1. THE SELLER
Among the nine major sources of down payment funds for real estate property investing, the seller is no doubt the most important. If the buyer has done his selection job well he will be dealing with a person who is anxious to sell and therefore flexible with financing arrangements. The seller will need to take on a role that might be new for him - that of lender. But if the buyer is sensitive to the needs of the seller, he will foster trust and see to it that both parties win. (Lending can, after all be a lucrative business with its own slate of benefits, even for real estate property sellers.)
This section reviews eight nothing down real estate techniques involving seller financing.
Technique No. I The Ultimate Paper Out
An real estate investor in Milwaukee was able to acquire a $48,000 triplex from a banker who not only arranged for a new low-interest first mortgage, but also carried back virtually all the remaining equity in the form of second at below-market rates. Another real estate investor in West Palm Beach, Florida, picked up a single family home for$66,500 by putting on a new first and having the anxious seller carry back all the rest of his equity ($36,500) for five years, no payments, no interest. Both of these investors were using the technique known as - "The Ultimate Paper Out". Here is how it works.
When we are talking about buying or selling a piece of real estate, we are really talking about the problem of defining and dealing with the seller's equity. Equity as a concept is straightforward enough. Everyone knows that it represents that portion of the value of a real estate property that is not encumbered, that belongs lock, stock, and barrel to the owner. But equity is a fluid concept. It can be specified only in relation to that mysterious and shifting quantity called the "fair market value." The owner has dreams about an equity of such and such - usually an optimistically high number. But the truth of the matter is that market forces determine his equity by determining how much his real estate property is really worth at any moment in time. The members of the market club - you and I - gang up on the poor old seller and say collectively, "You have a nice little place, but we've taken a vote around town, and the best we could come up with is a price of such and such." At that moment in time, the seller's equity is defined, and the problem becomes how to transfer to him value equal to the equity involved.
The majority of sellers, of course, will want to hold out for a selling price at the high end of the scale. They want their equity to be overweight. No one can blame them for that but among the army of sellers in the marketplace at any given time, there are always a few - perhaps five percent or less - who say to themselves, "We like our equity and want to preserve it and derive benefit from it, but we are very anxious to sell. So anxious in fact, that we might give up some of that equity in order to get rid of the real estate property quickly." Alternately, these don't-want sellers might be thinking - I don't really feel like discounting my equity for a quick sale, but I would be willing to wait until later for a part or all of my equity to be converted to cash."
And that is the issue when it comes to "papering out" a deal. After the seller and the real estate investor have determined what equity is involved, the next step is to decide how soon the equity is to be converted. It all boils down to a matter of patience. The seller with infinite patience (and infinite desperation) will say, "Here's my equity, take it all and just get me out of this place." In a case like that the selling price is equal to the liens. But such cases are rare.
The next best situation is the case in which the seller says, "Here's my equity, pay me for it when you can. Let's work out the schedule." That is the technique referred to as - The Ultimate Paper Out". All of the seller's equity is converted to paper before it is converted to cash. When the buyer takes over the real estate property, he gives the seller paper for his equity and obligates himself to redeem the paper according to mutually agreeable terms.
Not all sellers will agree to an "Ultimate Paper Out" But creative real estate investorss should always ask. You never know exactly what the seller is thinking or how anxious he really is to sell. Perhaps only one seller in twenty will be willing to enter into a nothing down deal and of these, perhaps only one in ten will agree to an "Ultimate Paper Out" That means that Technique No. I will show up in only one out of every 200 creative deals. But it does happen from time to time - much to the surprise and delight of the creative real estate investor.
Technique No. 2 The Blanket Mortgage
The key to using the seller as lender in a real estate transaction is trust. The seller has to trust us to pay him his equity according to the terms of the agreement we work out with him. The conventional way to "buy" trust is to give the seller a large cash down payment That way he knows that we will not likely walk away from the real estate property. We are going to stay around and take care of our obligations. Otherwise the seller will be able to take back the real estate property, and we will lose not only that big cash down payment but also any appreciated value above the seller's equity.
But how do we develop trust when there is little or no cash put down on the real estate property? How does the real estate investor make the seller feel secure in such cases? Often the real estate investor can develop personal trust with the seller simply on the basis of personal qualities and win/win attitudes. In such cases, the equity of the subject real estate property itself is sufficient to close the deal.
