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5 Ways to Invest in Real Estate for Passive Income

Real Estate Investing

Real estate investors that have been in the business for a long time have learned creative ways to purchase real estate that you will find scant mention of in many modern forums, podcasts, or websites. Learning how to buy real estate creatively is one of the most valuable skills real estate investors can learn. Creative real estate investing allows you to build investment opportunities where others don’t even see a deal. You can structure offers where the numbers work, everyone gets what they need, and your competition can’t touch them because they don’t know how.

Most investors under 40 have one basic way to invest in real estate. You save up a 20-25% down payment in cash. Find a single-family house or multi-family building to buy with a real estate agent. You submit several low ball offers hoping someone is willing to take one. Call a bank and get a traditional FNMA or possibly a commercial mortgage. This method will work but it is a slow way to build a portfolio. The reason is that real estate is a capital-intensive business, and it takes a lot of money to build a portfolio this way. I know; I tried.

Some real estate investors decide to take a shortcut and start purchasing shares of Real estate investment trusts, or REIT for short. These are financial products sold by Wall Street, but instead of being a company, it is a trust that holds and manages a lot of real estate. If you choose the right ones, these are okay investments, but it isn’t real estate investing the way I define it, and it isn’t as profitable.

I define real estate investing as physical real estate you purchase and own directly. You are the property manager and hang onto it for the long term or forever. If you ever sell this property, it is because you have fully depreciated it, or it is part of a more complex deal to purchase another piece of real estate that improves your portfolio. You get benefits by owning and managing real estate that you can’t get by holding a REIT. Here is a quick list of the benefits:
  • Leverage: The most significant advantage with physical real estate investing is that you only put down some of your money and borrow the remainder. We will discuss shortly how you “borrow” that money.
  • Income: You earn a steady income stream of nearly tax-free income monthly that beats any REIT for the same dollars invested.
  • Tax-Advantaged: Due to tax laws that allow for depreciation, management, and small business expense deduction, a lot of the taxable income you get from owned real estate has several favorable tax deductions. You don’t get any of these advantages with a REIT.
  • Tenants Purchase the Asset: You put some money into the deal and then borrow the remainder. That debt is paid off over time by your tenants, who pay you rent each month; part of that rent payment reduces your debt on the property.

I have covered these benefits in more detail in my Real Estate Investing 101 article, which I encourage you to read. In this article, I will show you creative ways to purchase real estate that doesn’t involve walking into a bank and applying for a mortgage but still allows you to generate passive income. Let’s get started.

Seller Financing

In short, seller financing means the person selling the property acts like a bank. Instead of you going out and getting a mortgage and paying off the seller at closing, the seller carries the mortgage, and you pay the seller each month instead of some bank. You and the seller work out a monthly payment amount the house can afford to pay (note that phrase, it is important), an interest rate, a down payment amount, and the term or length of the loan. The seller writes a note, binding it to the house with a mortgage. This is how it works when you buy any house, except typically, a bank is involved, and the bank and market fix the terms. There is no negotiation on the down payment amount, interest rate, amount of the payment each month, etc. You do have some say over the length of the mortgage, but still within a fixed box that is typically in years ranging from 10 to 30, with 30 being the most common.

When you work with a seller, these terms can be negotiated in infinite ways. For example, I once purchased a house from a seller with a $10,000 down payment which was about a 12% down payment. The payment was $328 per month and carried an interest rate of 3%, payable once per year in a lump sum with a term of 15 years. Why these specific terms? Because that is what I needed for the deal to work as a rental property. At the time, I didn’t want to put more cash down (remember, higher leverage produces better returns), and the house couldn’t afford a higher monthly payment based on what I could rent it for each month and cover all my monthly expenses plus a mortgage payment and still generate positive cash flow. The lump sum interest payment allowed me to keep monthly payments a little lower while still paying interest and getting a faster amortization of the loan.

Landlords grow rich in their sleep.

― John Stuart Mill

Subject To

Currently, as I write this, new mortgages are clocking in around 6% if you go to a bank and get a standard FNMA mortgage, which again is almost how all people purchase a house that is the rate you expect. To most people, these are high-interest rates. Given the high price of houses in many markets when you increase interest rates you make real estate investing even harder and monthly cash flow more elusive. However, a short time ago, mortgage rates bottomed out around 2.5 to 3.5 percent depending on exactly when you bought or refinanced. Mortgage rates have hovered around 4% for almost a decade. There are a lot of mortgages out there on many houses with these low rates locked in for 20 and 30 years right now. Real estate investors can take advantage of those under the right circumstances.

