When The Seller Acts as the Bank
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Earlier, I referenced “seller financing” in the acquisition of a property so I figured I should expound on that idea a bit.
To date, I’ve used seller financing in three personal transactions: two commercial buildings and one residential property. It’s also been used in transactions where I’ve acted as a broker. It’s one of the first questions I ask whenever talking to a prospective seller.
WHAT IS SELLER FINANCING?
Put simply, seller financing is when the seller extends a “loan” to the buyer on their own property. In other words, the seller becomes the bank. Seller financing is much like collecting rent, except a seller won’t have the headaches of fixing broken toilets or dealing with tenants. In the unfortunate event a buyer (borrower) quits making payments, the seller can foreclose on the property and take it back.
Seller financing usually happens when the seller has no debt (mortgage) on their property. It may happen with a current mortgage in place, but that’s very rare and comes with its own difficulties. All of the seller financed deals I’ve been part of, either as a principal or as a broker, have been with no existing debt on the property.
Seller financing happens for one of two reasons: either the seller wants it or the buyer wants it.
WHEN THE SELLER WANTS IT
What are the reasons a seller would want to “act as the bank” and carry a loan on their own property?
Stream of income
A seller may want a series of payments over an extended period of time. Usually the sellers who chose this path are older and no longer want to actively manage a property. They want the continued income stream and to avoid the large tax ramifications of a lump sum capital gain.
Often, there are “prepayment” restrictions before a certain date (e.g. 10 years). This guarantees the seller a stream of payments for a set time before either a balloon payment is due or the loan can be refinanced.
The property can’t get conventional financing
If a property can’t get traditional financing, a seller may consider “acting as the bank” on the sale of his own property. This may occur for a variety of reasons including raw land or certain vacant properties in which banks are hesitant to lend. In a situation like this, a seller may opt to finance the sale to move the property.
To attract buyers
Sellers may offer to finance a sale just to attract more interest in their property. There are some buyers who get excited when they see “seller financing” advertised. They jump at an opportunity to run numbers and see if the property makes sense. Often, that extra excitement was created by those two words: seller financing. A sale may still occur with traditional financing but the idea of seller financing got investors to stop and take a look a detailed look at the property.
WHEN THE BUYER WANTS IT
Buyers want seller financing for several reasons.
Bad credit / Low cash for down payment
These are your high-risk buyers who won’t qualify for a traditional loan. Previously, the sub-prime loan market gave a lot of these buyers an option, but when that lending opportunity went away seller financing became a lot more attractive.
To Save Their Capital
When a buyer wants to “keep their powder dry” they don’t want to invest all of their capital. This buyer will have solid credit and enough capital available to get conventional financing (20-25% down). However, they prefer to save more capital for either additional purchases, to upgrade the property being purchased, or just to reserve that cash.
A Quick Close
Seller financing can avoid a lot of hurdles that traditional financing requires. With bank financing you are going to be subjected to in depth credit checks which may require special letters of explanation on anything that doesn’t fit the norm. If you are partners in various LLCs, be prepared to submit your K1s along with the tax returns for those partnerships. Then you’ll have to pay for an appraisal, wait for the appraiser to visit the property, write the report and send it back to the bank. Once that’s done the packet is sent to underwriting for final approval. If it gets approved, you can schedule a time to come in and sign the loan package.
Seller financing is much quicker. Once you agree to terms, you traditionally fill out a credit application that the seller will run. You also provide your financials in whatever form they want (e.g. balance sheet, tax returns). They may have a question or two for you, but that’s usually it. No appraisal is needed and it’s not sent to underwriting. Approval happens quick and you move to closing.
HOW IT WORKS
After a price is set and seller financing is agreed upon, you need to determine six things:
- Down payment
- Interest Rate
- Length of loan (amortization schedule) & balloon payment
- Pre-payment penalty
- Escrow Company
The down payment and interest rate are fairly simple concepts which I mentioned above.
