Your borrowers should have an exit strategy from the beginning to prevent problems later.
An exit strategy is a plan that an investor uses to liquidate their position in a financial asset. Real estate investors should plan their exits from the onset of any deal. Here are six exit strategies that you, as a private lender, can suggest to real estate investors as they plan for the disposition of an asset.
- Sales-Leaseback Arrangement
A sale-leaseback arrangement, also known as a leaseback arrangement, is a real estate exit strategy that allows investors to rid themselves of their property and still maintain residence for an agreed period. Basically, the leaseback strategy provides the seller with capital, while the buyer makes money from the long or short-term rental agreement that was assessed at closing.
Another benefit of this arrangement is that it lowers the seller’s capital commitment—like tax costs and rates—without losing the use of the property. For example, let’s assume an investor needs financing to pay off some debt but was unable to access the mortgage market because of a poor credit score. The investor can sell his property with an agreement that the property will be leased back to him for a certain period.
Repositioning is an exit strategy that allows the investor to convert the property into a different asset class of the real estate market. This type of strategy adds value to an asset by changing the usage of the property from a less demanding one to one with a higher demand and, therefore, a higher return on investment (ROI).
For example, if a residential property is in a city where an office complex is in higher demand, the investor can reposition the property by modifying it to suit the market’s needs. The benefit of this exit strategy is that it raises the value of the property and increases the investor’s ROI.
Another way an investor can reposition is to buy an underperforming asset and create value by renovating and refurbishing the property. The main point of this is to achieve the full potential of the asset and increase the rent. And if the investor decides to sell, he increases his ROI because he sells at a premium price.
- Cash-Out Refinance
Cash-out refinance allows an investor to liquidate the equity on a property by applying for a loan that is beyond the existing lien against the property. Cash-out refinance is different from traditional refinancing in that the traditional refinance option allows an investor to apply for a mortgage to pay for the existing lien against the property. Cash-out refinance allows the investor to borrow more than the existing mortgage and receive the excess cash at closing.
Another disparity is that traditional refinancing allows investors to renegotiate better terms and rates. The cash-out refinance option does not give the owner the chance to renegotiate for a better rate—but to pay more than the existing rate. One important thing to note is that the maximum amount of cash an owner can receive depends on several factors—the loan-to-value (LTV) ratio, the interest rate and credit score.
For example, an investor has a property worth $200,000 but still holds a $50,000 mortgage on the property. If the investor needs cash, they can liquidate the equity they have in the property by applying for a cash-out refinance loan—applying for a higher mortgage than the previous one and receiving the excess as cash at closing.
- Rent to Own (Lease Option)
Rent to own, also known as a lease option, is an exit strategy that allows a tenant to lease a property for a certain period with an agreement to purchase the property at the end of the lease term. This investment type involves two agreements—a traditional rental agreement and an option to buy the property. This exit strategy is beneficial to both the seller and the buyer.
For the buyer, applying for a mortgage can be a bit tedious, because a good credit score and cash for a down payment is needed to qualify for this type of mortgage. However, with the rent-to-own exit strategy, the investor can enter a rental agreement while paying the down payment and building a credit score to qualify for a mortgage.
On the other hand, this strategy offers the seller a stable source of income for the lease period, and the potential to be rid of the property at the end of the lease. Also, the owner doesn’t need to prep the property for listing. The prospective buyer has been in the property as a tenant and already knows everything about the property.
Although this investment type is enticing and can attract buyers in less time, they do need to be careful about the type of agreement entered into with the seller. It is advisable to work with an experienced real estate attorney to prevent entering into a legal obligation that may be regretted later.
- Seller Financing
Seller financing, also known as owner financing, is a strategy in which the seller provides the financing for purchasing the property. It means the seller serves as the mortgage lender and handles the mortgage process by providing the loan. When this strategy is used, the buyer is required to pay some sort of down payment to the seller and make installment payments for the remaining balance. This strategy is best used in a buyer’s market to entice buyers—where the supply is greater than the demand.
One of the benefits of this strategy is the potential for both parties to save a substantial amount in closing costs. Another is the ability to negotiate better terms, rates, repayment schedule and other loan parameters. On the side of the buyer, there is no problem with having a poor credit rating. Unlike with conventional mortgage firms, an appraisal may not be required and the rules and regulations are flexible.
Conversely, although the real estate agreement is legally bound, the buyer still doesn’t have full ownership of the property. Until the buyer pays the debts, the property still belongs to the seller. Another con of this strategy is that the seller (who serves as the financial institution) will also likely face the risk of delinquent borrowers. If the seller doesn’t have employees who are experienced in managing assets and dealing with default borrowers, they will face the consequences.
- Hold and Sell
Hold and sell is similar to the rental investment strategy. The difference between the two strategies is that a rental property is held on a long-term basis, while the hold-and-sell strategy is for a short period. This investment strategy involves an investor buying an undervalued property or a property in an unstable market, keeping it for a certain period and properly selling the asset when the market is stable.
Choosing this exit strategy is risky and it requires some calculation and market analysis to determine ROI. New investors planning to use this strategy are advised to work with an experienced agent and other experts in the field so they don’t run into problems.
One of the benefits of this strategy is the stable income source that it offers when the investor is holding the property and the high ROI it is sold.