NoMoneyDownRealEstateInvesting.doc March 3, 2004
No Money Down Real Estate Investing—an Example of Bootstrap Financing
Introduction
I just met with a couple, Betty and Phil (not their real names BTW), who have almost no money and now own four buildings with 9 (residential) rental units. To understand how they did it, read on…
Firstly, they got people they met in an investment club to invest their self-directed RRSP funds in second mortgages. For each building Betty and Phil bought for around $300,000, the financing worked something like this:
A. they got $225,000 from a first mortgage from their Bank;
B. they got $70,000 from a second mortgage funded by five third party investors who funded the seconds pari passu with their self-directed RRSP funds;
C. Their own equity—just $5,000 per building.
You might think that this is riskier than say having one building with all their $20,000 in equity in it; i.e., less leverage in the deal. But I think their actual risk profile is less with smaller amounts of equity in their four buildings instead of all their equity in one building.
Get Rich, Slow
Why is that? Because if they had one building with say two apartment units in it and one becomes vacant, they would have an occupancy rate of 50% and a vacancy rate (obviously) of 50%. If they have four buildings with 9 units and one becomes vacant, they have a vacancy rate of 11.1%, which is self-evidently better than a vacancy rate of 50%.
Banks in
They also want to give you plenty of incentive to make sure you don't default (i.e, they want you to make every effort to protect your (larger amount of) equity)—it’s basically heads they win, tails you lose with most Canadian Banks.
Secondary Financing
You might justifiably ask why would a bunch of investors sink their RRSP funds into Betty and Phil’s properties? I mean they are taking some of the risk and funding most (over 90%) of the equity (yes, second mortgages are considered a form of equity) yet they have zero actual ownership interest in the title of the property—Betty and Phil own 100%. So why not get rid of Betty and Phil and just own the property themselves or cut Betty and Phil in for say 10% and own the balance themselves?
Well, first of all, they don’t want to be active investors. These are people who are not happy
with the fact that the prime rate in
Second of all, they trust Betty and Phil.
Thirdly, they want Betty and Phil to take the business home with them at night—they have to find the right opportunities, negotiate the deals, rent the darn units, fix and repair stuff that gets broken, deal with midnight moves by tenants who skip on them and a million other details that go into any successful business operation.
Fourthly, they don’t actually want to own property—they are at a different point in their lives (usually) and just want a higher return on their funds.
Fifthly, there is a difference in the leverage between the two groups—it’s called asymmetric information. Phil and Betty know real estate; they are bloodhounds for undervalued real estate. The investors don’t know diddley about finding the best buildings in the best locations and scooping them up for a low price and then filling them up with great tenants paying top rates.
Lastly, they know that if Betty and Phil fail, they always have the option of stepping in and taking over the unit if they can make the first mortgagor whole (in case of a default).
My advice to Phil and Betty is to make sure that their second mortgages are not interest-only mortgages. They were talking about making them interest only so they could lower their monthly outlays. This, I told them, is a bad idea.
Interest-only mortgages have a habit of never get paid off (i.e. by definition). By making the seconds interest-only, they are not getting the benefit of forced savings, the principal is not being retired and their investors are not getting their money back.
Betty and Phil should want their investors to get their money back—a bit every month so that over time, they will own their buildings with just the first mortgages and over more time, they will own all the real estate with no financing at all.
A Student Query
Here is a query I received from one of my students; it is typical of the questions I get about bootstrap financing. The stories are all pretty much the same whether it’s real estate development they are thinking about or starting a new tech company or a services company or even a new not-for-profit org.
“Bruce,
I was one of the Architecture students that sat in on your
entrepreneur class. (Very interesting class by the way.)
I am interested in taking your
The reason I am interested in the
The story you told about your two former students that are
purchasing/renovating/selling homes was very motivating.
We recently received a tip about a property that would be an excellent starting
point for the business but we have little financing to pull it off.
As a student and after dragging my wife away from her job so that I can pursue
my master’s degree at Carleton, the chances of us getting a mortgage through a
bank are slim to none.
I guess I'm looking for advice on alternative financing, specifically a small
business loan.
Thanks,
Jim (not-his-real-name) Evans”
My Answer
Without knowing all the details of any particular project, it is dangerous to give advice. But that has never stopped me from having an opinion.
There are any number of solutions and at the end of the day none of them may work—bootstrap financing is risky and failure is always a possibility.
The approach I usually take as far as real estate is concerned is to enter into a conditional APS (conditional on things like financing, building inspection, environmental review ...). Unless you have tied up the property, all you have is an idea and ideas are cheap. People you want to approach for financing won’t take you seriously because they don’t know if you can actually close the deal even if you had the dough lined up.
Many Vendors are willing to take some risk with honest would-be Purchasers. What you are looking for is motivated Vendors—people who need to sell because of estate planning reasons, a personal financial crunch, a marriage breakup, other investment opportunities and needs, whatever. So I tell my students to be direct in their approach—always disclose to the Vendor what they are doing (but tell them the ‘Smart Truth’). Get the Vendor to trust them and then be sure to earn that trust.
So you tell the Vendor that yes, you need to line up the financing but yes, you have a plan to do that and you should have a plan before you do anything.
So you try to tie up the property by offering a conditional
deal with a conditional period which is typically 60 to 120 days. Now you are
considered to be an “owner under Agreement of Purchase and
That is, money has changed hands (even though there is a string on it—it can be pulled back if the deal collapses) which makes the deal, real so to speak.
During that conditional period, you run and around and try to get your financing lined up as well as do all the other things you need to do to close on the property.
Jim Evans will probably need either a co-signer or some passive investment money or both. Here is how it might work for Jim and his spouse:
1. The co-signer simply co-guarantees Jim’s mortgage for him; Banks don't really like this anymore but some will do it. They hate the idea of having to chase someone else’s personal guarantee—it is a problematic legal process and expensive too.
2. Jim needs to arrange for imaginative secondary financing such as what Betty and Phil did.
I mentioned to Jim that I have a young friend who arranges difficult mortgages and I would give him his contact co-ordinates once I know more about the exact nature of their proposed project.
Why Invest in Real
Estate?
I tell most of my SME clients and my students that real estate investing is usually a good idea. Why is that?
Well, here are a few reasons:
- Forced savings— most people are really bad at saving so, if at a minimum they own their own home or condo or (for entrepreneurs) their own business premises, every month that they make their mortgage payments, they are paying off (‘saving’) some of the principal.
- Get rich slow—real estate is not a get rich quick scheme. But most markets have some real estate inflation and, at least, real estate markets don’t usually sink as fast as say tech stocks did in the great bubble burst of the early 2000s.
- If you own your own business premises, you have a diversification of risk (I advise that you should keep the real estate in a separate company from your operating company so if something happens to your business, you can always sell your real estate separately and, hopefully, live to fight another day).
- If you own rental property, your tenants are helping you with your ‘forced savings’ since they are paying off the part of the principal on your mortgage every month for you.
- Hopefully, you real estate portfolio is providing you with some cash-on-cash return too so that every month you are getting some help with what my spouse calls “IGA money”; i.e., money you can touch, feel and spend.
Dr. Bruce M. Firestone,
Dr. Bruce M. Firestone
B. Eng. (Civil), M.Eng.-Sci., PhD.
Real Estate Sales Representative
Metro Suburban Realty Ltd.
613.723.2222 x 229 w
613.723.2345 fax
bfirestone@metro-sub.com