When someone who owns a house needs to sell but has no equity in their home, they are in big trouble. For example, say someone purchased a house five years ago with a 30-year fixed rate mortgage of 3.5% but needs to sell right now, which is a common occurrence. Unfortunately, even with that low interest rate, most of their monthly mortgage payment was almost entirely interest, with minimal principal being paid down. This means they have little to no equity unless their house has massively appreciated during that time.

Further, what if the house has problems like a leaky roof or a bad furnace or needs other work? These repairs will likely need to be completed before they can sell to a traditional home buyer. Finally, what if they lost their job, got 4-5 months behind on their mortgage, and are now in foreclosure? They likely need more time to sell the house traditionally by listing it with a real estate broker. If you pile on little equity and repairs, you have a seller who might need to bring a pile of cash to the closing to sell their house! How many sellers want to BRING cash to the closing instead of walking away with a check? Nobody I know.

This is where a creative real estate investing comes in. The seller would sell their house to the investor, who agrees to take over the mortgage payments and leave the existing 3.5% mortgage in place or, as investors call it, subject to the existing loan, which is where the name of the strategy comes from. The real estate investor could give the seller some cash to help them move and get back on their feet again. They would agree to take the house as is and do the repairs necessary to fix the house back up. They would catch up on the back payments on the mortgage, and the seller’s credit would improve. The real estate investor purchases a house with a mortgage far below the current market rate. The investor benefits from taking over the existing financing instead of getting all new financing at a higher rate and going through the full qualification process. This helps the investor get into the investment for less money than a 20-25% might be.

What is the Subject to Catch

If this sounds too good to be true and you have never heard of it before, you need to understand a few things. First, you aren’t taking over the loan payments in a way most people understand. Yes, you pay the mortgage monthly, but you didn’t call the bank and formally take it over. Banks don’t allow that; they want you to refinance the mortgage and put it in your name at the new higher rate. The mortgage will remain in the name of the person that originally took it out and you aren’t changing that.

The danger here is that the bank can “call” the loan, which means if they find out the house has been sold to the real estate investor, they can demand the entire mortgage be paid off immediately. In practice, this rarely happens, and with how the modern mortgage market works today, it is even rarer still, but it is possible. An investor needs to be aware of the possibility in case it happens. There are some strategies that real estate investors can use if this happens. The easiest would be to sell the house and pay off the old mortgage. I will cover other strategies in a future article. Just understand that no matter what you hear from people that don’t know or understand this strategy, it is NOT illegal. It is perfectly legal but does come with a small amount of risk that you need to be aware of. This call by the bank is called the due-on-sale clause.

Another downside of this strategy is that the original mortgage is still in the seller’s name, which will likely prevent them from getting a new mortgage until the original is paid off, which might be a while if the loan still has several years left on it. However, remember, what was their alternative before you came along? Foreclosure, taking money they don’t have to closing? Making repairs to the house with money they don’t have just to sell it at a loss? As a real estate investor, you are taking a bad situation and making it a little less terrible for the seller while securing the property on terms that work for you. I once had a real estate investing mentor tell me that our job was to help people out of the quicksand, but not join them in it.

Real Estate Investing Lease Agreement

Master Leasing

Master leasing is a strategy where you get into real estate investing without using any of your own money. It is a fantastic strategy to build up your passive income whether you are a relatively new investor or very experienced. In this strategy, you aren’t buying the property. Landlords and homeowners can easily find themselves in circumstances where they can’t sell the house they own. Here are just a few reasons:

  • No equity
  • Taxes at the time of sale would be high
  • Slow real estate market
  • Tired of managing the property

I have encountered homeowners and landlords in one or more of these situations. As a real estate investor, you may want to avoid purchasing the house from them for many reasons. You might not have any capital for a down payment. You may want to avoid securing a mortgage at 6%. Maybe you aren’t sure what market conditions will look like over the next 18-24 months and want to adopt a wait-and-see attitude. So, if you don’t purchase, how do you do it? You might be good at property management. Developing good property management and people skills are potent assets in real estate investing. You can leverage yourself into many deals with just these two skills, even if you have no money. This is one of those ways. Too many investors want to immediately hire a property management service for their rental properties, but this deprives you of learning some valuable skills that will grow your portfolio with little money.

With a master lease, you agree to lease the property from the owner just as any renter would, but you will turn around and sublease the property to someone else and manage that tenant. You make a monthly profit between the rent you pay the owner and the rent you collect from your tenant but never own the property yourself. Other names for this are sandwich lease because you, the real estate investor, are sandwiched between the owner and your tenant. You make money on the spread between the two rental amounts.

