Can you wrap your head around this strategy?
Buying and holding good cash flowing rental properties long term is the goal when it comes to real estate investing. But is owning a property as a rental the only way to produce a good cashflow?
If you don’t know the answer, that’s okay, because today we’re going to talk about a strategy that allows you to have passive income without the joys associated with landlording. Sound good?
Today’s column comes from a conversation I was having with some investors from out of town who were in a precarious position. (Actually, out-of-state is the correct term here) Somehow they had found a house to buy in my backyard here in Calhoun. They were newer investors and had decided to look for subject-to deals to buy and hold as either long term rentals, or to sell on a wrap with owner financing.
And if you don’t know what either of those two strategies are, let me explain:
A subject-to deal is where you buy a house that has a mortgage on it. In a traditional closing you pay off your seller’s mortgage with either your own cash or with the money you got from a loan to buy the house. In a subject-to deal, however, instead of paying off the seller’s mortgage, you leave it in place after the closing and agree to make payments on that seller’s mortgage until it is paid off.
And you know how I’ve told you that Ashley and I have never had a mortgage in our name? Well, that’s because every house that she and I have ever lived in has been purchased using the subject-to strategy. And we have bought many long-term rentals using it as well.
Now if you don’t want to keep the house as a rental but you still want to make passive income on it, then you could sell the house and use a strategy called a wrap-around mortgage, or wrap for short. This strategy is often referred to as an all-inclusive second mortgage as well. And you’ll understand why in a minute. But to understand how a wrap works we need to look at some numbers.
Let’s say you bought a house subject-to and it had a mortgage with a balance of $150,000, an interest rate of 3.22 percent and principal and interest payments of $650 a month. You discover that you can sell that house for $200,000 on a 30-year fixed mortgage with a rate of 6.58 percent and receive payments of $1,330 a month. This would gain you a cashflow of $680 a month without any expense factor, which I’ll explain in a bit.
Now the reason why it’s called a wrap is because the note created at the end sale for $200,000 includes the underlying $150,000 mortgage. In other words, the new note wraps around the original note and makes them one. But technically, since the underlying was never satisfied, the wrap mortgage is in second position.
The wrap is in second position, and it includes the underlying first mortgage. That is why it is called an all-inclusive second mortgage.
So one house that yields $680 a month with no other expense sounds pretty good doesn’t it? That’s why selling with a wrap is a very viable and profitable strategy. The downside to it is that eventually the house pays off, and it may happen sooner than you think.
The wrap mortgage that we figured in our hypothetical house was based on a 30-year mortgage. So to get payments of $680 a month for 30 years sounds amazing. The problem with that is that it probably won’t last 30 years.
According to a Redfin article I saw recently, in 2021 the average homeowner tenure in Georgia was 9.8 years. That means people only live in one house for 9.8 years before they sell it. So according to that, you may only get about 10 years’ worth of payments, not 30.
Ten years is not a bad middle term investing strategy. But that redfin statistic was figured from purchase to sell. I don’t think it included refinancing mortgages. That is important because if interest rate changes or appreciation make it advantageous for your buyer to refinance you out of the deal, your cashflow can go away even quicker than the 9.8 years mentioned.
If they do, you will still have a chuck of cash waiting for you at the end because you created equity between the spread of the underlying mortgage and your wrap.
So the positives of a warp are they have higher cashflows with no expenses. The downside is that you never know when they will pay off and, because you sold the house, you have lost all future appreciation.
Next week we will come back to the investors and talk about their precarious position. But, if you will pardon the pun, I think I’ve given you enough to wrap your head around.
Joe and Ashley English buy houses and mobile homes in Northwest Georgia. For more information or to ask a question, go to www.cashflowwithjoe.com or call Joe at 678-986-6813.