Builders use paper in many ways.
1) Sell a Second
Some builders make it easier to sell homes and open the market to lesser qualified buyers through taking back a second after a lower LTV first (with the knowledge and cooperation of the lender – not in “secret”). Depending on these notes and the LTV ratios the discounts are usually quite high, but they cut down on holding costs (expensive with a construction loan) and marketing costs.
2) Trade the Second
Builders can take the second and trade it into other property to be developed (land, lots) or even for materials. This can happen at face value in some cases or through “Lemonading” which is the process of adding ingredients together. As the saying goes, “If life gives you a lemon – make lemonade”. The term lemonading came about where you add something you don't want in with a nicer package.
An example of Lemonading is adding cash or a note in with a property that you are having a hard time marketing. So, maybe the property has a short term negative cash flow and you add in a short term note to balance the cash flow (in that case the note is the “sugar”).
So a builder might use the note individually in a trade or as part of a bigger package. That could look like $80,000 cash and a $20,000 note for a $100,000 parcel of land.
A builder can also take these notes and go to a bank REO department that might have some land he would like to develop. A big win/win. .(See “Overtrading”)
3) Keep the Second
Builders can end up really short on cash flow sometimes. A note (even a higher risk one – that he created) can balance out the cash flow or might make a better investment than whatever else he/she is investing in.
Some builders put notes into their pension funds or other investment portfolio (like personal – buys the note from his company). Of course, the pension fund cannot necessarily buy a note from you or your company, but the note can be created into the pension fund if you do it in the right way.
4) Borrow Against the Notes
Though the notes might demand a high discount to sell them, they will build the builder's net worth and borrowing power. That's one of the nicest things about paper. The more you buy – the better you look. They beef up the overall financial statement and are also an asset that a banker might loan against because they will base the loan primarily on the builder and their credit. It might be possible to borrow more against the note in this manner than the builder would receive by selling it. AND – there are tax incentives to borrow against notes instead of selling them.
5) Builder with a Nice “Fannie”
Sorry. (It's that Bill and Ray humor that rubs off) I have a friend who is a long time builder that occasionally just goes without the banks. He writes his own paper – to “Fannie Mae” standards and now has several million in his pension fund. It's also very liquid. If private paper is documented and collected properly FNMA will buy it.
6) Simultaneous Sale
Just as investors can buy properties through creating and selling a note, the builder can do the same. Again, it may not be as good as going to the bank, but might open things up to more buyers and result in less holding costs and marketing costs. The builder could possibly even work out a buy down on the rate or put aside some cash to buy down the payments for a while (subsidize).
7) “Backsiding Paper”
Many builders and developers have a strategy of development where they fund their deals through selling land, property, condos, etc. on seller financing with a buyer in place that generates cash for more deals.
Land Developers have used this for years. They buy the land – usually with a large percentage of seller financing – and then divide it and sell it for low down on seller financing. They then sell the notes to buy more land and do the same.
I had a friend doing this with “Condo Conversions”. He bought a large apartment complex and did a condo conversion a few units at a time (usually easier with a stock cooperative “Co-Op”). As one unit was complete, they sold for a low down on seller financing – at a much higher price than his cost now that it was a condo and had been upgraded. The cash then went into converting more units.
8) Paying Paper with Paper
Now, to take it a step further, some developers pay their seller financing with the seller financing they create – totally bypassing the discount. I.E. – buy the land, apartment, etc. with seller financing and as you develop and sell on seller financing, that is used as full credit to reduce the existing seller financing.
The builder can also use the seller financing (notes) as payment for many other forms of debt. I have a builder friend that became very over-leveraged in a bad market. He used his banking relationships and knowledge of paper to actually borrow money from the banks to buy paper and then trade that out (sometimes to the same bank) to retire his debt. Everybody wins and he and the bank avoided bankruptcy.
Just a few of the ways to use paper as a builder.