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MEET A, B, AND C

The term “wholesaling” has gotten a lot of attention in the last 15 years. Those that dream of striking it right in real estate investing but struggle to find the capital necessary to take their turn at the plate often turn to wholesaling in order to get into the game. What is “wholesaling” and what role to wholesalers play in the marketplace? Let’s also discuss the A to B, B to C transaction.

Wholesalers are marketers that are great at knocking on doors and turning over rocks to find people that are willing to sell their property, but haven’t listed it publicly for sale. The wholesaler will enter into a real estate contract to purchase the property from the seller, but they will use an “assignable” contract to do so. Most standard real estate contracts have a box to check that says something like “this contract is assignable.” This allows to the wholesaler to assign his or her right to purchase the property to another party. In such a case, the wholesaler is paid an assignment fee by the investor that they assign the property to and then the go off in search of more properties to wholesale to well-funded investors.

What if the contract can not be assigned? That’s where the A to B, B to C transaction comes in. Party “A” represents the seller of the property. Party “B” is the wholesaler that enters into a contract to purchase the property from Party A. Unfortunately, they don’t have the money to close on the transaction. At this point, they go out in search of Party “C”, an investor that would love to purchase the property. Good wholesalers not only search for property, but they also build a stable of willing investors to take good deals to. B, the wholesaler, enters into a second contract with C to sell the property for more than what they are buying the property for from A. They get a sizable, not refundable deposit from party C for the “B to C” transaction and have it placed in escrow at the closing agent, usually the same agent that is doing the A to B transaction. They then take that contract to a fourth party called a transactional funder. This entity will provide a very short-term loan to Party B in order to complete the first A to B transaction with the idea that they will immediately be paid off by from the B to C transaction. Transactional funding isn’t cheap, but it gets the deal done. In most cases, the A to B and the B to C transactions occur within a day or two of each other…many times they occur on the same day.

The whole process is nerve-racking, but it is certainly a way for someone with little or no money to join the lucrative real estate market.

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THE IMPACT OF BORROWING ON A FLIP

To borrow or not to borrow, that is the question. Real estate investors have long sought hard money loans to fund their projects, but what is the impact of using hard money loans on profit? Unlike most of the articles on the site, this one is going to have us doing a lot of math together. My apologies in advance for bringing back bad memories from your high school Algebra I class.

Let’s say that an investor purchases a home for $120,000 and puts $30,000 into the rehab of the project. Let’s look at the impact on profitability if the investor obtains an 80% hard money loan at 9% interest with 2 points. For the $120,000 loan, the investor would automatically owe $2400 as soon as they sing the loan papers due to the 2 points. They would also be paying $900 per month in interest on the project. For illustration purposes, let’s also not take into account any closing or other costs to compare apples to apples.

The deal looks pretty good if the investor is able to sell the home for $200,000. If they were to simply pay cash for the deal, they would make $50,000…a very respectable 25% return on investment. Let’s say, however, they use the above-mentioned financing scenario and it takes them 6 months to buy, rehab, and sell the property. They would pay a grand total of $7800 to the lender in interest on their $30,000 cash injection ($150,000 purchase price and rehab budget minus the $120,000 loan). The profit drops to $42,200, but you make a whopping 140% because you only injected $30,000 of your own money into the deal. So far so good with using hard money, but what happens if the profit margin is much thinner or if it takes a much longer time that you expect to sell the property?

Let’s start with examining a scenario where we only sell the property for $165,000. If we paid cash, our profit is $15,000, or a somewhat respectable 10% return. If we borrow, however, our profit drops to $7200 (due to the $7800 we had to pay the lender) for a return of 24%. The percentage return is quite strong, but margins are getting quite tight when it comes to dollars and cents. Let’s use that same $165,000 sales scenario, but let’s imagine that it takes 12 months to sell the property instead of six. Our lending costs eat up almost all of our profit.

Borrowing money to finance projects is a risk…a risk that should be analyzed for every deal that you do. Be sure you have built a great model and you’ve built in enough to handle the unexpected if you are borrowing.