The late-night television airways are full of “nothing down” stories. Are they true? And, if so, is it possible to buy real estate with “no money down.” Furthermore, does it make sense to buy real estate with no money down?

Everybody wants to buy real estate with no money down (especially if you have no money), since it is the ultimate form of “leveraging.” However, keep in mind that there is nothing special about buying a property with no money down. On the other hand, if you can purchase the property at a substantially below-market price and with no money down, you then have a good deal. This is buying 100% loan-to-purchase, not 100% loan-to-value.

The problem with buying a property at a below-market price is that lenders tend to “penalize” you with their loan regulations. Fannie Mae conforming loan guidelines usually require that an investor put up 20% of his own cash as a down payment. The 20% rule applies even if the purchase price is half of the property’s appraised value. Thus, the loan-to-value (LTV) rules are based on appraised value or purchase price, whichever is less.

A common, but illegal, practice is for the buyer to put up the down payment and for the seller to give it back to the buyer after closing “under the table.” An even dumber method is to over-appraise a property, effectively financing a property for 100% of its value. People may get away with it all the time, but these practices are loan fraud, punishable by a nice vacation at Club Fed.

Many investors refinance every few years as property values increase, using the extra cash to buy more properties, as suggested in the best-selling book, “Nothing Down.” While this process does increase your leverage, it also increases your risk. There is nothing inherently wrong with taking out cash in a refinance, so long as the cash is used wisely. Spending the money as profit is not a smart use. If you end up with high LTV and/or negative cash flow on the property and housing prices fall, you are in for a world of financial hurt.

A Real-World, Common-Sense “Nothing Down” Deal

As you can see, there are smart and not-so-smart ways to buy “nothing down”. The following is an example based on a real deal I helped a student of mine put together:

Sandy is interested in purchasing a home to live in, but she doesn’t have much cash. She just started her own business and cannot not qualify for a conventional or FHA low-down payment loan. Sandy finds a seller with a nice property, with very little equity, but a low-interest rate loan. Sandy leases the property from the owner for three years for $1,200 per month, with an option to buy at $162,000. The house is currently worth $179,000. The seller agrees to the discounted price because he saves a real estate commission and can wrap up the deal quickly.

The agreement provides that the seller give Sandy a 25% ($300) credit towards the purchase price for each rent payment Sandy makes. Sandy also puts up $1,200 as a security deposit, which will be credited towards the purchase price when she exercises her option to purchase the property.

After 12 months, the property has appreciated in value to $189,000. Or, if the property values do not increase, Sandy has made improvements to the property that increased its value. In addition, Sandy’s “equity” has increased because of the $300/month rent credit. Thus, after 12 months, Sandy’s equity position is $31,800:

$162,000 original option price
less $ 3,600 rent credit
less $ 1,200 security deposit
$157,200 “strike price”

$189,000 market value
minus $157,200 strike price
Equals $31,800 “equity”

Sandy exercises her option to purchase the property at the “strike price” (original option price, less credits).

The Lease/Option “Refi”

In funding a loan to buy the property, most lenders would consider this transaction a purchase, and base their LTV requirements on the option strike price ($157,200), not the appraised value ($189,000). So, if Sandy were to borrower 90% LTV, most lenders would have happy to give her .9 x $157,200, which is $141,000 (which is actually about 75% loan-to-value). In short, the lender is treating the exercise of a purchase option the same as a home purchase, effectively “penalizing” the buyer.

A small number of lenders will treat Sandy’s transaction as a refinance, in which case the LTV is based on the appraised value, not the option strike price. So, a 90% LTV refinance would allow a lender to give Sharon .9 x $189,000 = $170,100, which would cover the strike price ($157,200) and the loan costs (approx $4,000). In fact, Sandy would have enough cash left over to buy new furniture. Or, Sandy could simply borrow less, having a lower monthly payment. Either way, this is solid, “nothing down” deal.

Note that a lease/option “refi” is not an ordinary transaction, so be patient if you are looking for a lender that will fund in this manner; it will take a lot of phone calls!

by Attorney William Bronchick