There’s been a lot of chatter lately about a possible repeal of all or part of the Dodd-Frank Act and what that might mean to housing in general and small real estate entrepreneurs in specific.
If you’re wondering how an omnibus finance-regulation law affects you at all, here’s the quick answer:
If you SELL houses to OWNER-OCCUPANTS (not other investors) using owner financing (mortgage and notes, deeds of trust, or land contracts) more than 3 times in a calendar year, you fall under the exact same regulations as Bank of America and Wells Fargo.
- The requirement that you fully qualify your buyer as to ability to pay (which is just good business), debt-to-income ratio, and credit. The law does not define what “qualified” means, but it does say that you must have documentation that the buyer is qualified, or suffer some consequences (below)
- The requirement that there be NO BALLOON in the loan. In other words, if the loan has to be amortized over 15-30 years to make the payment affordable for a typical buyer, you have to commit to collecting payments for that long.
- The requirement that your deals be processed by a “Licensed Mortgage Originator”. This is a person licensed by the state to process applications and deal with buyers. Although YOU set the standards for qualification, prepare and provide all the paperwork, do all the advertising, and accept or reject the applicants, you are forced to 1. Find (good luck) and 2. Pay for an LMO who will even close non-institutional deals. If you do, it will probably cost you around $1,200
Fail to do any of these things, and the penalties are pretty steep: a borrower can demand and, upon proof that you’ve failed to do these things, collect 2 year’s worth of payments back, in addition to whatever punitive damages the court might want to assess.
As you can imagine, these hard-to-meet requirements have had a chilling effect on most investors’ willingness to finance properties to homeowners, and in turn has locked tens of thousands of potential homeowners out of the American Dream.
Because, thanks to other provisions of Dodd-Frank that limit fees on mortgages, most banks will not consider a loan of less than $50,000 to anyone, no matter what their credit or qualifications. Furthermore, most banks will not finance properties that need significant work.
This means that potential homebuyers who want to buy cheap houses and fix them up themselves are left out in the cold unless they can pay cash or get loans from family and friends
Back before Dodd-Frank, they had a much more readily-available option; buying from investors in what was called ‘Repair for Equity’, ‘Option to Buy After Repairs are Made’, or ‘Sweat Equity Deals’.
How These Deals Work
These deals basically worked like this:
- The investor (that’s you) purchased a property needing repair at a very low price
- The investor then offered that property at a higher—but still under-market—price, with financing (usually in the form of a lease/option or contract for deed) to the public
- The buyer put down a small up-front payment, repaired the property, and ultimately refinanced it, usually within a 2-5 year time frame
Although there were dozens of mix-and-match variations of this deal, the general idea was that the investor got a high return on his money, didn’t have to repair the property, and ultimately got a cash payoff. The buyer—who was at least SUPPOSED to be a skilled handyman/contractor—got the advantage of being able to use his skills and the investors’ financing to acquire a property he wouldn’t otherwise be able to, at a price that allowed him to have immediate and future equity in the property.
These deals were in high demand last time financing was hard to get; I did perhaps 150 of them for myself and others between 1989 and 1998. Yes, there are potential pitfalls to this (and any) strategy if it’s not done right—a topic I’ll go into next week. But in general, they were profitable for the investor and a good opportunity for the buyer.
What comes around goes around, and many potential buyers with a lot of skills and a little money and not a lot of credit are out there once again, looking for these deals. In other words, if you can provide the supply, the demand is back—and if the overbearing, expensive regulations go away, they’ll be a strategy that you DEFINITELY want to look into.
A Real-Life Example
Let me give you the most recent example of the ways in which these deals can create income and cash for you with minimal hassle:
Last month, I sold a 4 bedroom brick home on a nice street in a rental area.
The buyers were a young couple, and the husband had grown up on the street. The wife’s father was a contractor who had originally approached us about buying the house as an investment, but bowed out when his daughter and son-in-law decided they wanted to live there.