Real Estate Investing In a High-Priced Market

If you live in a high-priced market such as Los Angeles, San Francisco, New York, Miami, Denver, or Austin, where property values are high, you might find it challenging to purchase a property that cash flows each month. Real estate investing is tough, but not impossible in these markets. The monthly mortgage, property taxes, insurance, and repairs might make positive cash flow difficult. Each month it would cost you to own this investment property! It is a bad investment if I pay money each month instead of receiving it. However, the owner of that property may have purchased the property a long time ago. Their monthly expenses and mortgage could be considerably lower or even mortgage free if they have owned it for a long time.

For example, suppose you found another real estate investor nearing the end of their career and had purchased the property in Los Angeles 30 years before or possibly inherited it. The price they paid would create capital gain taxes for them if they were to sell at today’s prices, but if they lease it to you, they can still get an income, avoid taxes, avoid management, and continue to benefit from future appreciation.

Real estate investors can leverage their property management skills to get into a property they would never be able to purchase outright and make the numbers work, generate an income each month, and lay out no money to start. Everybody wins. You can basically start and run this business with a laptop, cell phone, and meeting people at coffee shops. There is one caveat I need to mention here. Don’t try this strategy if you don’t have any property management experience or training. This strategy is powerful because you are bringing a skill and experience that is relatively rare in real estate investing and that is property and people management. If you implement this strategy without any skills or experience and you have never managed a property or tenants before you are setting yourself up for a fast failure, bad reputation, and possibly a lawsuit. I already had my own rentals, years of management experience, and a lot of training before I used this strategy. I suggest you do the same. Now if you are new in this business a good trainer and starting off slow, i.e., just one property will get you started if you don’t have any rental experience or properties of your own. Once you have got your feet wet with one property and are handling it well then start adding more. I have found Dave Tilney and Jeffery Taylor two of the best property management trainers in the real estate investing business.

I once met an investor that lived in southern California, where real estate investing is very difficult due to house prices. There is almost no way to purchase most of these properties and make the numbers work. The price for the property is too high. This investor had 23 properties under long-term master leases. With every master lease she added to her portfolio, she generated additional income streams with none of her own money. She was making several thousand dollars per month in passive income. She did not have to purchase any of them. She had none of her own money in any of the properties. She was cash flow positive from day one. With minimum investments, this is an easy way you can create a large passive income portfolio quickly. What did she bring to the table? Excellent people skills and a proven property management system.

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.

— Winston Churchill

Options

This is the fourth way to use creativity in real estate investing with lower amounts of money. Real estate investing doesn’t always require that you buy a house, or at least buy it right now. As a real estate investor out every day searching for a property to buy, I inevitably find people with financial issues and a house who don’t want to sell it to fix their financial problems. Most real estate investors don’t know what to do with this situation, and they walk away if the person doesn’t want to sell the house. There is a way to invest that still solves everyone’s problems.

An option is the right, but not the obligation, to purchase something at a known price today in the future. The price you pay is called the strike price. In the future, if the asset’s value is worth more than your strike price, you would likely exercise your option and purchase at the strike price. You won’t if the future price is equal to or below your strike price. The beautiful thing about doing options on real estate is houses rarely stay the same price or fall in value, and they almost always go up in value. Certainly, it can go down, and you never know how much it will increase, but most real estate investors would tell you this is a reasonably safe investment, certainly a lot safer than a stock option.

Here is a quick case study to get you thinking about this. Imagine you are a real estate investor and come across a homeowner with a bad roof that needs fixing. The cost for the repair is estimated at around $15,000, but they don’t have the money to do it. Accessing credit for the project is also not possible. However, they don’t want to sell their home. At this point, your average real estate investor simply walks away because they don’t know what to do with someone who needs money but doesn’t want to sell their house. The creative investor talks to the homeowner and discovers they have kids in school that are about six years away from graduation. The homeowner wants to ensure the kids can finish school and possibly attend college in the area before moving, which might be ten years. Let’s say the house is valued at $200,000 today.

The investor proposes that they put up the $15,000 out of their self-directed Roth IRA to purchase an option allowing them to buy this house for $225,000 any time after ten years. The homeowner gets the money they need today for the roof and continues to live in the house for the next ten years. In 10 years, the home might be worth $290,000, but the investor can exercise their option to purchase that house for $225,000. The homeowner keeps everything up to $225,000 minus whatever they have left to pay on their mortgage. The investor gets everything over $225,000; that is approximately $65,000. Plugging these numbers into your financial calculator shows that your $15,000 investment in that option gave you a 14.75% return on your money over ten years. Not bad and is much better and probably safer than most stock market investments.

