Wraparound Wisdom

What is a wraparound seller-financed note? Simply put, a wraparound is a second position note wherein the payor pays the seller who, in turn, continues to pay the first note. You, the note buyer, come into the picture by stepping into the seller's shoes. You purchase the second note (the wraparound), and receive the payments on it from the payor, and then forward the payments on the first note (the underlying), to the first lien holder. Because the underlying first note is secured by an existing mortgage or deed of trust with a smaller dollar amount, the wraparound second note, with its larger dollar amount, is viewed as “wrapping around” the first. A wraparound is also sometimes called an “all-inclusive”.

Wraparounds can be lucrative if properly selected. However, while they are difficult to understand at first, once you grasp the essentials, they are truly fun and profitable. The key to a wraparound is to use income from the wraparound note payments, which come from the payor, to continue paying the underlying first note. You then get to keep what is left over. The benefit of leaving the underlying note intact, rather than paying it off, is that you can pay substantially less cash for the wraparound because the underlying still exists and must be paid. In the ideal transaction, you may also be able to realize a much higher interest yield on your lower cash outlay.

Even though the basic structure of a wraparound note is not terribly complicated, there are many details which you, the note buyer, must look into before deciding to buy a wraparound. The most important items, of course, are those that assure the profit of the transaction. Let's see how an actual wraparound would work using an imaginary example:

Assume that you want to buy a $100,000.00 wraparound note where the payor will pay 120 monthly payments of $1,377.50 at 11% interest — a realistic model. Assume also that the seller still owes a $62,500.00 underlying note (the first mortgage), with 120 monthly payments of $791.72 at 9% interest — also realistic. What's left over is $585.78 per month for 120 months. In order to establish a reasonable purchase price for the wraparound, you must first perform some calculations on the wraparound note, by itself, ignoring the underlying for the moment. To begin with, you treat the wraparound as if it were a first mortgage and ask yourself the usual questions. What would you pay for a $100,000.00 note in order to realize a good competitive rate, an interest yield of 12%? Your calculator tells you that the amount is $96,012.48, a dollar discount of $3,987.52. Now assume that you pay the seller $96,012.48 for the wraparound, from which funds the seller pays off the underlying of $62,500.00. That leaves the seller $33,512.48 cash.

Now, you begin to think about leaving the underlying note intact and making payments each month from the proceeds of the wraparound. First, you pay the seller $33,512.48 for the wraparound note, which is the same amount the seller would receive if the underlying had been paid off. This gives you the same dollar discount of $3,987.52. You will receive 120 payments of $1,377.50 from the payor and will forward 120 underlying payments of $791.72 to the first lien holder. This will leave you with 120 payments of $585.78, which your calculator indicates is a 17.16% interest yield on your $33,512.48 cash paid to the seller.

A number of important points are revealed from this hypothetical transaction. For example, you can realize greater gains by leaving the underlying in place, rather than paying it off. The additional complications of leaving the underlying in place are more than compensated for by the hidden advantages, such as the huge profits you can make if the payor pays off the note early. Even though you must keep track of two notes instead of one — one providing income, the other incurring cost — the basic principles of wraparounds are simple. Your income (payments to you), less your out-go (payments from you), is what you have left. The primary requirement is to make sure that what you have left over is sufficient reward for your efforts.

Look at what would happen in our hypothetical example if the payor immediately paid off the wraparound note. You would earn a quick profit of $3,987.52. If you had forced the seller to pay off the underlying, you would have earned this profit by paying $96,012.48. Instead, you left the underlying note intact and paid only $33,512.48. Would you rather make a profit of $3,987.52 on an outlay of $96,012.48, or on an outlay of $33,512.48? Although it's not likely you would encounter an immediate payoff, it is common to experience an early payoff which would increase your interest yield substantially. The advantages of buying wraparound notes are obvious. It does, however, take a certain amount of skill to wisely select wraparounds in the real world of note buying. You will find the advice of your attorney and tax professional essential in completing your wraparound purchase.

