By Tod Snodgrass
With prices falling all over the country, due to higher interest rates, the current recession and COVID overhang, Real Estate Investors (REIers), need to be up to speed with both the risks and benefits of undertaking new investments in general, and the financing of those properties in particular; specifically, why creative financing options, including Subject-To, seller-carryback and paying a purchase premium for a property, are sometimes advisable, under the right circumstances.
In real estate everything is negotiable, and seller-carryback financing (usually in second position, behind the first mortgage) is a favorable way for cash-poor buyers to come up with say, the 10%-20% down payment required by most lenders. The seller basically agrees to become the bank to the buyer. For sellers, they usually can get a higher sales price and/or sell their property more quickly if they carry a note, versus if they sold the property without offering favorable financing terms to buyers. Also, for some sellers, they may like to have a steady monthly income stream that is generated from the interest and/or principal payments on the note, especially for retired sellers. In other words, for REIers, seller financing can help them buy a property that they otherwise maybe couldn’t afford.
What are the risks of seller financing? For sellers, the risk is if the buyer defaults on the loan and they might have to take the property back or even be forced to make payments on the first position loan while they try to sell it again. The risk for the buyer is that they may be on the hook for a balloon payment (say 3-7 years out) where they will need to pay a large lump sum or refinance; also, the monthly payment for the seller note is an additional expense.
In a Subject-To transaction, neither the seller nor the investor-buyer tells the existing lender that the seller has sold the property. The investor-buyer begins to make the payments and does not obtain the bank’s permission to take over the loan. Lenders put special verbiage into their mortgages and trust deeds that give the lender the right to invoke a “due-on sale” or “acceleration” clause in the event of a transfer. It means the loan balance could be due in full, and that could put the new owner at-risk of losing their property if the lender finds out about the transfer and initiates a foreclosure action. So yes, Subject-To properties do put investor-buyers at risk. Since the property is still legally the seller’s liability, it could be seized should they enter bankruptcy. Additionally, the lender could require full payoff if it notices that the property has transferred hands. There can also be complications with insurance policies on the property.
However, experienced investors see Subject-To as relatively low-risk, overall, everything considered. Also, it is important to know that taking a property Subject-To is not against the law. It is a civil matter, part of contract law. There is No “Due-on-Sale Jail”. Many people are under the mistaken impression that transferring title to a property secured by a “due-on-sale” mortgage is illegal. It is not.
Last, Subject-To should not be considered permanent financing. Think of it as a form of bridge or gap funding. The main idea is to buy the property from a distressed homeowner at a discounted price, based on asset value. Next, you rehab the property, then rent it out for a few months to establish an income track record; finally, refi or flip (sell) the property based on the (usually higher) CAP rate. Done right, you are effectively playing “both ends against the middle”: buy a distressed property at a lower-then-normal, asset-based price, then refi/sell it for a higher-than-normal, CAP-rate-based value. A two-fer!
Why would a seller agree to a Subject-To mortgage?
- Sellers agree to Subject-To mortgages when they are desperate to sell a property quickly.
- They may be in danger of foreclosure or unable to keep up with their mortgage payments. It may not
- be an ideal scenario, but it can make for a quick sale by keeping the bank out of the equation.
- The investor-buyer brings the loan current: that is, he pays off the overdue balance, thereby removing a potential black mark on the seller’s credit rating.
- The investor-buyer makes the payments each month on the mortgage, insurance, etc. which can also reflect positively on the seller’s credit rating.
Overpaying for a Property
A. Sometimes it makes sense to offer more than the asking price for a property, assuming it makes economic sense to do so. Consider paying a premium in order to:
- Induce seller financing, say to cover the down payment
- Generate substantially higher deal volume
- Give you a leg up on the competition by outbidding them
- Avoid normal closing costs, points, appraisal fees associated with a bank loan = big potential savings
B. Caveats to seller financing:
- Make sure you have run your numbers correctly so that you are able to achieve positive cash flow, from the get-go. Avoid deals that burden you with negative monthly cash flow.
- Ensure that you are properly capitalized just in case unforeseen or extraordinary costs come along
References: Kris Cummings, Henish Pulickal