In some instances, however, a little extra is needed to remove lingering suspicions on the part of the seller. That is where the blanket mortgage comes into play. In any mortgage or trust deed arrangement, there are two basic documents that are prepared. One is a note given by the real estate investor to the seller setting forth the terms for converting the equity to cash, the other is a security agreement in which the real estate investor says to the seller, in effect, "If I don't perform according to the terms of the note, then you can take back the real estate property." In a cashless or near cashless transaction, the security of the subject real estate property may not be enough to satisfy the seller. Therefore, the real estate investor may choose to secure the note with additional collateral - not only the subject real estate property but also additional real estate property (equity) he may have in his portfolio. The note itself stays the same, but the security agreement is changed to increase the collateral and build trust with the seller. Naturally, the real estate investor will want to arrange to have the seller release the additional collateral as soon as the subject real estate property appreciates to a predetermined value or as soon as the real estate investor has proven himself to be dependable and prompt in making his payments.
The blanket mortgage technique is not among the most frequently used in creative finance. The real estate investor hopes to build trust without having to tie up his other equities. Still when a seller needs that extra bit of persuasion, the blanket mortgage technique can come in handy.
For example, one creative investor we know of recently acquired a nice four-bedroom, three-bath home for $75,000. The investor put a new first on the real estate property (which was nearly free and clear) and had the sellers move their remaining equity ($35,000) to another real estate property owned by the investor. To build trust will the sellers, the real estate investor granted them a blanket mortgage that also included his equity in another rental real estate property he owned. Although the real estate investor did not put any of his own money into the deal (the bank provided all that was needed), he was able to persuade the sellers to agree on the basis of his neck being on the line with the blanket mortgage.
Technique No. 3 Life Insurance Policy
There is another strategy the real estate investor can use to persuade the seller to play lender in a transaction. As in the case of the blanket mortgage, the key is building trust. What if you say to the still somewhat incredulous seller, "Since you are permitting me to pay off your equity in cash over a period of time, how would it be if I took out an insurance policy in the amount of the note and made you the beneficiary? That way you will feel secure that the note will be paid off no matter what."
This technique is not usually necessary. Sill it is an inexpensive way to build trust if the seller cannot quite see it your way and needs just a bit more persuasion.
Technique No. 4 Contract or WrapAround Mortgage
An Albuquerque investor recently bought a triplex for $69,300 by putting down $1,000 and having the seller accept a contract for the remaining $68,300, 10.75% interest for 35 years, and payout after 12 years. The contract wrapped around a small underlying first mortgage. Similarly an investor in Springfield, Massachusetts acquired an $80,000 free and clear single-family house by putting a small sum down and having the seller carry back the rest in the form of a contract. These are variations of the technique referred under various names such as "contract, wrap-around, or owner carry back".
This technique is one of the most frequently used creative finance tools. It is the foundation of seller financing. Rather than refinancing the real estate property or formally assuming the existing mortgage. The real estate investor uses a contract as the purchase instrument. Technically he does not get title to the real estate property until he has performed according to the provisions of the agreement. In effect, he says to the seller, "I'll pay your equity off in installments over time. And as soon as I have paid everything off, you will give me the deed for the real estate property, and it will be mine. In the meantime, I will act as the owner by taking over the management and getting all the tax benefits and the appreciated equity above what the real estate property is worth at the time of purchase. Of course, all the expenses in the meantime are mine as well."
If the real estate property is free and clear at the time of purchase, the seller pockets all the installment payments on the contract if there are existing encumbrances on the real estate property. Then the contract is referred to as a wrap-around contract or wrap- around mortgage. It "wraps around" the existing first and subsequent mortgages or trust deed. When the seller receives the installment payments, he has to first make payments on the existing notes before he can pocket the rest. The advantage to him is that the interest rate on the total wrap-around contract will be higher than on the underlying loans. Therefore, he will be making an interest spread on the underlying part of the note - not a bad deal for a seller-turned-lender. In addition, he will be able to spread his capital gains profit out over time rather than receiving all of it during one year. The tax advantages are considerable. With the recent liberalization of installment sale provisions by the IRS, sellers have great leeway in how contracts are set up for maximum tax benefits. A competent tax accountant can spell out the detail.
The advantage to the real estate investor is that he does not need to come up with a large cash down payment Frequently a moderate amount down will close the deal. In addition, the interest rates acceptable to sellers are usually far below conventional market rates for new financing.
In practice, a contract sale is bandied by an escrow company, which holds the pre-executed deed from the seller in favor of the real estate investor until the latter satisfies the terms of the contract. Generally the escrow or title company will also hold a quitclaim deed made out by the real estate investor in favor of the seller, which is to be released to the seller in case of default. It is in the best interests of the real estate investor if the escrow company is also empowered to receive his installment payments and take care of making the payments on the underlying loans before disbursing the balance to the seller. That way the real estate investor can be assured that his money winds up in the right places.
