Seller financing is my favorite form of creative financing. Seller financing is exactly what it sounds like. The seller or owner of a property will finance the deal for you, just like a bank or traditional lender. This means you will need to impress the seller enough for them to give you the financing, but you won’t need to qualify with a traditional lender.
If a seller is openly advertising seller financing, be careful. The property is likely in unbelievably bad shape. Don’t immediately discount a deal if it is advertised with available financing, but do expect a fair amount of distress. In my best seller-financing deals, I had to convince the seller to carry back financing. These were deals that were distressed but not terribly so.
Once you have analyzed the deal, you’ll be ready to make an offer for seller financing. If the seller accepts this offer, you will need to verify the seller has equity in the deal to give you the financing. This is one of the drawbacks to seller financing. If the seller has a mortgage on the property, then they can’t finance it to you, and you won’t be able to take possession of the title. If the seller has a mortgage, a Master Lease Option (MLO) may be a better way to go.
Important Note: Some investors will do what is called a “wrap” or “subject to” financing. This is where a seller keeps the existing mortgage in place, and the new buyer makes the payments for the old owner. I don’t agree with this type of financing at all! The seller is giving you interest they don’t have. They are “wrapping” your mortgage around the existing mortgage or allowing you to take over the deal, subject to the existing mortgage.
This can violate a “due on sale” clause that’s in the seller’s mortgage. This clause states that if the property is sold, the mortgage balance is due at the sale of the property. This means you won’t get a title and don’t actually have any rights to the property. If you put any money down, you could lose it easily. If the bank finds out there’s a new owner operating the property and the mortgage was not paid in full, they have the right to make the full balance of the loan due immediately.
Most advocates of this type of financing will tell you the lender won’t care about this type of transaction as long as someone makes the payments. This may or may not be true, but either way, you are taking a large risk. I don’t want you to confuse this with seller financing. If a seller has a mortgage, then it needs to be paid off before they give you financing.
You want to research the property and find out about the mortgage before you give the seller any money.
PRICE VERSUS TERMS
You should always try to get the best price for any property you are trying to buy (this goes without saying), but most buyers and sellers tend to focus too heavily on price. Sellers also tend to be more sensitive to the overall price they will get for a property and less focused on the terms of financing.
Price makes a big difference when it comes to exit strategies, and you should never pay too much, but the terms of the loan will make or break the operations of the deal while you have it. The terms of the loan include:
- Term (length of the loan)
- Interest rate
- Down payment
- Amortization schedule
As I’ve discussed already, you need to solve problems and bring value when seeking CSF. If a seller is going to provide you with financing, then you need to be prepared to give a higher sales price.
HOW TO GIVE ON THE PRICE AND TAKE ON THE TERMS
In many cases, I’ve given the seller most or all of the asking price when they were willing to carry back the financing. My rule of thumb is, the more distress a deal has, the easier it is to get into. If a seller has a distressed asset, wants a high sales price, and I must get a mortgage and qualify for a loan, then I’m not likely to be interested. If a seller has a distressed asset and they are willing to help me solve their problems, then I’m interested! You shouldn’t have to jump through too many hoops to help someone else solve their problems.
In the fall of 2015, I bought one of the best deals I had ever seen. A portfolio of 196 apartments in middle Georgia, consisting of three smaller properties ($26,531 per door). The asset was in fine shape physically but had low occupancy due to the seller’s personal neglect.
Due to the low occupancy, I was only able to get a high interest rate, short-term loan from a commercial lender. The monthly payments to the bank were going to kill the deal for me; the property wasn’t producing enough cash to cover the note.
As a solution, I got the seller to carry back a second mortgage with an interest rate of 0 percent. This effectively reduced the amount of money I needed to borrow from the lender, and it made the deal work. The seller got the overall price he wanted, but he had to help me on terms to get the deal done.
Give on price, take on terms.
