Substitution Of Collateral

An extremely valuable and strategic tool to use when acquiring Real Estate is the “Substitution Of Collateral”. As you know, if you have been reading my articles, I am a strong proponent of acquiring (and sometimes selling) properties wherein I can obtain Seller Financing. This tool could also be effective if you, as a buyer, are obtaining Private (other than seller) financing. It probably would be difficult, but not impossible, to obtain this substitution from an Institutional Lender. OK, so what am I talking about with this “Substitution Of Collateral”? Let me give you an example or two. I believe learning sticks better if you can tie it to an example of how something works.

Charlie Barrow is a budding Real Estate entrepreneur who has a mentor. Charlie has a good paying day job; however, he is looking to acquire, hold and manage Rental houses to supplement his income when he retires. Charlie finds a single-family house For Sale wherein the seller, R. Bishop, has already stated that he would consider financing the house for a buyer.

The house needs some repair and Charlie is confident that he can handle that for about $3,000. The estimated value of the home, after repairs are made, is $125,000. The house will rent for $1,100 per month.

So after conferring with his mentor, Charlie makes Mr. Bishop an offer to buy his home. After negotiating, Charlie and Mr. Bishop agree to the following terms:
Sales Price $90,000.00
Down Payment $5,000.00
Seller Financed Loan $85,000.00

Monthly Payment (P&I) $565.51
Estimated Taxes & Insurance $167.00
Total Monthly Payment $732.51

Following his mentor’s advice, Charlie also negotiates the “Right of Substitution” of the collateral for the Loan. The seller agrees that in the future Charlie may move the Loan from the house to another property. The other property would need to have an appraised value of at least as much as the value of the house. The seller further stipulates that the appraised value of the new collateral must be at least $15,000 more than the sales price of the house he is selling.

OK, so they close the deal. Charlie makes the repairs and the house now has an appraised value of $125,000. Charlie has received approval from his bank for a future loan of 80% of the appraised value, payable over 30 years at 6% interest. His monthly payments, PITI, would be $766.55 giving him a positive cash flow of $333.45 per month.

Charlie, feeling very confident now, is looking for another house. He soon finds one somewhat similar to the one he just bought from Mr. Bishop. This house is owned by a Mr. & Mrs. Clarke who are asking $100,000 for the home. The house has been on the market for over 6 months. The Clarkes have indicated they might finance; however, they need at least $40,000 as they are moving to be near their children and need as much cash as they can get.

Sensing an opportunity here, Charlie asks Mr. & Mrs. Clarke what the price would be if he paid ALL CASH. After some negotiating, Charlie offers the Clarkes $85,000 cash for their home. They accept the offer from Charlie for that amount.

Charlie now goes to Mr. Bishop and tells him that he wants to move his loan from the house he bought from Mr. Bishop to the house he is buying from Mr. & Mrs. Clarke. They agree and hire an appraiser for the home. The appraisal comes in at $105,000.

Now Charlie goes to his bank and obtains the $100,000 loan on the house he bought from Mr. Bishop. The loan will close simultaneously with the purchase of the Clarke house and the movement of Mr. Bishop’s loan to the Clarke house.

So, after the smoke clears, let’s see what happened:
1. Charlie obtains a loan from the bank for $100,000.
2. Mr. & Mrs. Clarke receive $85,000 cash for their home.
3. Mr. Bishop’s loan is now secured by the house acquired from the Clarkes.
4. Charlie now has approximately $700 per month cash flow from both houses.
5. Charlie also has $15,000 cash left over from the bank loan. This will repay the repairs on Mr. Bishop’s house and leave more for repairs on the Clarke house.

Now Charlie can repeat this process over and over again. Isn’t this Real Estate business a fun thing?

These posts are the opinion of the author who is not engaged in rendering legal, accounting, or investment advice. If such advice is required or desired, the services of competent professional persons should be sought.