A few years back I had called on a fellow landlord who was known for selling off properties and providing owner financing too.   Now I knew he had problem tenants in a property but also knew the area was appreciating rather rapidly and it was in my main target neighborhood.  I wasn’t sure how long I’d own the property but had a plan of flipping the property for a profit and providing the seller with the opportunity to obtain better collateral by allowing the substitution of collateral on the existing loan.

So we agreed on a sales price of $60k with $13K down and the remainder financed at 8% on a 30 year amortization and a 5 year balloon.   That comes out to a monthly principal and interest payment of $347.78/month.   Now I suspected that the home was occupied by drug dealers and was working on the most efficient way of moving them out when I received the call from the property manager whom managed the property for the seller and who I elected to handle -at least until the occupants were removed.   I hadn’t owned the property two weeks when I was advised the police had done a raid, the entrance doors were busted down, premises vacated, and how I wanted to handle it.   I went to inspect and secure the premises.   Problem number one removed.

I then gauged the markets and up-fitted the property into a better than rent ready condition; however, not a full retail rehab deal.   The goal was to target this house towards an entry level home buyer that was looking for an affordable well priced (discounted) home for the neighborhood. So $15k in improvements latter the home was sold via word of mouth to Realtor’s with one bringing in a buyer at $105k.   Not a bad day huh?

During the coarse of the 7 months I owned the property,   my owner financed lender was receiving his payment every month -3 to 5 days early.  If you’ve read some of my other owner (or private money) financing stories such as, Creative Financing, I stress treating your lenders (especially individual lenders) with complete 100% professionalism. Eliminate the worry of when the payments are coming.   Be proactive if changes to the plan occurs.  Protect that investor.

Why?

Because this lender provides opportunity to creatively take down and control real estate. The number #1 issue in real estate is financing.    You’d be surprised how much opportunity a private lender can provide you by treating the relationship with 100%  ethical, fiduciary, and moral respect. I guarantee you that any private lender can provide much more than what you have now if you follow these basic tenets.

So when we went under contract, I called my private lender and advised him of the up coming sale.  I asked him if he’d be interested in continuing to receive payments on his loan or if he preferred to be paid off.   He asked what I had in mind and then I advised him of a free and clear rental property I had in a better neighborhood and at a better rental income rate.  He thought it would be a great idea -he much preferred to get a continuing income stream as long as the collateral was strong.

What do you think happened?

The next day he called and advised he was comfortable with the new property as collateral and asked how we’d proceed. I advised that we’d use our same attorney that closed the original loan, that a substitution of collateral document would be signed, notarized, and recorded, and of coarse -I’d provide title insurance and fire insurance at no cost to him. I highly recommend that you always use a title company or an attorney to perform any closing to provide proper third party legal advice and compliance.  Eliminate concern and the unprofessional image that a kitchen table closing can create.

Another angle to look at is putting in a Substitution of Collateral clause in all your Deed of Trust (Mortgage) documents when you obtain private money and/or owner financing. Typically one would have the statement that ‘borrower will provide lender a property of equal or greater value for substitution in the event the borrower refinances or sells the property’.  Always have an attorney help draft your legal documents.

So what is the real opportunity to a borrower whom exercises the creative tool of substitution of collateral?

You see it provides you with the opportunity to continue using other people’s capital (or money as most say with OPM) to help provide the flexibility and leverage needed to navigate the capital intensive world of real estate. This deal was more than just buying his problem rental property -it was about buying the use of his money.

The real buy was on the use of the money going forward -not really the real estate.

You see I parked the money on a free & clear rental property that gave him greater comfort in collateral then the existing property.  Now, I can take that money for another deal that does not have owner financing (assume I want to go buy another fixer upper). It was all cash; however,  now I could buy for $60k (with this money), put $15k rehab into it, and sell for $105k (just as I did with this property as stated above) -thus rinsing and repeating.   Would this be a smart and effective use of these borrowed funds?  Absolutely. Naturally, one needs to operate prudently and make sure the return on capital far exceeds the cost of those borrowed funds.

I was literally discussing this scenario with a fellow real estate investor today. He has an owner financed home that isn’t performing to his standards and to sell he would lose @$10k.  The private money loan is @4% on $80k with a monthly payment of $400.00.   This investor is looking for a better investment property but without owner financing it becomes a challenge.   The best private money he can find presently is 12% and he wants another long term investment. I advised him to calculate the cost of the 4% money on $80k over 10 years.   That equals $48,000 as a cash-flow cost.   Now what would be the cost of that 12% loan at just interest only over 10 years?   $96,000.00

Wow!?!  Do you see that!!!  The difference in cost of funds (not including any principal reduction) is $48,000.   Basically the 12% money costs twice as much. Guess what I advised?   Find a replacement property (another wholesale priced purchase) of greater value and substitute collateral.   Get rid of the drag (existing property) even with a $10k immediate loss.  Over 10 years he would still realize a $38,000 cost saving with the cost of his funds not to mention have the opportunity to get a higher cash-flowing  and/or appreciating real estate investment.

Did you see what I just said?   (might be worth printing out and re-reading)

Essentially this investor bought a poor performing property with great financing terms.   By shedding the problem property (even at a loss), he has the ability to take the great financing terms (loan) with him to a new investment where he’ll make his money when purchasing a distressed asset at wholesale pricing.   Thus lining up great financing with a great investment via the use of Substitution of Collateral.

Guess what happened with my owner financing? I just spoke with the Private Lender last month about extending the loan out for another five years.   He has no problems; however, was a bit surprised by my question being that I brought it up a year in advance.   I just advised him I was planning out my year and wanted no surprises for both our sakes.   He laughed and thanked me.

Think this private lender would let me substitute collateral or even borrow more money from him?  Absolutely -as he’s already stated. Build relationships.  The money will follow and the tool which we call real estate will assist in creating wealth to all whom participate.

By: Tyler McCracken -a Charlotte, NC Real Estate Investor

Written by Tyler McCracken

Local Real Estate Investor & Hard Money Lender in Charlotte, NC - Read Bio at our "About Us" page on the top right of this page.

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