In this example, you used money from a self-directed Roth IRA, so the money was inaccessible to you until retirement anyway. Waiting ten years to exercise your option wasn’t a real hardship. When you exercise the option, it generates a nearly 15% return tax-free. The homeowner got to live in their house for the ten years they wanted and received the money to fix their roof when they needed it. They continued to live in the house and take care of it, making it a hands-off investment for you. Everyone wins.

You can structure an option any way you and the person selling it agree. It can be for any strike price and term to exercise that you both can agree on. The option can be sold at whatever price works for both parties. I like to design my options to a price that solves the person’s financial problem and still generates the return I seek. That is where the financial calculator comes in. If it isn’t clear by now effective real estate investing is about finding solutions to people’s problems in a way that helps them and you.

Lease/Option

The fifth and final strategy to invest in real estate involves putting two or three of the above strategies into one deal. Real estate investors call this “structure stacking” because you use multiple strategies or structures to assemble a deal.

A lease/option is two tools. First, it is a master lease from above. As noted above, you lease and sublease the property to a tenant. In addition, you negotiate when you lease or at some point during your lease an option to purchase the property at a known strike price in the future. You earn income today with the lease and can purchase the property for a price today that is likely lower than you could buy the same house for in the future. You could even bring in a third strategy with seller financing, where your option allows you to buy at a specific strike price but use seller financing when you do.

Let’s do a case study to bring it together. You come across a landlord with an excellent property in a nice neighborhood. He purchased the property for $120,000, but today the home is worth $235,000. He has owned this property for 20 years, and it is paid off. He has rented the house for 20 years and enjoys the income he receives each month, but he no longer wants to do the management. He spends six months a year in Florida and isn’t around. He doesn’t want to sell it because his recaptured depreciation and capital gains would create a high tax bill.

A real estate investor offers to master lease the property from the landlord for a monthly price that still generates income for the owner but allows the investor to make a profit. The investor takes over maintenance and management, and the owner will get a check each month and no longer worries about day-to-day issues coming up. In addition, the investor negotiates an option to purchase the home for $235,000 in 8 years, which the investor expects to be in a lower tax bracket at that time. To make this more advantageous to the owner, they negotiate a seller financing arrangement if the investor exercises the option in 8 years. The investor gets into a nice house for much less than it would cost to purchase. They benefit from monthly cash flow and future appreciation (the option). The owner gets out from under management, receives some monthly cash flow, and with the seller financing arrangement, would likely lower their tax bill if the investor exercises their option. Again, everyone wins.

Which Sellers Will Agree to Creative Strategies

The number one question most potential investors have is what kind of people would agree to creative strategies like this. Doesn’t everyone just sell for all cash? First, you need to understand something; nobody wants a giant pile of paper money. What they want is what that money can do for them. What it can buy or the problems it can solve. As an investor, your job is to figure out what that “it” is and figure out a way to get it to them without giving them all cash for their house. This takes time, creativity, and strategy, but it can be done and is done by good investors every day. Real estate investing is a lot like assembling a puzzle. You are always searching for the right pieces to put in the right places. That is what you are trying to do when you are finding motivated sellers.

First, you generally need to find a motivated seller. This is someone that wants or needs to get rid of a property and has some motivation for doing so quickly. Most people that fall into this category have one or possibly two problems:

  • House Problem
  • Money Problem

House Problem

A person might have a house that needs repairs they can’t afford. If they are a landlord, they might have a house they don’t want to manage and want to retire. If they are older, they may have a house with stairs that are difficult to manage. The real estate market might be slow, and it is difficult to sell. The house might have features that make it difficult to sell, such as an odd-shaped yard, outdated design, or on a busy street. The bottom line is that there is something about the house itself that is creating stress or motivation in their life that they want to eliminate.

Money Problem

The person has issues and needs to get money or stop paying money they can’t afford. This could be someone in foreclosure. It could be someone that needs money for a large repair. It might be a couple that is getting a divorce, and neither partner can afford the house without the other income. It could be a retiring landlord that needs to avoid a large tax bill. The bottom line is that selling the house through a real estate broker will take time and is not possible or desired. They have a money problem now that needs solving quickly.

We are all faced with a series of great opportunities brilliantly disguised as impossible situations.

- Charles R. Swindoll

Where It Won’t Work

No real estate broker understands these strategies, and all of them want a sales commission when the house sells. If someone has no distress regarding their house, plenty of equity, money, and time, they are not motivated to do anything except wait for a full price, all-cash buyer. In a scenario like this, you are unlikely to put any of these strategies in place. First, you need to talk to the seller, which the real estate broker will do their level best to keep you from doing. In addition, if you are in a hot real estate market where prices are climbing rapidly and houses are in short supply, this will be far more difficult but not impossible to do.

