Buying Real Estate: Which is Better Price or Terms?
© 2016 by M. Mitch Freeland
Some real estate experts feel if you cannot get the price you want for a property, at least you can try to get favorable terms from the seller. It is not a very good idea to fall into this trap. In most situations, price is definitely more important and profitable than terms. The price you pay will allow you to sell quickly, when you need to, and for a profit. If you rely on terms, you are generally obligated to hold the property for a longer period of time than you may be comfortable with or had planned on. Here is an example of what we mean:
You find a house advertised “No Money Down, Owner will Finance”. You talk to the owner on the phone and he tells you the house is for sale for $200,000 and he will carry a note for the entire amount at 10% interest over 10 years and amortized over 30 years.
After further investigation you find the following:
1. The comparable homes in the area are priced at around $170,000. This makes the house 17.6% over priced. But still, you are not interested in buying at market, you want below market. So, the property is actually close to 40% over valued to you. You should be buying the property at about $120,000 to $130,000 depending on the amount of fix-up it would need.
2. The house has been completely rehabbed. You cannot add any value to the property. You can not force appreciation; there is nothing for you to do to make the property more valuable.
3. The monthly mortgage payment is $1,755, with a balloon for the balance at the end of 10 years. You realize the rental rate in the area is $1,400 per month for that type of house. This will give you a negative cash flow of $355 per month. You further realize the market has slowed and inflation is low. Real estate in your area is forecast to appreciate about 3% the next couple of years.
On the terms offered buy the seller, you may think, “Great, no money down and I don’t need to go to a lender and get financing; this is an easy deal.” Wrong. It’s ridiculous to think that terms can beat price on any transaction. Lets breakdown your possible loss: (1) $30,000 over comparables; (2) $355 per month negative cash flow; (3) property taxes and insurance of $3,600 annually; and (4) $1,000 miscellaneous expenses, repairs and vacancies. You will have negative cash flow of $8,860 your first year and a $30,000 equity loss because you over paid for the property. If the property appreciates 3% for the year, it would only appreciate from the comp rate of $170,000, the average home price in the area; and 3% appreciation from that figure would come to $5,100. After the first year you would still end up losing about $33,760. Some people get caught up in this trap; don’t let it be you. It would take many years for you to come close to breakeven.
There is a flipside to this story. If you are the seller and you are trying to sell the property at 17% over the current comp price and secure a high interest note with the buyer, then it could be a good deal for you to sell on terms. However, danger lurks. With higher monthly payments than what can be collected from rents, you may want to sell to an owner/occupant rather than an investor. An investor will have to deal with the negative cash flow and there could be the possibility the investor grows tired of being in the red. And you may even have to foreclose if the investor folds under the pressure.
Another situation where terms are actually good for you as the buyer is when the property price is low enough to show you a handsome monthly cash flow. Securing good terms from the seller when a strong cash flow is possible is a good situation when you do not have to come up with much money for a down payment and you have the funds for the repair work covered. It is more difficult to get positive cash flow from a rental house with very little money down, unless you buy it for a very reasonable price. Multi-family properties have a greater probability of showing good cash flow with a low down payment (10% or lower) and good terms than a single rental house. However, a single rental house will typically have lower tenant turnover and is usually less management intensive.
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