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The Pros And Cons Of Seller Financing - Part 2

Pros And Cons Of Seller Financing

By Robert Duplicki      July 24, 2021

To expand my suggestions from Part 1, the opinions about the pros and cons of seller financing are partly based on familiarity and usage.

Real estate investors who use seller financing see mostly pros. Real estate agents who periodically solve their client’s needs by using seller financing, see mostly pros. Most other people who have never used seller financing lack the knowledge to evaluate it.

For most of the people who have never used seller financing, when they learn a little about it, they will probably see cons compared to receiving cash at closing from bank financing. But many of them will find themselves in situations where bank financing is less than ideal, or simply won’t be available.

When bank financing is not the answer, the reasons why are the real cons. Seller financing provides the pros.

If you make a big deal out of the small cons, you will limit yourself from potentially better solutions.

“Who Are Good Candidates For Seller Carrybacks?”

Here is the answer provided by attorney J. Robert Eckley of Eckley & Associates in The Paper Source newsletter of April 2015:

  • The owners/sellers who have equity but cannot compete with the down-driven foreclosure and short-sale market and so have held themselves off the market.

  • Those parties who have deals they could or would accept, but fruitlessly are seeking reasonable residential jumbos and commercial loans to facilitate them but have been frustrated by the access hurdles (too much down, too much invasion for privacy to qualify for the loan, willing to pay but the property won’t appraise in the current market enough to get conventional money, complexities in source verifications, self-employed, otherwise unable to squeeze into “one-size-must-fit-all” financial straightjacket uniformly offered by banks etc.).

  • Those parties seeking “business opp” loans.

  • Those potential buyers who are wanting to move in or up and who are endlessly waiting for the market to bottom, but would jump if they had better financing options, including options that delayed price computation or “going hard” on price for a few years.

  • Those who have one “credit ding” but are otherwise in great current financial shape.

  • Those whose all-cash history has generated no credit rating or history at all.

  • Those parties wanting real estate investment leverage but who cannot get it with high bank-required points and down payments.

  • Those who want high cash-on-cash cap rates but cannot get it with high downs and straight amortizations.

  • Lenders wanting to sell salvageable paper they are unable to imagineer (or cannot manage by regulation) into working, all with resulting down pressure.

Mr. Eckley concludes with the comment “There’s more, but that is enough for examples.”[2]

It’s great to see these examples from someone who knows what they’re talking about. So I believe this is also a list of seller financing pros. While the timing of the original article should be taken into account, most of these examples apply on an ongoing basis. These examples also provide insights into future markets. We should keep these points in mind looking ahead.

If A Note Is Sold At A Discount Is That A Con?

Compared to selling a note equal to the full unpaid balance it sounds like a con. However, when you sell a note you are not selling cash. You are selling a promise to pay. As explained before, notes come with risks and related factors that lead to notes being sold at a discount.

If we consider just the math, think of selling a note as the reverse of winning a lottery drawing. When you win a lottery you have the choice of receiving the winnings as a lump sum of cash, or in annual payments.

Look at this example taken from finance.zacks.com[3]. If you won a $12 million jackpot in the multistate Mega Millions lottery game, you could take $461,538 a year for 26 years and get the entire $12 million, or accept a lump sum of $7,042,000 equal to 58 percent of $12 million.

So you only get the advertised jackpot if you accept payments for 26 years. Otherwise you receive $7,042,000 which is the cash value today. In other words you are accepting a 32% discount to get your money now. Just like selling a note, you are accepting a discount to get your money now.

Is Substitution Of Collateral A Pro Or A Con?

What is substitution of collateral? It is transferring an existing mortgage from one property to another. Since this isn’t something banks like to do, it sounds like a pro for seller financing. Here are some examples of how you might use this technique.

Let’s say you bought an investment property for $100,000 using seller financing. Call this property A. Mr. Seller is holding a first mortgage for $70,000. You also own property B which is worth $200,000. There is a first mortgage on it for $80,000. This could be a private or a bank mortgage.

You have a buyer for property A, able to pay you cash (a down payment plus bank mortgage). So you are willing to take $100,000 because you have a cash buyer. But you are not ready to pay off Mr. Seller if you don’t have to.

You offer to pay Mr. Seller $10,000 now, if he will move the mortgage to property B, where it becomes a second mortgage. He agrees. This is substitution of collateral. Chances are you’ve developed a relationship with Mr. Seller, and he knows you make the monthly payments on time. And $10,000 cash provides a favorable inducement. There is no need to mention that you have a buyer for property A.

What is the benefit of substitution of collateral in this example? Other than potential closing costs, depending on what you negotiate, you put $90,000 in your pocket instead of giving $70,000 to Mr. Seller. You do owe him a second mortgage for $60,000 but it doesn’t take much thought to see the benefits of this transaction.

Here is a second example of substitution of collateral. After spending time at home during the pandemic, you’ve decided to take an early retirement. Over the years you have done a little real estate investing and now you would like to do more. You own your home free and clear. You approach your bank for a home equity loan. But they are not comfortable with the change in your employment, and your home is now older than fits their guidelines. What could you do?

Let’s say you own a small apartment building (property A) and you want to move up to a larger one(property B). Property A is encumbered with a first mortgage and a seller financed second. However you have upgraded the property over the years which has increased the value. So if you sell property A there is some equity, but not enough for the down payment on property B.

You could solve this by moving the seller financed second from property A to your home where it will become a first mortgage. Now when you sell property A, you will be able to pay off the first mortgage, and have enough cash left over to pay a down payment on property B.