Procedure

How do you actually buy a wraparound, in the real world, that might be considerably more complicated than our ideal example? You must go through all the details with one objective in mind: that you can make an attractive profit. To assure yourself of an acceptable profit you must complete three major tasks: First, you must examine all the legal documents to rule out any potential trouble. Second, you must verify all the numbers and terms to make sure they are accurate and complete. Third, you must sort through the technicalities to eliminate unnecessary risks and expenses.

Legal Documents

To begin with, inspect both notes and their security documents (the deeds of trust or mortgages), and any amendments to them. The seller may not have copies of the underlying documents, so you must obtain them from the first lien holder. This should be easy to do, if you obtain the written permission of the seller, because such information can be released with consent of the seller who is paying the underlying note.

Examine the underlying documents first. If they reveal problems, you must take care of them before doing anything else. The most serious problems may even defeat the main reason for buying the wraparound. Two specific problems in the underlying documents, which could require you to pay off the underlying note immediately, are a due on sale clause and a prohibition against junior liens. A due on sale clause means that the seller should have paid off the underlying lien when the property was sold. A prohibition against junior liens forbids a wraparound because a wraparound is a junior lien. If you find either of these clauses, make sure they were waived in writing by the underlying lienholder. If the seller failed to get a waiver on either of these items, you should not buy the wraparound.

You may still find the wraparound attractive by paying off the underlying note and converting it to a first position note. This, of course, defeats your purpose of buying a wraparound, but it is a vital first step in checking out any wraparound presented to you. Another problem to look for in the underlying documents is a prohibition against early payoff. This could spell trouble if the payor on the wraparound pays off the note early, wants clear title, and expects you to use the funds to pay off the underlying note. If the underlying note holder will not accept early payoff, you will not be able to provide clear title to the payor in a timely manner which could lead to a lawsuit.

If you find a prohibition against early payoff in the underlying documents, you must make sure that the same provision is included in the wraparound documents to prevent this problem. Since such prohibitions are not legal in some States, check with your lawyer to see if they are enforceable in your State. Avoid buying wraparound notes if the underlying documents contain a prohibition against early payoff and the wraparound documents do not. They must conform with each other.

Numbers and Terms

Your next task is to establish the amount of profit you can reasonably expect from buying the wraparound note. What you're actually buying in a wraparound is the future cash flow you will have left over after getting income from the wraparound and paying out the costs of the underlying. You, therefore, need to carefully examine both notes (the wraparound and the underlying), to make sure there will be a satisfactory return. This means carefully verifying all the dollar figures of both notes and comparing the terms of the wraparound with the underlying to make sure there are no hidden costs that might reduce your expected profit. This careful examination may also reveal where you could find some extra profit.

Verifying all the dollar figures and terms is easiest if you use a checklist. There are fourteen major numbers and terms you should verify for both the wraparound and the underlying notes. The general rule is that any provision in the underlying must also appear in the wraparound in order to protect your profit. However, if a provision appears in the wraparound note, but not in the underlying, it could be a source of extra profit for you.

Numbers and Terms: Wraparound: Underlying:

Principal Balance? $_________ $_________

Monthly Principal and Interest Payment? $_________ $_________

Day of month payment is due? DAY:______ DAY:______ (Should be before the underlying)

Annual Interest Rate? _________% _________%

Default Interest Rate? _________% _________% (Higher than stated rate when note in default)

Late charges? $_________ $_________

Extra payments? $_________ $_________

Variable interest rate? _________% _________%

Variable payments? $_________ $_________

Pre-payment penalty? $_________ $_________

Charge for waiving due on sale clause? Yes__ No__ Yes__ No__

Approval required to sell? Yes__ No__ Yes__ No__

Payment in full provision? Yes__ No__ Yes__ No__ (If yes, should be due before underlying)

Reserves collected for:

Real estate taxes $_________ $_________

Fire/hazard insurance $_________ $_________

Private Mortgage Insurance

(PMI) Premiums $_________ $_________

Federal Housing Authority

(FHA) Premiums $_________ $_________

Life Insurance Premiums $_________ $_________

The first item, principal balance owed on the wraparound note, should show a number which is larger than the amount the seller owes on the underlying note. If it does not, you do not have a wraparound note to buy because the seller has no equity. The wraparound should also have a larger monthly principal and interest payment than the underlying. If not, you will have no cash flow or a negative cash flow.

