One of the most valuable tools an agent or broker can use is seller financing. You can either know about seller financing, do it right and close more deals or you can watch potential commissions go down the tubes. In most cases, agents participate in setting up seller financing without structuring things properly or protecting their clients.
Pleasure and Pain
There are basically two types of human motivation. One is to gain pleasure and the other is to avoid pain. Would you agree with me that making more money would fit under the category of pleasure? Would avoiding a lawsuit or a loss of money be a way to avoid pain? If you agree, then you should have some good motivation to read this article, because we will talk about ways to do both.
It's Your Neck on the Line!
Whether you are an agent or private investor, there is a great deal of liability in the field of real estate. In particular, right now agents all over the country are being sued for the results of their negligence. A large number of these lawsuits have to do with the “paper” involved in the transaction. The courts are saying effectively, an agent has a liability to structure any carry-back financing to avoid problems and to best fit the needs of both buyer and seller. Many lawsuits have to do with the agent not disclosing dangers and risks with certain types of financing.
Ignorance in Action
In the case of investors, they are paying prices now for the decisions they have made in the past few years. The use of seller financing sounds easy and wonderful as it is preached over the podium, yet there are risks – AVOIDABLE ONES! I am in no way saying that there is anything wrong with seller financing. What I am saying is that for it to be used responsibly there are certain areas, options and alternatives that need to be known. In particular, there are six areas that can be of vital concern:
- FUTURE USES
If You Like Profit
If you like to make money, then you should be very interested. A while ago I was giving a lecture and a young man asked to say something. He had attended my lecture the previous week and had made himself $17,000 from one idea that I had shared with the group. In another case a man back East wrote to me and thanked me because he had made $15,000 from an idea in one of my articles.
Knowing about what I term “NOTE KNOWLEDGE” can make a big difference in the size of the smile on your banker's face when he sees you walk in. Now let's look at these six areas in some more detail:
How the terms of a note are structured can make a big difference in the value of the note, the salability of the property and the ability of the buyer to meet his obligations. A good example to look at would be the “balloon payment”. Is an agent being responsible to the client by putting the buyer of a property at the mercy of future money market conditions? Many of the foreclosures the last few years were due to buyers being unable to meet their balloon payment obligations. Why not explore other alternatives?
A good option to a balloon payment note is to structure a gradual yearly increase in the amount of the monthly payment. (Understand that this could complicate the note and make it a little less saleable ). This could totally eliminate the need for a balloon payment. Other options might be a shorter amortization on the loan or various clauses to provide flexibility if there is a balloon payment.
Graduated Payment as a “Balloon” Alternative
By a gradual yearly increase in the payment on a note, the amortization length can be greatly reduced and can eliminate the need for a balloon payment. This structure can be a very attractive opportunity whether a person is paying on the note or receiving payments. If a person is paying on a note, the security and peace of mind of not having to worry about the balloon payment is well worth the gradual payment increase and may make a property more saleable.If a person is receiving payments on a note, eliminating the balloon payment may make the note more valuable and more saleable.
Let's use as an example, a $10,000.00 note bearing interest at 10% with a 30 year amortization. The payment would be $87.76 per month. If this note had a five year balloon, the amount would be $9,657.21. If the payment graduated just $30.00 each year, the note would be completely paid at the end of six years.
This would also raise the present value of the note from $6,344.84 to $6,909.91, based on a 24% yield. If the payment graduated just $40.00 per year, the note would amortize in just over five years and would be worth $7,198.79, (for a complete breakdown see the chart). The increase in the payment in the first year is a 34% increase. This may not look too attractive, but it may look much more attractive than a $9,657.21 balloon.
The concept does not need to have equal or even steady increases to work. Unless you program a computer to do the work, you will just have to experiment and play around with the numbers to find out what will work The example below shows how to determine how long a $30.00 per year increase in payment will take to amortize the loan. The first step is to figure the amount of the principle balance after the first year of payments. The new balance is brought down to the next line, the interest rate stays the same, the payment is increased and the calculator solves for how long the loan would now take to amortize. The balance after one year's worth of payments is then calculated and brought down to the next line, the payment increased and etc.