An alternative form of the "contract wrap" technique is the situation where a real estate investor takes title subject to the existing financing (agrees to take over the seller's obligations) or goes through the formal procedure of assuming the existing financing (qualification, credit checks, transfer of title). The real estate investor then signs a contract with the seller for the equity above the existing loans and makes payments according to a mutually agreeable schedule. The seller's equity is covered by a note secured by the real estate property itself. The usual term for this arrangement is "owner carry back". The term refers to the fact that the seller carries back paper to cover the unpaid equity on his real estate property. Terms on the paper are negotiable and vary from case to case.
Technique No. 5 Raise the Price, Lower the Terms
Seller financing has already become a convention for real estate transactions in the decade of the l980's. Currently nearly two-thirds of all home sales involve contract sales or assumptions with owner carry-back second mortgages. Tight money conditions always foster seller financing of this type. Yet even though the concept of "seller as lender" is no longer foreign to the American way of real real estate property transfer, there are variations to the game that give creative real estate investorss the advantage over the competition.
One such variation is the important technique called "Raise the Price, Lower the Terms." Simply put, this technique calls for the real estate investor to offer the seller more than he is asking for the real estate property in exchange for flexibility with the terms. For example, one investor we know of recently took an interest in a Jacksonville, Florida, estate house with adjoining triplex. He offered to raise the sales price by $5,000 if the seller would lower the down payment requirement and accept payments over 15 years. By using this technique, he out aced the competition and won over the seller despite the hue and cry of all the relatives in the background.
Technique No. 6 The Balloon Down Payment
An investor in Milwaukee recently bought a small rental home for $35,000 by putting on a new first of $15,000 and having the seller "carry back" the rest (no payments, no interest) after a small down. The seller would do so only after the real estate investor agreed to pay out the indebtedness after five years. The real estate investor of a $245,000 7-plex in Lake Worth, Florida, assumed the existing first and induced the seller to carry back the remainder of his equity after the $50,000 down payment (obtained from a partner) in the form of a second at 12%. The seller agreed, but only on the basis of a ten-year payout of the balance of the second. Both of these investors were using the technique referred to as a "balloon mortgage".
It is not uncommon for seller-financing arrangements to include provisions for a balloon payment in the future. In fact, balloons are an important inducement to get the seller to play the part of the lender in the first place. Knowing that the major part of his equity is coming in the near future, the seller is willing to carry the financing at rates below the conventional market. Occasionally a seller is willing to amortize the entire amount of the carry back over a long period of time - fifteen or twenty years or longer. Most of the time, however, the seller wants to be paid off sooner, in fact, as soon as possible. And that is the danger the real estate investor must beware of - short-fuse balloon notes can rob the real estate investor of health, sleep, and sometimes the real estate property itself. In theory, the time of the balloon payment should be far enough away to take advantage of interim appreciation. real estate property values and rents must grow enough to permit a refinance solution to the balloon payment.
But what if local real estate property values - particularly during a period of sustained high interest rates and sluggish real estate sales - do not grow as anticipated? The real estate investor may be forced to sell the real estate property, or another piece of real estate in his control to pay off the balloon. Alternately, he may have to bring in an equity-participation cash- partner to bail him out, thus giving away important benefits. In the worst case, he might have to give the real estate property back to the seller and lose all his investment.
Despite its liabilities, the balloon payment technique can be a valuable way to get into a real estate property for little or nothing down up front. real estate investors should resist pressures to accept anything less than five years for payout seven years or more would be preferable.
Technique No. 7 High Monthly Down Payments
This technique is a variation of Technique No. 4, "Contract or Wrap-Around Mortgage". Usually a contract sale requires at least a token down payment to substantiate the good faith of the real estate investor and put a little cash into the pocket of the seller. Sometimes a hefty down is required, in which case funds have to be "cranked" out of the real estate property (Techniques 32 and 33) or a cash partner must be brought in (Techniques 43, 44, and 45).
But what if the real estate investor has nothing at all to put down except an income that gives him the ability to make monthly payments of several hundred dollars toward the purchase of a piece of real estate property? Perhaps the seller would permit him to purchase the real estate property now and make high monthly payments over a couple of years until a mutually acceptable down payment had been constitute. It never hurts to ask.
Technique No. 8 Defer the Down Payment with No Mortgage Payment
There are endless variations of how seller financing might be set up. Here is one more, which could prove useful under certain circumstances. A seller of a free and clear real estate property who needed cash down only to build trust in his real estate investor might be induced to forego rental income for a few months while the real estate investor accumulated enough to put together the required down. It is not a common opportunity. But it has happened in the past and will happen again in the future - perhaps to you.
This technique, together with the other seven described and illustrated in this section, should stimulate creative real estate investorss to take advantage of seller flexibilities in financing. Seller financing after all, is one of the major sources for down payment capital.