Additionally, the due date of the monthly payment on the wraparound should be earlier than the underlying payment. If not, you could receive timely wraparound payments from the payor on the 15th, and still be late for an underlying payment which was due on the 5th. Moreover, you could not charge your wraparound payor a late fee because the payment to you was not late. To avoid late payments on the underlying in such a situation, an extra payment could be made on the underlying at the time your note purchase closes. The details of this extra payment could become a negotiating point between you and the seller, settling who would be charged for the extra payment.

If the interest rate on the wraparound note is less than on the underlying note, proceed with caution. Such wraparounds are not attractive and diminish your future cash flow. Under these circumstances, you may consider paying off the underlying and then buying the wraparound note as a first position note. If the interest rates are equal, you may not make a large interest yield, as in our hypothetical transaction, but you may be able to buy such a wraparound for less cash by not paying off the underlying. Even then you would have the chance of an early payoff which could provide you a comfortable profit for less cash outlay.

The default rate is an interest rate which is higher than the stated rate, and is charged only in the event of default on a note. Not all notes have default interest rates. The worst default problem in a wraparound situation is a default interest rate, written into the underlying note, without an identical or higher default interest rate written into the wraparound note. In such a default scenario, you would be faced with a serious choice: whether to continue paying the underlying payments out of your own pocket, or to allow the underlying to go into default and be charged the higher default interest rate. If, at some point, the payor resumes payments on the wraparound, you would be able to resume paying the underlying from the proceeds. However, if the wraparound does not have a default interest rate written into it, you would not be able to charge the payor default interest when wraparound payments resume, and would thus lose money. If they both have default interest rates, you should be able to break even, or make some extra interest, unless the default interest rate on the underlying note is greater than the interest rate on the wraparound note. Your best position is to have a default interest rate in the wraparound note, but not in the underlying note. This way, you can charge the payor, but the underlying cannot charge you a default interest rate.

If there is a late charge on the underlying, make sure there's at least the same late charge on the wraparound which you an charge the payor. While this will not keep you from being late on the underlying, the wraparound late charge should be at least as large as the underlying's late charge to cover your costs. The best situation is to have a late charge written into the wraparound, without a late charge written into the underlying. This would allow you to charge the payor without being charged yourself by the underlying. If there is a provision for extra payments written into the underlying note, make sure that a provision for equal or greater payments is also written into the wraparound note. For example, if a $10,000.00 balloon payment is due in the underlying note, in addition to the regularly scheduled monthly payments, the wraparound note must contain an equal or larger balloon payment to provide funds to pay the underlying note.

If variable interest rates and variable payments are involved, on either the underlying or the wraparound, it may be impossible to predict the exact future cash flow. If the variables have a “floor” (lowest rate), and “ceiling” (highest rate), you may be able to use them to calculate a conservatively predictable future cash flow. Use the floor rate on the wraparound and the ceiling rate on the underlying to calculate the actual amounts. If the interest rates are variable, the payments should reflect these variations so you do not lose money. A pre-payment penalty is another factor which must be included in the wraparound note, if included in the underlying note, in order to make a profitable purchase. If the underlying note has a pre-payment penalty, but the wraparound does not, you should subtract the largest expected pre-payment penalty from your offering price to cover this possible future expense. You will thus be prepared to pay this potential cost because you will have planned for it in your purchase price. If you are lucky enough to buy a wraparound note that is never pre-paid, you will not have to pay a pre-payment penalty to the underlying note holder. The net result for you is a higher rate of return on your money.