If you are paying more for a property, then you need to be overly aggressive with the terms of seller financing. You need this property to cash flow on a monthly and annual basis, regardless of what you pay for it. Keep in mind that seller financing does not have to be 100 percent of the loan.
Sometimes a seller can assist with the down payment by taking back a second mortgage. Here are some factors to consider when structuring the loan.
Now, you can. Discover the best-kept secrets of the two creative, effective financing strategies other investors don’t want you to know about: Master Lease Options and Seller Financing.
INTEREST-ONLY PAYMENTS
If a deal does not have good cash flow at the beginning, try to negotiate interest-only payments. This allows you to keep more rental income to service the property and to allow for cash flow. You can even offer to make interest and principal payments when the deal begins to make more money.
An interest-only (IO) loan is ideal when the monthly payment is much less than if you were to pay principal and interest.
The lower monthly payment will allow you to produce more cash flow while maintaining the same amount of rent due. This allows you to spend the cash flow to stabilize the asset.
DEFER ALL INTEREST AND PAYMENTS TO THE END OF THE LOAN
If a property needs major renovations, then defer all or some of the payments to the end of the loan. If the seller wants to start receiving a check at any point during the loan, you may also try to get them to defer payments during the repositioning of the property.
For example, if you decide a property needs X amount of repairs that will take X amount of time to complete, then you’d inform the seller that payments for those months will be added to the purchase price and paid at the end of the loan. This will allow you to complete the necessary repairs while the property is not cash flowing. It’s particularly important that you don’t over encumber a property with
added expenses as you are bringing it back to life. If a seller doesn’t see it that way and must be paid even when the deal doesn’t make money, then that may not be the right deal for you. Let them handle it on their own.
INTEREST RATE
You should not expect to get the market’s most competitive interest rate when you get seller financing. You should try to get the best interest rate you can negotiate, but you also need to offer an interest rate that will be attractive to the seller.
Keep in mind it’s not unusual to pay 2–3 percent more in interest than the current lending rates at your local bank.
This is not expensive when you consider all the benefits of having the seller finance the deal for you. Whatever interest rate the seller may want, you need to make sure the interest plus principal (debt service) allows you to cash flow the property after you have completed the repairs and leased the units.
Here’s another important point: there’s a legal minimum required interest rate for private loans. This minimum interest rate is called the Applicable Federal Rate (AFR) and sometimes called the arm’s-length rate. This is the minimum interest rate a private lender can give without violating federal law. The law was put into place to prevent people from “gifting” assets to others (usually family) by calling it a loan with a 0 percent (or incredibly low) interest rate. This would effectively allow someone to transfer wealth while avoiding gift or transfer tax. Therefore, the federal government created the AFR.
This concerns you directly if you are getting (or giving) private loans. If you get a loan or seller financing with an interest rate below the AFR, the IRS may consider that a gift, not a loan. The lender may be charged punitive fees and an income tax. This could have terribly negative consequences for you and your lender. Internal Revenue Code (IRC) Section 7872 governs the AFR, and the rate changes periodically.
You’ll need to consult with an accountant and visit the IRS website for updated minimum rates. This will keep you and your lender in compliance with this tax code and help avoid any unnecessary lender surprises.
DOWN PAYMENT
This is an area where you can get creative. Try to put down as little money as possible but just enough to make the seller comfortable with the deal. If a property needs repairs, then follow this one simple rule: use the down payment to make the repairs.
Decide how much cash it will take to complete the needed renovations. You will make this decision during your analysis and inspection period. Instead of giving the seller the down payment directly, use that money to fund the needed repairs. You don’t want to give the seller a cash down payment and then be in need of money to do the repairs.
If the seller doesn’t agree with your use of the down payment for the repairs, explain that if you were to default on the loan and they took possession of the property, it would be in better shape than when they gave it to you. You can also offer to put this down payment into a third-party escrow account. This allows the seller to see that the money exists and that you have the cash to do the repairs. You can then draw out the money as the seller approves the work you are doing. This added level of security will help convince some sellers to give you financing.