The length of loan is also fairly simple, but this is a point of negotiation. Unlike a traditional bank loan for a residential house, most seller financed loans won’t be fully amortizing. Therefore, you’ll set an amortization schedule along with a balloon payment. It will look something like this:
“A 20 year amortization schedule with a 5 year balloon payment”
What this means is that your loan payments will be calculated over a twenty year period, but at the end of the fifth year, the loan will be called due, meaning you’ll have a balloon payment to fulfill the loan.
A pre-payment penalty may come into effect if the seller wants to get a series of payments and doesn’t want you to pay him off early. This comes into their motivation for selling.
An escrow company is important in that they will act as a “middle-man.” They’ll take payments from the buyer, process them, and then send to the seller. They keep track of all payments including interest and principal. It will cost a few bucks each year. I think my last experience was $90/year (split 50/50 with the buyer and seller). Don’t do this on your own as it could expose both of you to additional risk. Be professional and use an escrow company.
RESIDENTIAL VS COMMERCIAL
These are not hard and fast rules on how seller financing differs between the worlds of residential and commercial. This is what I’ve experienced in my pursuit of properties with seller financing.
Residential
Bank financing has been attractive for some time now. If a buyer can’t qualify for bank financing, that means bad or no credit.
Some sellers can go into aggressive mode at this point and command a higher down payment. They can ask for 30% - 40% down and 7-8% interest. You might say that’s ridiculous, but it’s not. The market is exceptionally tight now for home buyers. Sellers don’t need anyone who can’t qualify. However, if a buyer is willing to put up 30-40% then why not take it?
This is where a good residential broker comes in handy. While I’m a commercial real estate broker, I don’t represent myself in residential deals. I have an agent who sends me seller financed listings with something along the lines of, “Check this out. This one looks promising.” We’ve kicked a lot of tires and there are some worthwhile deals out there.
Last year, I bought a little house for $70,000 with seller financing. The terms were 12% down at an annual interest rate of 6%. I had one week to do my due diligence which I did (home inspection, included). It closed two weeks after my offer was accepted.
Commercial
In the world of commercial properties, seller financing happens differently. With sellers of residential property, most aren’t professional investors. However, the majority of landlords with commercial holdings are professionals.
When the great recession occurred, banks weren’t lending easily and seller financing was often the way a property moved.
One of the first buildings I ever sold as a broker was with seller financing. A doctor owned a small building that he managed himself. Half of it was vacant and he was having some difficulty leasing it. His wife and he spent half their time in England so a vacant building was trouble if it wasn’t filled by the time he left. He if I would be interested in selling it. We talked for a bit and I found out he didn’t have any debt on the building. I then asked if he would be interested in selling it on contract. He thought it was a great idea and we put the house on the market. It took only a couple of weeks and we had an offer. This was in 2010 when the market was still cool and properties were hardly moving.
I realize this is a general statement, but seller financing of commercial property has to beat traditional lending. In today’s economy, you can’t ask for a 20% or larger down payment. You can achieve traditional bank financing with 25% down without any effort. Seller financing has to beat that.
Also, the interest rate can’t be silly. In my neck of the woods (Pacific Northwest), most current seller financing contracts are in the 5%-6% range. If it goes much higher than that, the buyer is just going to get traditional financing. Currently, commercial lending is easily available if you have good credit and a decent track record.
SPEAKING OF TRACK RECORD …
Once you have bought a seller financed project and either paid it off or financed out of it with traditional financing, you have created yourself a resume. Keep notes.
The house I bought last year on seller financing was done because of my track record. I provided the seller names and numbers of others would sold on contract to me to verify my ability to perform. I believe that’s why he went with me instead of waiting for another potential buyer. It took thirteen months, but I paid him fully off.
Once you establish a reputation as an investor, people will start to ask you if you want to buy their projects on seller financing. This is where you have to start learning to say ‘no’. Just because you can buy a project with seller financing, doesn’t mean you should.
What about you? Have you used seller financing before?
Are you looking for a seller-financed property?