A charge for waiving the due on sale clause should be in the wraparound if it's included in the underlying. This is usually a cash charge or an increase in the interest rate. The “approval required to sell” clause, in the underlying documents, requires the first lien holder to approve any sale of the property. This permission is not usually withheld unreasonably. It is primarily to let the first lien holder know who the property is being sold to, so the first lien holder can approve the financial and credit worthiness of the new buyer. It is another feature which must be included in the wraparound if it appears in the underlying.

There is a “payment in full provision” which requires special precautions. If this clause appears in either note, be absolutely certain that the due date on the wraparound note is before the due date on the underlying note. Otherwise, you will have to pay off the underlying first, from your own pocket. Worse yet, the wraparound may not provide funds in a timely manner, leaving you with a large negative cash flow. If reserves exist, the first lien holder usually collects them for up to five separate items:

(1) Real estate taxes.
(2) Fire/hazard insurance.
(3) PMI Private Mortgage Insurance/FHA Federal Housing Authority premiums.
(4) Life Insurance.
(5) Cushion (a cash buffer to cover expenses).

The wraparound should have a separate reserve account of its own. Typically, the wraparound reserve account only collects reserves for real estate taxes, fire insurance, and sometimes a cushion. If this is the case in a wraparound proposal you are examining, you must make sure that the difference between the underlying and the wraparound reserve payments does not constitute a hidden cost to you. If it does, there are several approaches to solving this problem. The seller may be able to eliminate one or more of the five reserves on the underlying. For example, PMI and life insurance may no longer be necessary and can be canceled. This could save a small amount of money. If there is an FHA premium due on the underlying note, there may be a refund in the future when the underlying is paid off. Along with your administrative duties, you will be getting the seller to sign an assignment of the underlying note reserves over to you. Since you are forwarding payments to the first lien holder, you should have a signed document from the seller assigning the underlying reserve account over to you. Another of your duties is to guard against double fire/hazard insurance. Check to make sure that the underlying is not still paying the seller's old fire/hazard insurance policy, instead of the payor's new one, and that the seller has canceled the old policy. Also, make sure that you are correctly listed as one of the mortgagees on the payor's insurance policy at the time you buy the wraparound.

This checklist will help you keep in mind the basic rule that the terms of the wraparound should be equal to, or better than, the underlying. If they aren't, you probably have found a hidden cost.
Next, prepare an amortization schedule on the wraparound note, and an amortization schedule on the underlying note, to determine the expected future cash flow on each note. Then, subtract the underlying cash flow from the wraparound cash flow. This will give you the basic future cash flow which you can expect to receive.

At this stage, the amortization schedules will tell you if the wraparound pays off sooner than the underlying. If it does, you must take immediate steps to prevent it. Find the point in time at which the wraparound and underlying balances will be near equal. Then, increase the payments on the underlying to the level where the both balances will be paid off at the same time. Structure this as if it were legally required by the underlying. If you fail to factor this in, you may have a false understanding of your future cash flow and, if you don't do this in advance, you may find yourself still paying money on the underlying while receiving no income from the wraparound. The wraparound amortization schedule, taken from the terms of the wraparound note, will also reveal a payment in full provision if it exists in the wraparound note. If the wraparound balance is greater than the underlying balance at the payment in full date, you will not need to plan an increase in the underlying payments.

Reserve Balances

Verifying the reserve balances on both the underlying and the wraparound is crucial. You can verify the underlying reserve balance by simply submitting a written request to the first lien holder. Be sure to also include a request for the reserve account payment record. Calculating the reserve balance of the wraparound, however, can be highly complex and frustrating. First, examine the closing statements of both the seller and the payor, from when the property sold, to see if the payor was debited or credited for reserves. Then look at the complete wraparound payment record of the payor to see exactly how much the payor has paid toward the reserves in cash. Finally, examine the reserve account payment record on the underlying and charge the payor for all appropriate expenses. Only then can you calculate the payor's reserve balance to make sure it is equal to, or less than, the underlying reserve balance to avoid yet another hidden cost.

