Here is one of our more creative deals spelled out. I hope it helps you envision ways that deals may be structured. Let’s see how many different structures are working together to make this deal.
First, our second rental, which was the first one that was bought explicitly as an investment property, had appreciated and taxes were going up (the first rental was my bachelor pad). We talked about the sale of this second rental in the blog post called “Farewell to a Teacher”. We made the decision to sell in an effort to get some better cash flowing properties. I always tend to regret selling property but this one did ultimately help us boost cash flow, which was our goal.
During the ownership of that second rental we were able to strip some equity through a cash out refinance and reap 30,000 dollars in 2018. This was tax-free money and was used to help in the purchase of two other properties. The 30,000 was more than our original downpayment on this house so we now owned this second rental for zero money – kind of like an extended BRRRR deal. If BRRRR is unfamiliar to you, check out this article that breaks down the BRRRR Strategy. At this point the cash flow decreased to 170 dollars per month after PITI, not accounting for vacancy and repairs so it would end up just barely breaking even over the long run.
In August of 2020 we decided to sell and see what we could get for it to move into a better cash flow position. We sold for 185K and netted 57K at closing. This would be taxable income as well as cost some depreciation recapture. The only way around that tax burden was to do a 1031 tax-deferred exchange. This would be our first one so we started to look for replacement properties with an eye for properties that would cash flow better.
As we asked around for advice our wise investor friend, Rick Pozos over at The Pozos Report asked us why we hadn’t been shopping for replacement properties before we completed our sale. We replied that we were busy traveling and it hadn’t been a real priority. With only 45 days to identify our replacement property in the midst of a seller’s market, time was definitely not on our side. The 45 days is an IRS rule and there is also a 180 day timeframe in which you must close on the identified property. Tip: confer with a 1031 intermediary well ahead of selling your property so that you don’t break any rules, such as taking money into your own bank account, thus voiding this tax deferral.
We found a triplex property on the MLS that was back on market and listed for 195,000. We offered 160,000 and the seller countered with 180,000. This is where terms can make the deal. If we bought it fir 160k and held with private money for six months to get the required seasoning to refinance it, we would end up paying about 8k in interest. So we agreed to their price if they would carry the note or seller finance it for seven months at zero interest. They agreed!
The effect of this was that we would pay 7,000 dollars straight to principal this reducing the amount to refinance to 117,000 (remember we had a big down payment on this one). Then we hit a big snag. The zoning was not appropriate for a triplex and the bank would only do a loan at 65% LTV (loan to value) instead of our usual 75%. Luckily this would still work to pay off the underlying loan and give us healthy cash flow.
We realized that this zoning limited our value to re-sell if we should ever decide to so we went one step further. We petitioned the city for “conditional use” zoning which, if approved would essentially permit this property to be used as a triplex as it had been for many years. It cost a thousand dollars to apply and we wrote letters and knocked on doors of neighbors to explain what we were doing because the city would be checking with them to see if there were any objections.
Ultimately we were approved for conditional use which should increase resale value and the ability of future buyers to get financing on this property. Thus it was a value-add by zoning change rather than material improvements to the property.
After all is said and done, we figure our profit from the sale of 57,000 is now over 70,000 in equity and we have deferred the taxes for a long time. Our cash flow went from zero to well over 700 dollars a month after all expenses. We consider this a big win and it came about from making offers all the time and being creative by combining strategies. No two deals will come together the same way but I hope this gives you some ideas about how you might use creativity to create value; which is what we aim to do as investors.
Remember that the house we refinanced and sold at the beginning of this story was bought the old-fashioned, boring, traditional way before we knew anything about creative structures. So a boring base hit has essentially led to five more doors in our portfolio. I hope this motivates or inspires someone to do a deal, even a base hit. Remember that in real estate base hits become home runs over time.
There are still deals out there so go make some offers and, as always, keep the main thing the main thing!