Financing deals plays a large part in starting or expanding your portfolio. When financing your next purchase, rehab, etc. we need to leverage every financial tool available. Whether it is your favorite podcast, real estate self-help book, or family friend / “real estate guru” most will push you into the direction of owner-financing when traditional methods aren’t possible.
What is Owner-Financing?
The owner agrees to serve in a role typically filled by a bank or lender. Both parties must agree to a purchase price and terms of a loan similar to a mortgage. However, as payments are made, an escrow is not typically established for covering property taxes and insurance
A Key Condition: A property is required to be owned outright by the seller (or down payment covers any/all loan amounts) prior to closing. As a buyer, if this condition is not met then don’t waste the time in typing up an offer-to-purchase.
How do you decide on terms? If you are presenting a seller-financing option as a buyer, have a plan for the details. Be prepared to offer the following:
- Define the down payment
- Set a monthly payment
- Establish the term length
- Implement a balloon payment (if needed)
- Industry standard interest rate
As with any real estate transaction discuss the transfer of HOA payments and applicable utilities.
1. Define the Down Payment
Researching market rents is important here. Focus on a DSCR of 1.1/1.2, but ultimately set your per month cash-flow and establish it here. Remember its P-T-I (Payment, Taxes, Insurance), plus HOA dues if applicable. Plan to set aside money for taxes and insurance since your mortgage company typically handles this for you.
2. Set a Monthly Payment
3. Establish the term length
If there is an area to focus extra on, it will be the term length. Too long and the seller might be disinterested, too short and you may not be ready for the large balloon payment at the end. Think of your exit strategy when developing terms; fix/flip after a lengthy renovation, agency loan REFI, or a long-term holding
A balloon payment is the final payment owed upon the loan reaching full term. This occurs when you down payment and monthly payments don’t cover the mortgage within the agreed upon time. This requires a large one-time payment to satisfy the loan. Be careful to ensure you are able to cover the balloon payment with a well planned exit strategy or likely forfeit all your money paid and rights to the property. Foreclosure rolls back to the seller.
4. Implement a Balloon Payment (if needed)
5. Industry standard interest rate
Perhaps the easiest point to negotiate is the interest rate. Interest provides an incentive to the seller for owner-financing. The seller maybe incentivized with the interest earned in addition to the purchase price. The sellers bottom-line profits require an amortization schedule, set down payment, and profit margin from the final sale.
Having a seller willing to participate in a owner-financing deal can be lucrative for both parties. The seller may sell their house at purchase price with interest, and a previously non-qualified or over-leveraged buyer able to acquire the property.
As for closing, a term sheet can be added to the purchasing agreement just as any normal addendum and looked over by the closing attorney prior to closing. The real estate attorney will cover the terms and ensure all money is collected similar to other transactions in addition to ensuring monthly payments are worked out between both parties.
Does the target property suffer from serious disrepair? Is it back on the market from a failed attempt at agency lending?
Does the seller lack appropriate documentation for a lender (i.e. Rent Rolls, Profit & Loss Statements, etc.)? Are there zoning conditions or issues?
Does the seller own the proper outright? No loan?
When Should I Pursue Owner-Financing?
If you can answer yes to any of the scenarios above, then the property in question maybe a candidate for an owner-financing deal. The key is the last question: “Does the seller own the property outright (free and clear)?” If there are no liens then you may proceed without complication. Use the other questions as talking points or points of leverage when approaching the seller.
Summary
A beautiful aspect of real estate is being able serve in the role of a problem solver. Understanding the various tools available will allow anyone to have a higher success right of making both parties happy and adding yet one more door to your portfolio. Now with this simple break down, hopefully you are able to add owner-financing to your repertoire of financing your next real estate project. Until next time!