$30 Per Year Graduation to Pop a 5 Year Balloon
Balloon Rollover Clause
This clause provides for the extension of a balloon payment for another year if financing is not available. It may include the payment of part of the balloon–such as 10% of the remaining balances. Another version of this also requires that the holder of the note helps to look for the financing.
A carry back note can be structured a variety of different ways. Thought should be taken as to the exact structure and the needs of buyer and seller. An example might be when a seller is carrying back a large amount of equity, such as $150,000. Many agents would create one $150,000 note and run to cash their commission check. Never mind the seller that might have a need to sell or hypothecate that note at some point in the future. Don't give any thought to the fact that there are fewer buyers for notes that large – causing the note to be harder to sell and discounts consequently higher.
A better idea may be to create several notes secured by one trust deed. This would be just as safe, yet provides smaller notes in case the seller needs all or part cash at a later time and needs to sell the notes. Several other times for splitting notes would be in the cases of split-ups of partnerships, divorces, gifting smaller notes to others or pre-division of interests of heirs in estates. For example, a couple taking back a $150,000 note might take back ten $15,000 notes that could be gifted to their children over a period of time. I call this a “Horizontal Split”.
In most states there are different forms that you can use and different times and situations to use each. For example, in Utah there are definite advantages to buy using an AITD (All Inclusive Trust Deed) and selling on a UREC (Uniform Real Estate Contract). It is important to know the needs of both buyer and seller as well as the laws and forms in your state. They change constantly, as in Utah where a few years ago some people hated the sight of the Uniform Real Estate Contract (now totally revised). In addition, there are circumstances in buying or selling when a wrap-around is a better idea than a second trust deed. There are also situations where the opposite is true. An example might be a seller with a tax liability when selling on a wrap may be considered an installment sale and using a second trust deed could trigger large taxes.
The clauses and wording of contracts can make a substantial difference in the future happiness of buyers, sellers and their real estate agents. One clause that would have made a large difference in my past would have been an “EXCULPATORY CLAUSE”. I became liable for payment on a note on a property I hadn't even seen, let alone owned in over two years. That is an expensive way to learn. In other cases you may want clauses included for the protection of buyer or seller. Sometimes clauses are justify out or even changed before the closing. Two years later is not a good time to find out. Exculpatory Clause – This clause states “The property is the sole security for this note.” This means that there is no personal recourse on a note.
When representing a buyer, there could be some circumstances where you would encourage this clause. When representing a seller, you would be wary of this clause and should know that it may affect the salability of the note.
Substitution of Collateral – This type of clause is used to provide for the replacement of the existing collateral with some other collateral. A sample clause that can be used in an earnest money receipt and offer to purchase (an offer) is “collateral for this note may be substituted at any time before or after closing with sellers approval.” After closing refers to being able to replace the collateral at a future date. Before closing gives an out so that the same contracts may be offered on more than one property at one time. A similar clause should be included in the note.
Prepayment Penalty – This clause provides for a penalty for the early payment on a note. You would generally not want this clause in a note, unless it is a wrap-around note that you don't want paid off early. Most holders of seller financing would love to be paid off early. A clause providing a penalty could discourage a potential early payoff.
Prepayment Discount – A clause like this is one that you would want in a note you are paying on. It could provide for a discount of a certain amount or percentage if you pay off the note early. This clause could make a note less saleable for the note holder.
First Right of Refusal – This provides for the payor on a note to have the first right to buy the note if it is offered for sale. It usually provides that the payor has the right to buy the note for the same price that someone else provides a written offer for it.