REPAIRS
Once you obtain the property, you’ll likely be responsible for the repairs and cost of operations on the property. This is okay because you’ll be using the income the property produces to do these repairs. The difference between the expenses and what the property produces is the cash flow,
and you get to keep that!
You’ll need to be prepared for any larger repair expenses. These are known as capital expenditures or cap ex. Budget for them by setting aside a capital expense reserve account.
Take a portion of income from the property and set it aside to pay for these expenses. I suggest setting up an escrow account outside of your normal operating account for this money. This will keep you from spending your savings on normal operations.
A good rule of thumb is to save about $250–$300 each year for every unit on the property. This will create your capex reserve account. It’s good to get in the habit of doing this for two reasons. First, it helps protect against the risk of unbudgeted repair items. Second, if you refinance the deal with a bank, it’s likely they will make you set this money aside as part of the loan.
INSURANCE
If you’re going to be a new owner with seller financing, you’ll likely need to get your own insurance policy. Contact local agents to get the best prices. Make sure price is not the only factor you consider when getting insurance. Cheap insurance won’t come with much coverage. It’s hard to give a rule of thumb for insurance pricing per unit as the information changes so quickly, but in general, it’s important to talk with insurance agents when you’re analyzing deals.
TAX BENEFITS
As the new owner of record, you will now receive the tax benefits of the property. This is good for you. If the owner wants to retain the tax benefits, then an MLO may be better than seller financing. Consult an accountant to discuss your tax strategies before the closing. I suggest you do this during your due diligence period on the property.
RECORD THE TITLE
This is a tremendously important step in any form of creative financing, especially in seller financing. I strongly suggest you have a real estate attorney create the contracts and documents for any creative financing deal. You’ll be able to find seller financing documents and MLO contracts online, but you must have your legal counsel review anything before you submit it to the seller.
Next, have an attorney or title company conduct the closing. They’ll be able to do a property title search to make sure the seller can convey a clear title to you. It would be a disaster to give the seller a down payment and take possession of a deal, only to find out they didn’t tell their business partner (who also has ownership) what they were doing. An attorney/title company will clear the title. If any existing liens appear, then you will be notified before you close. I assure you, this will be money well spent!
POINTS TO REMEMBER
A seller cannot finance equity they do not have. Seller financing will only work if the seller has no underlying mortgage. If the seller does have a mortgage, you need to have enough down payment money to pay off the original debt. If the loan amount is more than your down payment, you can’t offer seller financing. You should move to make an MLO offer.
You’ll likely be making offers at or near full asking price if a seller is going to carry back a mortgage. If this is the case, make the terms (interest rate, length of loan time, down payment) highly favorable to you. Negotiate terms that allow for the most amount of cash flow. Use that cash flow to fix up the property.
Always utilize the services of an attorney. Have legal counsel create and/or review all documents before executing them. If a seller does not have an attorney to represent them during this transaction, you should demand they seek legal counsel as a condition of your contract. This is for your own protection. Your seller could make the argument that you took advantage of them somehow with the contract, but if the seller was represented by legal counsel, it makes it harder for them to claim ignorance or to claim you took advantage of them.
ACTION ITEMS
Start the process of building your legal team. Even if you don’t have any deals yet, it’s a good idea to start looking for an attorney with creative financing experience. This is most applicable to MLOs. Most commercial attorneys are familiar with seller financing but may be less experienced with MLO contracts. Seller financing is typically less complicated than an MLO.
Start this process by networking. Ask local real estate investors who they use. You may be able to find good references at your local real estate investment association (REIA) group meeting. There are also many online groups specific to the multifamily industry. Try networking for referrals there.
When speaking with a prospective attorney, ask about their experience with seller financing mortgages and MLO documents. Notice, I said to ask about their experience, not their knowledge. You don’t need an attorney who has read about MLO and CSF deals. You need one who has done them.
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