Here is one more example of substitution of collateral. You own a property which has a first mortgage, bank or private, and a private second mortgage. You are planning to complete a 1031 Exchange with your property. If you can substitute the collateral for the second mortgage, you will increase the equity in your property, which will lead to a more favorable exchange. While there may be some inducement needed to make the substitution of collateral, that’s ok if the numbers work out.

Now that you know the benefits of substitution of collateral, here are a few ideas to maximize its usage.

First, the process may not require inducement. Just ask. Your circumstances at the time may be enough of a reason. Or, there may be a trade off. For example, you make a cash payment which reduces the mortgage that is being moved. Since the balance is now less, you might be able to get the amount of monthly payments reduced. It’s negotiable because it is seller financing!

Second, when you purchase the property include an addendum in the contract of sale that allows for substitution of collateral in the future. When you choose to use this technique you won’t need to offer an inducement, since you already have an agreement allowing you to do so. However, the other party to the contract will need to be notified that you are proceeding with the substitution of collateral, before a title company will process it.

Third, substitution of collateral does not require that you substitute one property for another. Anything of value to the mortgage holder could work. Examples are stocks, automobiles and other personal assets. Just don’t try this with a bank.

Fourth, this technique allows you to make additional use of existing financing without needing to requalify or pay new loan origination fees.

While seller financing offers the pros of substitution of collateral, I have mentioned the use of bank financing above as well. You need to understand how they can be used in conjunction to meet your needs. Substitution of collateral is a tool that fits in more for real estate investors. It also works better with motivated sellers. Yet having some familiarity with substitution of collateral could help homeowners and business owners take advantage of investment opportunites.

Subordination

In this section I will provide more background about subordination, before getting into how it’s used with seller financing.

Subordination has various applications pertaining to mortgages and commercial property leases. The basic idea is that one obligation takes priority over another. The lesser priority is subordinated.

A common example of subordination is a first mortgage having priority over a second and a second mortgage having priority over a third. The number assigned to the mortgage corresponds to the timing when it was recorded. So a first mortgage was the first one recorded, to provide collateral securing a promissory note made on a specific property.

When a property is sold the proceeds will be used to pay lien holders in the order they are recorded. This also applies in the event of default by the payor, and a subsequent foreclosure sale.

Liens are legal claims on another’s property until a debt is paid. Liens include mortgages, mechanics liens and state and federal tax debts. When one mortgage is subordinated to other liens, there is a greater risk that the proceeds from the sale of a property will not be enough to pay the total amount owed.

Keep in mind that federal tax liens automatically become a primary lien ahead of a first mortgage. In some states this also applies to mechanics liens.

The concerns banks have about subordination could affect the typical person reading this article, whether personally, or as an advisor to others.

Let’s say a first mortgage exists followed by a second lien. This could be a second mortgage that was used to purchase the property. Or it could be financing acquired later, such as a home equity loan or a line of credit. Now the first mortgage is being refinanced. When the existing first is paid off, the second mortgage automatically moves into first position.

It is the property owner’s responsibility to ask the second mortgage holder to resubordinate to second position. The bank doing the refinance of course will insist on being a first mortgage. They should help you with this process. But things may not go smoothly, so it’s best to plan ahead for this situation.

The ideal starting point is before you accept second mortgage financing. Banks are not required to disclose their policy regarding subordination. So ask the lender if they allow subordination. If not, find a different lender. If they do, get an explanation about when they will subordinate, when they won’t and what’s involved in the process. Get their policy in writing and have it made part of the loan documents.

The connection between subordination and seller financing is more related to the mindset of an investor.

One example is to purchase property where the seller agrees to subordinate the payments they receive as a second mortgage. The seller financing could be viewed as the down payment for a first mortgage, but with the agreement to subordinate. If you approach a bank for the first mortgage, they probably will decline because the down payment is borrowed. But a private lender or a hard money lender could agree to this arrangement. In effect this would be a “no money down” purchase.

Another use of subordination together with seller financing is to pull cash out of a property you own. If you have a seller financed first mortgage, you could qualify to refinance it with a bank mortgage. Ask the seller to subordinate their first mortgage rather than pay it off. This may take some inducement like making a partial cash payment toward the seller financing, or agreeing to a 1% higher interest rate on the subordinated mortgage. The seller may not even want their mortgage paid off because they want to continue receiving the monthly payments.

If you consider your own circumstances, and use your imagination, you may find other uses of subordination in conjunction with seller financing.

Before closing this section on subordination, here is a heads up on one more bank issue.

If you are considering a HUD backed reverse mortgage, and you still have an existing mortgage, you might not need to pay off the existing mortgage in order to obtain the reverse mortgage. Once again, subordination is a key issue.

The lender providing the reverse mortgage will require a first mortgage. HUD will provide a backup mortgage that only provides funds to you if the lender no longer can. The HUD mortgage will be a second mortgage. This process will require the lender who is providing your existing mortgage to subordinate to third position.

Without getting into further details, be advised that the scenario described above is achievable. In order to succeed, give yourself plenty of time, and find an experienced advisor to work with.

In conclusion, subordination applies in a variety of ways, both with seller financing and bank financing. In bank financing, subordination is a given in certain situations, and the better you understand it, the better results you will receive. But I see the use of subordination, together with seller financing, as a pro that you are unlikely to do with bank financing.

References

  1. Photo by Gerd Altmann from Pixabay
  2. J. Robert Eckley of Eckley & Associates in The Paper Source newsletter of April 2015. "https://www.eckleylaw.com
  3. By: Herb Kirchhoff | Reviewed by: Ryan Cockerham, CISI Capital Markets and Corporate Finance | Updated February 05, 2019 https://finance.zacks.com/lottery-annuity-vs-lump-sum-2136.html

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