Technicalities

Wraparound purchases have many details which must be dealt with. If you neglect any of them, you could be placing yourself at financial risk. These details are major technicalities which must be handled.
You must clearly understand that a wraparound is a junior lien – a second mortgage or deed of trust. Like all seconds, you must have the wherewithall to protect yourself if the wraparound goes into default and you have to pay the underlying out of your own pocket. This is a risk that you must take with your eyes wide open.

The question of personal liability can arise when you buy a wraparound note. In most situations, when the seller sells the wraparound note to you, the seller remains personally liable for paying the underlying first lien note holder. However, if you do not take certain precautions, you could incur personal liability. This means that you could also become personally obligated to pay the underlying note, instead of simply forwarding payments from the payor to the underlying first lien note holder. The debt for the underlying note could therefore appear on your personal credit report and you would have to disclose the liability on your financial statement. In allowing this to happen, you are essentially assuming the underlying with all its obligations. If you do assume it, you may face a charge for the assumption, along with lengthy paperwork, and possibly an increase in the interest rate or payments.

To avoid assuming the underlying you must have included in your documents specific language stating that you are not assuming the underlying, and are not becoming personally liable for it, but are simply agreeing to forward payments to the underlying upon receipt of funds from the payor of the wraparound. Another technicality you will need to handle is making sure that you receive all future correspondence from the underlying. The easiest way to do this is to have the seller send a change of address notice to the underlying note holder, giving your address as the proper place to send all correspondence. This way the underlying will send all the seller's correspondence to you.

Be alert for an offset clause in the wraparound note which gives the payor the right to make payments on the underlying note, if the seller fails to do so, and offset the amount due to the seller. This may render the note “non-negotiable”, a legal liability which would prevent you from being a “holder-in-due-course”. A holder-in-due-course is a person protected by an elite legal status which prevents claims by the payor and others against the note. You are not likely to be a holder-in-due-course if the wraparound note is governed by and subject to the terms and conditions of another note (the underlying). Your wraparound must stand alone. You may thus want the wraparound note amended to remove the offset language. To accomplish this, the payor might cooperate if a neutral, professional, third party servicing agent is engaged to send the payments directly to the underlying and send you the difference. The payor will then not have to worry about non-payment of the underlying.

If you use the services of a professional third party servicing agent, you must remain alert to extra principal payments that might be made by the payor. The third party servicing agency does not usually keep track of the underlying balance, so you must remain vigilant. If you ignore extra principal payments, you may find that your wraparound balance is going down faster the underlying balance. This could leave you with cash to pay and no income stream with which to pay it. You can prevent this problem by instructing the servicing agent to forward any principal payments you receive to the underlying note holder. As a final detail in handling wraparounds, be aware that many wraparounds generate not only a cash flow, but also an equity build-up. Your wraparound equity is your ownership portion of the wraparound. You can calculate the amount of your ownership by subtracting the amount owing on the underlying note from the amount owing on the wraparound note. An equity build-up is the increase in the dollar amount of your ownership over time. Not all wraparounds generate equity build-up, but those that do usually have an underlying interest rate less than the interest rate on the wraparound note.

There may be income tax consequences of having an equity build-up that would not be likely to occur if your wraparound equity simply remained constant over the life of the wraparound note. If you have an equity build-up, you may be required to pay income tax on the increasing equity. As you can see, wraparounds involve many detailed tasks you must perform before you can make a reasonable price bid, or even decide whether you wish to make the purchase. Once you have completed a few transactions and have built up some experience and judgment, you will find that you will be able to do the necessary homework with speed and confidence. Wraparounds can be a great deal of fun, but they require much wisdom to be profitable.