utilities, taxes, insurance, vacancies, etc. The remaining $2,000 is left over to pay the mortgage and whatever is leftover goes into Joe’s pocket.
Let’s assume that the parties agree on a price of $500,000. Joe will put down $50,000 as a down payment and finds a bank that will lend $450,000 on the property at 4.25% amortized over 30 years. This makes the monthly payments $2,213.73. What is the problem with this? The property is negative cash flow as the gross rents of the property are $4,000, the expenses are $2,000, and the mortgage payments are $2,213.73. So Joe has to come out of pocket $213.73 every month to keep the property. This is not a healthy situation for Joe as he does not know how long he can come out of pocket for the property.
Joe decides that he wants to avoid negative cash flow at all costs. He talks it over with the seller and they decide that the seller will seller finance the property rather than get cashed out. The seller ultimately decides to do this as it allows the seller to:
- Defer his capital gains tax
- Earn interest on his investment
- Have his investment secured by real estate
- Leave a greater inheritance for his children
- Have a higher selling price
So, Joe & the seller decide that they will raise the price to $510,000. Joe will provide a down payment of $50,000. The seller will carry $460,000 fully amortized at 4.25%, like the bank would. The only difference is that the seller agrees to carry for 40 years rather than just 30. The seller agrees to do this as it gives his heirs a cash flow stream for 10 years longer. Let’s see what it does for Joe’s cash flow by calculating the monthly payments.
Answer: Enter the following numbers in your HP10bii financial calculator (if you don’t have one, no worries, simply follow along)
N (Number of Months) = 480 (40 years has 480 months)
I/YR (Interest Rate/Year) = 4.25 (this is the interest rate that Joe and the seller agreed)
PV (Present Value) = 460,000 (this is the balance that the seller agreed to carry)
PMT (Monthly Payments) = ??? (this is what we are solving)
FV (Future Value) = 0 (it is a fully amortizing loan)
After entering the above information, the answer comes out to $1,994.65/month.
This means that after “stretching” out the payment stream from 360 to 480 months, despite the increase in price, the monthly payments drop by approximately $220/month (under the $2,000 threshold), meaning that the property is now cash flow positive. This ultimately results in Joe getting $6/month in his pocket, which is not amazing, but he is not coming out of pocket to keep the property and receive all of its other benefits, which is most important.
Note: If you have any questions on seller finance or want to learn more about it, I offer a more in-depth description in my "Comprehensive Guide to Evaluating Rental Properties & Introduction to Seller Finance" which you can get below.