Second Mortgage, Carry Back

Hi Sam

If you skip to p 300, you will see another paragraph which outlines another example with a second mortgage.

This is what I reckon this relates to – I hope some of our more experienced forum members out there will set me right if I have got this wrong too.

Anyway here goes:

There may be times where the vendor is willing to help you out with the deposit. I gather in negotiating or initial discussion with vendors it is just a matter of asking.

So, I would imagine that the vendor has experienced some growth in the value of the property or that means to say, their equity in the property has also gone up – since the time they first purchased the property. Best case is they experienced a growth in the property market values.

The example in the book is showing that you can increase the positive cashflow (CoCR) figures by utilising creative problem solving. (If you read his second book, the approach is ‘Problem + Solution = Profit”) Here the ‘problem’ as he states on p162 is “You should have arrived at a CoCR of 20%. If I was your mentor then I’d suggest that the return on this deal was nothing special given the risk involved”….(then he goes on to solutions) “However, before you accept or reject this opportunity, we need to consider ways of negotiating different terms that will increase or maximise our CoCR. You can do this by increasing the net annual cashflow and/or decreasing your initial cash outlay.”

So the solutions was either to:
Increase net cashflow (buy a property in a low vacancy area where rents look like they have a good likelihood of increasing or negotiate where possible to reduce cash outflows by getting better deals – which we could say neither of this was the case since he goes on to the other solution)

Decrease your Initial Cash Down. (If you compare the first example to the second you will see that the Initial Cash Down > Total Cash Needed has decreased.

How did it decrease? By the vendor agreeing to take a second mortgage. Does this affect the vendor negatively – no it would not. Because s/he as the vendor has already experienced some paper profit from an increase in the value of the property, say in this case $50,000. Upon selling the vendor will realise the profit. However, the vendor can also make more money on the $50,000 by carrying back a second mortgage.

In so doing, the vendor is helping you – by getting another mortgage from a lender – because this in effect reduces the initial deposit amount for you (compare the deposit amounts in the two scenarios – table 11.5 is reduced by $50,000).

So the vendor has helped you to Reduce Your Initial Cash Down which has the effect of increasing the CoCR – which makes the deal more viable at 34.45% compared to the first scenario of 20.48%.

But the vendor does not do this for free. By doing this you will be paying the vendor slightly higher interest rate. The vendor in getting the second mortgage on the $50k will go for a interest only term of say 8% from his lender. You offer to pay the vendor 10%. So the vendor earns from helping you too. Your agreement will of course, state that you are required to make the repayments to the vendor each month and the vendor will make repayment to the lender.
Win-win.

Then the book says:
“Negotiating this deal would be particularly beneficial if you could use the $50k in cash you saved by seeking a second mortgage and apply it to another investment providing an after-tax return in excess of the 10% annual interest rate. The trick is to remember that you’ll need to repay the second mortgage in five years time.”

In that case, the second mortgage is a five-year term. So, Steve is assuming that you have some more money to invest but you chose not to spend it on initial outlay and save it. In effect on this property you increased the CoCR.

So it is now an open option for you to take advantage of the situation and seek out another investment property that will give you an after-tax return of more than the 10% interest rate. So with the money you saved, you use that as a deposit on another investment property that brings you returns that is more than enough to cover five years of 10% interest rate repayments to the vendor (and as much extra return above that as you can get from your choice of investment property). In effect this second investment property that you find brings enough positive cashflow returns that are enough to cover the repayments required for the first property.

So that is an example of creative problem focus + solution = access profit in the deal.

Of course to begin with in this scenario, you are confident of getting approval for loan in the first place – just as with any property purchase. The second property investment ideally you have already got several in mind and earmarked along your list of targeted possible properties you have researched and found.

I hope I have been clear enough and that this is accurate.

More experienced members please feel free to amend any mistakes I may have made in my attempt to explain this.

Thanks

Alex[blink]

Answers come from the courage to ask