Subordination Clause – This clause provides that a note can be subordinated to another loan. This means that another note takes priority to the one that is subordinated. An example might be when a seller takes a note and agrees that at a later date he will allow the buyer to put on a new first loan. The seller then ends up with a second instead of a first that he had. This clause would be used on a property where there is remodeling or some other major cash outlay and a new first or second loan may be needed at a later date.
Principle/Payment Reduction – If an extra payment is applied to reduce the principle of the loan, this provides that the payment may be reduced by the amount needed to amortize the loan in the same period of time that was originally scheduled. This results in the ability to lower the payment on the loan when extra principle payments are made.
Assignment of Rents – This clause provides for the ability to take over the management and income of a property (within state laws and practices) during the foreclosure process.
K.I.S.S. – The old adage applies with notes as to keep it simple stupid. The more complicated a note is the harder it may be to sell.
SPECIAL NOTE – Some sample wording and uses of clauses are given here as an example only. You should verify wording and practices with your legal counsel. In many areas, getting heavily involved in the wording of clauses could be stepping outside the domain of a real estate license.
What is the seller going to do with the note he takes back? Will he need to sell it at some time? Do you know what it is worth? Does the seller? Seemingly minor differences in terms can make a large difference in the value of the note. Details like whether a buyer has personal liability, what position the note is in or the loan to value ratio can drastically change the salability of a note and its value.
Let's say you have a seller that has a $100,000 property that is free and clear. They receive an offer that they consider acceptable for $6,000 down and a first trust deed and note for the balance of $94,000. Note buyers look for loan to value ratios of 80% or less. This could end up being an un-saleable note for your seller because the LTV ratio would be 94%.
Save your seller and everyone else some problems and suggest they structure two notes. A first loan of $80,000 and a second of $14,000. The first would now be saleable to a note buyer if the seller ever needed or wanted cash. I call this a “Vertical Split.”
Servicing – Many note holders sell their notes because they hate having to collect or have done a poor job of it. The payors fall behind and take advantage of the fact that the note holder sticks his head in the sand and tries to hide from the problem. Every note should be serviced properly. Either a professional company should do it or the note holder should have some instruction. A good payment history can help the salability of a note. When poor servicing is done, the payor can many times slip so far behind that they cannot catch up easily. Precious time is wasted and a note holder could end up having to foreclose needlessly.
Insurance – In a private note transaction, you should be sure that the seller is named as an additional insured on the “Hazard Insurance Policy,” in case of fire or other covered disaster.
Taxes – Thousands of note holders out there are unaware of their legal responsibility to provide tax information as to the interest received. A 1098 form needs to be filled out each year.
The terms of a note can be adjusted in ways to help with negotiations on the purchase or sale of real estate. An example might be when a buyer and seller are separated on the price. Let's say that a buyer has offered $85,000 for a property and will assume a $40,000 first loan. The down payment will be $15,000 and the seller would receive a $30,000.00 second loan at 13% payable $331.86 per month. The seller wants $11,000 more for the property.
What do you do? Would you walk away? Would you beat on the buyer and seller trying to get them to agree on price? In many cases when the seller is hung up on price, he may not be as hung up on terms. Do you know you can please both the buyer and seller at the same time?
If the buyer offered a $41,244.16 note at 9%, the payments would be $331.86 per month for the same period of time as the first note. Does the buyer pay any more? No! Does the seller receive his price? Yes! (even a little more) Both notes, if discounted, are worth exactly the same amount. The real difference is how it looks. You just have the negotiating advantage of understanding the correlation between interest rate and price.
Knowledge is Power
Whether you are a paper buyer or real estate investor (hopefully both), “Note knowledge” can be very valuable to you. I used to say that there are two types of people that need to know about paper – real estate investors and paper buyers. I have revised that now. The two types of people that need to know about paper are male and female. Real estate agents need to know how to protect themselves and their clients. Investors need to know how to be able to protect themselves and to make greater profits. Homeowners need to know how to be able to negotiate the best transaction and save themselves money. Anyone that ever puts a key in a door would benefit from this knowledge.