Owner financing is a very common real estate purchase structure that has really come into the forefront of buying and selling in a buyer’s market. So I decided I would put together a quick overview of what owner financing is, since most buyers, sellers, and even real estate professionals are usually unfamiliar with the term and the types of contracts involved. Remember, structuring owners, financing deals work for all types of real estate transactions, big and small, home or commercial buildings.
Owner Financing Overview:
Owner financing is when the seller holds all or part of the agreed-upon purchase amount. I always tell people to look at it in terms of a bank; the seller is holding the financing in the same way a bank would. The seller receives the monthly payments based on an agreed-upon rate and term with a future balloon date for full payoff. This type of real estate transaction is very common in a buyer’s market like we see now and even more common now that lenders have tightened their underwriting guidelines and or have completely stopped lending. These sets of circumstances have created a smaller buyer pool. However, the amount of property owners that still want and need to sell is still there. Seller financing can be a great way to bridge the gap between buyers and sellers.
Owner Financing Term Length:
The length of an owner-financed property can differ between the timelines of both the buyer and seller. Almost all owners financed monthly payments, whether commercial purchases or home purchases are amortized over 30 years. A typical contract balloon term is a minimum of two-three years since 24 months is a key number for most lenders to see that you have been making on-time payments on this property before landing on the buyer’s purchase/refinance of the owner financed contract. In addition, it allows the buyer to clean up any credit or financial issues that are dragging them down from buying if that is the buyer’s personal situation. But what is even more important in this market is that allowing the financial lending markets to stabilize and open back up. This has been the major factor for owner financing.
We have been structuring the length of our owner financing contracts out a minimum of three years with three one-year extension options. This brings the full possible balloon payment out to 6 years if needed. This is simply because we need to make sure we give those financial lending markets enough time to rebound and start lending again. In addition, we have had owners request longer terms because of the huge tax benefits that a longer term brings; we will get talk about that subject in another article.
Down Payment or No Down Payment:
The subject of providing a down payment on the owner financing contract is always a sticky one. From the seller’s standpoint, they usually want as much down payment as possible; why? Because if the buyer has some “skin in the game,” they are less likely to walk away from the property and contract. From the buyers’ standpoint, they always want to come in with as little a down payment as possible, thus limiting their risk.
Personally, from my experience and many others, I feel that most sellers should accept a smaller down payment, if one at all. I know… I know what you are thinking… WTF, why would I take the risk? My point of view comes from the simple fact that if a buyer has circumstances come up that they can no longer make payments on the property, they are still going to walk away if needed, regardless of having a down payment or not. Yes…yes… I know having a down payment would at least be some kind of compensation to the seller. However, from my standpoint, I would rather receive a few thousand dollars from the buyer and allow him/her to keep any additional monies for reserves and repairs on the property because they do and will come up. You see, from my experience, if someone runs into a tough financial spot, I would rather them have reserves that can float the payment until they get back on their feet vs. being tapped out of funds day one after buying a property.
This goes for both residential and commercial real estate. Maybe even more so for commercial real estate since there is a high volume of repairs, maintenance, and the normal unit turns, which having a reserve account is a must-have to be successful. And the best thing is that you can always have to compensate factors for low to no down payments such as higher interest rate and or higher balloon payoff.
Interest Rate in Financing:
This is one of the reasons I love owner financing. It allows sellers to charge higher interest rates, thus possibly receiving monthly cash flow from the property. If there is a mortgage on the property, it is very normal, depending on the type of real estate, to charge an interest rate to the buyer that is higher than what is currently being charged by the bank. We have seen rates all over the board, including interest-only payments, staggered payments, and payments that are equal to the current underlying mortgage payment from the bank. The key is to at least cover the current mortgage payment on the property, if there is one.
Make sure that it is written into the contract specifically stating who covers what expenses and repairs. Normally, since the buyer purchases the building, they cover all expenses related to the property just like an owner would. I have, however, seen contracts where the seller has to cover major repairs and OK any remodeling of the property. This is because the seller still has the ownership interest in the property and cannot let it go into disrepair or remodeled to the point that it does not do the property any good. I always prefer to have the buyer pay everything and notify me when upgrades or remodeling will be done.
Variations of Owner Financing Contracts:
Contracts will and do vary depending on the state you live in, the end goal, and if there is a mortgage on the property. Most lenders have what is commonly called a “due on sales” clause that is in the mortgage documents the owner signed when originally purchasing the property. What this means is that the lender has the option to, if they choose to call the mortgage note due if the property is sold. Now, many sellers get hung up on the fear that if the original lender finds out, they sold the property using owner financing to request full payment of the mortgage. After doing some research, and have found several cases in which the lender has found out and tried to call the note due, but with little success. Why? Because the mortgage and property are still attached to the seller’s name and with payments being made. If you look at it from a common-sense standpoint, why would a lender call due to a mortgage that is being paid on time as agreed upon? They do not; they are in the business of making money, not going after folks that are technically within the original guidelines of the mortgage. In addition, very few lenders ever find out because there is no need to inform them. However, if you as a seller are uncomfortable with it, there are ways to structure a contract that does not trigger the option to call the mortgage due, which I will go into.
Types of owner financing contracts:
o Land Contracts/Contract For Deed:
Depending on the state you live in, it is one or the other. Land contracts/contract for deed gives the buyer equitable title. This is usually used if there is no existing mortgage on the property. It allows the buyer to have some ownership in the property which, when the balloon term nears, that the buyer can usually get a refinance loan rather than a purchase loan. Why is that? Because the lender sees that you have an equitable title to the property and have successfully made the payments during that term. The refinance process is usually always easier since the buyer has a successful history with the property.
o Promissory Notes:
The promissory note is when a seller can carry the mortgage 1st or 2nd for the full purchase price balance, which is called an “all-inclusive mortgage” or “all-inclusive trust deed” If there is a mortgage, the seller receives an override of interest on the underlying mortgage.
o Subject Too:
This is where the buyer takes over the current mortgage subject to the existing monthly payments and paying no override of interest to the seller. This is a great way to sell if you are in financial straits and need to get out fast.
o Lease Options/Lease to Purchase/Master Lease Options.
The name really says it all. The buyer and seller sign a purchase agreement, option to purchase agreement, and often a rental agreement. The buyer is leasing the property with an option to purchase it in the future. Using lease options are normally used to get around the above-stated “due on sales” clause. Since the buyer is simply leasing the property, it does not trigger the clause.
End of Contract:
When nearing the end of the stated contract, the buyer should either use one of the one-year extension options if needed or go forward with the refinance/purchase of the property. This is where the seller is fully released from the property and usually sees a chunk of profit. At the end of the day, the property seller should have received monthly income along with an end balloon pay-off.
Remember, the whole goal is to bridge the gap between sellers and buyers during a very difficult economy. Using owner-financed contracts to buy and sell allows the market to continue moving forward and is truly a creative solution to market problems. In further articles, I will go into the benefits of owner financing from both sides of the transaction.