It’s in a condition I call “ugly but livable”: everything works, nothing leaks, but most things are pretty outdated.
I bought the property for $11,000, using a private mortgage at 8% interest. The after-repaired value is around $65,000. My estimate of repair costs—which included hiring contractors to do all the work—was around $25,000.
I did no work to the property, but sold it within a month to the young couple for $35,000 on a contract for deed under the following terms:
10 year term
Principal and interest payment $394/mo
The couple is expected to (and qualified to) to all of the work on the property.
So why in the world is this a good deal for them? I mean, they paid $35,000 for a house that needs $25,000 in work and will be worth $65,000 when they’re done!
- They won’t spend $25,000 to do the work. They’ll buy the materials (mostly through the contractor father, who gets discounts on most building materials) and do the work themselves. That’s why it’s called “Repair for Equity”—because they’ll actually invest somewhere in the $10,000-$12,000 range in the property, for a total of $47,000, max. And yes, it will be worth $65,000, and that’s $18,000 in equity for their work
- In the meantime, they’ll live in their own home for a total PITI payment of around $450 per month. The identical houses next door and across the street are rented for $825—thus, they’ll save almost $400/mo vs. renting the same property
- AND, in 10 years, they’ll own that house free and clear. The low sale price allows a shorter amortization than the usual 30 year with payments that are still reasonable. Every month, they’re buying quite a bit of mortgage pay down, which wouldn’t happen if they rented and wouldn’t happen if they had somehow been able to borrow money from the bank.
- Plus, owner financing is the only way in the current market that they could buy a house at all. The wife had just gotten a new job after a lengthy layoff; the husband’s credit was bad thanks to the loss of her income and a divorce a few years back.
Perhaps it’s obvious why I’D want to do this deal, but let me enumerate the reasons anyway:
- I put no money down, and got $2,500 down
- I paid $11,000 for the property and sold it for $35,000
- My monthly payments to my lender are $80.71 a month; I’m getting $394
- I didn’t have to repair anything
- If I choose, I can now sell the property subject to the contract for deed to another investor for around $30,000, paying off my underlying loan, and creating a return of 10-12% for the investor/buyer
Sounds great, right? And it is, under the right circumstances.
There are tons of people who want a deal like this, and tons of deals that you can make work like this.
Why It Works Better in a No-Dodd-Frank World
However, the only reason that it worked in a Dodd-Frank world is that this house is so inexpensive that it COULD be amortized over 10 years.
Were this a $250,000 junker house in LA, there’s absolutely no way you could amortize it over less than 20-25 years, and most people can’t a) get private lenders to finance a property for that long or b) hold out that long for a payoff.
With the balloon provisions of Dodd-Frank removed, or at least removed for the purposes of seller-financed deals, more expensive houses, and houses in more expensive markets, would be available to buyers with skills but bruised credit.
Because if you could offer a “work for equity deal” on a more expensive house that looked like this, I bet you would:
- House with an ARV of $200,000 that needs $50,000 in updating
- You pay $90,000 (70% of ARV – repairs) and borrow private money at 8%, 20 year amortization with a 6 year balloon, for a payment of $752.90
- You sell to a handy homeowner for $120,000 with $5,000 down with a 5 year balloon
- His payment at 8% is $961.91, for a positive, no-management cash flow of $209/mo
- And in 5 years, he goes to the bank with his fixed-up, worth $150k house and refinancies, at which point you get ANOTHER $25,000 in profit
All without lifting a hammer—your profit all comes from finding the deal and providing the valuable service of the financing.
If it works, it’s a win-win; if it doesn’t, you just sell the property again to another handy homeowner.
This isn’t the end of this discussion; next week, I’ll write about how to manage repair for equity deals for the maximum chances of success. But before then, how about contacting your congressperson and Senator and letting them know that you’d like to see these onerous regulations removed, at least for owner-held financing deals? As you can see, that could make a BIG difference to the way you do deals this year.