Finding Motivated Sellers

In real estate investing there is an art to finding motivated sellers and landlords that I can’t get into in this article. In a future article, I will discuss this in more detail, but for now, focus on finding properties that aren’t listed on the MLS by a real estate broker. If a house is listed on the market, your chances of doing a creative deal plummet to almost zero. I won’t say it can’t be done because fellow investors I know claim to have done it, but I have never personally been able to pull this off. You need to focus on what investors call off-market deals with motivated sellers. One place you can go to start looking right away is real estate investment groups. These groups go by many names but are usually found in most cities. Some larger cities might have multiple organizations. I live in a smaller city and have two of them. These groups are a great place to find retiring landlords or investors that need a partner on a project.

How Much Can the House Afford Pay

Every solution above, except for a pure option, involves covering your monthly expenses for the property out of the rental income the house will generate. You must know the market value of rent in your neighborhood, and it doesn’t work if you try to set the rent to whatever you need. If it is too high, nobody will rent your property. The market controls the amount you can charge.

Before you structure any deal, the number one question you ask is how much this house can afford to pay each month? If you have a house where the market rent is $1,000, then that is how much the house can afford to pay. You can’t go above this rate because nobody will pay it. Also, don’t make the mistake of deluding yourself into believing your house is nicer and, therefore, can get a higher rent. This might work for a small premium but is still very risky and probably won’t make up your shortfall.

When you sit down with a property owner or seller to negotiate a deal, you need to come up with a monthly payment or monthly rental amount (master lease) plus monthly expenses like property taxes, insurance, maintenance, utilities, and capital expenditures below your market rent. Your cash flow is the difference between these expenses and the rent you charge, and you must structure a deal that gives you cash flow from day one. Avoid getting into a situation where you lose money each month, or you may find your investing career short-lived.

Once you know how much the house can afford to pay (market rent), you know how much you must work with to structure a monthly payment, cover your operating expenses, and generate positive cash flow. I repeat, don’t start structuring a deal without knowing these numbers. Every local market is different, and you need to know yours.

Creative Strategies Plus People Skills

In all the above examples, there was a strategy that worked for both the investor and the property owner. All the techniques allowed a real estate investor to enter the property in a way that involved a lower investment, generated cash flow immediately (with the exception of an option), and solved the property owner’s problem. You need education, creativity, and people skills to implement these solutions, but it is a fantastic way to build your net worth over time.

You must listen to the property owner and their problems to select the right tool for the job. If they don’t want to sell the property but need to eliminate a financial or management problem, you can use a master lease or option, depending on the exact issue. If they want to sell but avoid paying a high tax bill, you can structure a beneficial seller financing offer. You might employ the subject to strategy if they have financial problems and need to get out of a house with no equity.

The critical thing to understand is that you need to build trust and a relationship with the seller or property owner. This doesn’t work if they think you are a snake in the grass that won’t honor your promises. It also won’t work if you pull out the wrong tool from your toolbox and try to make it work. You need to understand the issues, select the right tool, craft the solution that works for everyone, and keep your promises. It should also be clear by now that real estate investing requires a diverse skill set including marketing, sales, management, people skills, finance, accounting, tax, and creativity, which is one of the reasons I like it so much.

Conclusion

Most real estate investors understand only one way to buy a property. Find a house, pay as little as possible, get a mortgage to buy it, and hope the numbers work out. One of my mentors calls this the big damn hammer solution because it involves you going into a situation and offering a seller 40 cents on the dollar. If they refuse, you try and beat them over the head with negotiating strategies until they accept your offer. This is a very shallow and one dimensional way to approach real estate investing.

With creative real estate solutions, I can structure offers where I pay full price for a house and still make the numbers work. I have solutions for people that need money but don’t want to sell their house today. I have solutions for owners that don’t want to sell today but don’t want to manage the property any longer. I can stack these and craft these solutions in infinite ways to solve very specific problems. I can put deals together that my competition can’t touch because they know one way to buy a house. I know several.

Using creativity, a variety of strategies, and people skills allow me to build a real estate business that works for me and works for the seller or property owner. One of my mentors once told me that you never find a good deal; you make it. Structuring these offers takes time, patience, and skill, but knowledgeable and creative investors do it every day.

Disclaimer

The information contained within this website is provided for informational and educational purposes only and is not intended to substitute for obtaining legal, accounting, tax, or financial advice from a professional tax planner or financial planner. Full disclosure

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