My experience with most real estate investment gurus has been less than favorable, for reasons that I won’t go into here. There are a few exceptions, one of whom is here in Southern California and who I deeply respect for his intelligence and integrity. My interactions with him have all been so positive that I accept much of what he says without question.
When hearing him speak recently, I was surprised by a study he quoted stating that there was little difference in default rates between those house buyers who put in a 20% down payment versus buyers in a VA loan program who put down little or nothing. On the face of it, this argument seems backward. Logically, if you put down $20K, $50K, or a $100K into a property, you would be less likely to default since you now have “skin in the game.” In fact, I still won’t accept the conclusion of this research until it is backed up by similar studies showing the same result.
As a mortgage buyer, I like to see lots of equity in a property for two big reasons. First, I want the buyer to feel some financial pain if he does default, so a bigger down payment should lessen the chance that he or she will toss me the keys. Second, and much, much more important, I want to have an equity buffer. By this, I mean that I want the property to be worth substantially more than I pay for the real estate note. That way, if the buyer does default, I have a good chance of at least recovering my investment even after incurring the costs of foreclosure, fix-up, and resale.
The first real estate note that I ever bought was for a house on a large 5-acre parcel in northern California. The note was unremarkable except for one big piece – the property had been sold for $150K and the buyer had made a $125K down payment, thus leaving a note of only $25K. After conducting my due diligence, including ensuring that there were no senior liens on the title, I jumped quickly on this real estate note. After all, this note was almost a cannot-lose situation. Worst case, even if the buyer trashed the house and burned down the building before defaulting, the land value alone would have exceeded my investment, so I would have come out ahead. As it happened, the buyer actually paid off the note early so that he could refinance, which was even better.
Currently, I am in a similar situation with an even larger parcel in the Carolinas. In this case, the property was sold for $260K, with a $200K down payment, leaving a note for $60K. The note has good seasoning (meaning lots of payments received on-time), though it does have “some hair on it”, namely that the payer has horrendous credit. However, once again, I feel well protected. While I don’t want her to default on the note, the risk of me losing money even if she did so is remote.
Of course, notes like those two don’t come along that often. For notes with less equity, I am always going to require at least 30% equity in my purchase price. In other words, if a house is worth $100K, I would always pay less than $70K for the real estate note so that I keep that buffer. Usually, I accomplish this by just buying some of the payments (called a partial) instead of the full note so that it is a good deal for both the note holder and for me.
If you are considering selling a property using owner financing, get as big of a down payment as you can. Hopefully, the amount of equity will never come into play, but you’ll sleep better at night knowing that it is sufficient.
Photo: Elsie Esq.Finding Equity in Mortgage Notes by Alan Noblitt