What rate should I expect to pay on owner financed 2nd mortgage?

Question

I am considering a 11 unit building for $700k in NH and only have 10% down. My bank requires 20% down so the owner said he would give me a second mortgage at a rate of 10% for either 5 or 10 years. Is that a high rate or a good deal? Cash flow will cover it, but I don't want to be taken for a sucker.

Gino Barbaro · Answer

@Eric Hathway

Hi Eric

we just did an owner finance on 288 units for 20% of purchase price.  2.2 million dollars at 4.5%, 30 yr amort, we wanted 7 yr term, he balked and we settled at 5 yr term.  The seller was motivated and we got a great deal.  If your seller is motivated, I think 5-7% range is fair.  Banks are lending anywhere from 4 to 4.75 on 25 yr commercial.

If the deal is terrific, then take his loan, reposition the property and refi in the near future to pay him off and possibly extract some capital for yourself.

I always like to hear seller financing deals.  It shuts up all the people that say it's impossible to do.  They're not easy, but nothing good is.

Good Luck

Troy Zsofka · Answer

I agree that 10% is too high unless there is a compensating factor here.

Something for the seller to keep in mind: When a mezzanine lender takes a 2nd lien position, the interest rate is high because that is all they are getting out of the deal. However, when the seller takes a 2nd, they get something far better out of the deal: the sale of the property. In this case, the seller gets $630K (minus commissions, transfer tax stamps, and any current lien payoffs). That's the main benefit to him, and he needs to see the bigger picture if he wants to sell it.

On the other hand, he can turn the same logic back on you and say that you don't buy it without the 10% LTV second, and the bigger picture to you is making the acquisition. If he does that, then it comes down to who is the better negotiator.

What does the CAP Rate look like? I would say that if the CAP is way above market (before any value-add you're planning to realize), then the 10% rate on the second isn't so bad (assuming you don't have other options). On the other hand, if it's struggling to match market CAPs with it's current actual P&L, then he's getting a great price for his property and should be more flexible on terms.

Another thing to consider is what a 5% rate vs a 10% rate on the second does to DSCR (probably not much).

Good luck

Christopher Telles · Answer

Interest rates fluctuate as they are a larger part of the financial markets. A good rule of thumb is to use an index as a benchmark.

I like using the Prime Rate, as published in the Wall Street Journal, and then add a risk associated return.

Currently the prime rate is set at 3.25%. A typical 1st Trust Deed/Mortgage will have rate increase that today averages from 1 - 2% above the Prime Rate for a credit worthy borrower. This increase in interest rate, the 1 - 2%, represents the risk adjustment.

Theoretically, lenders use the discount rate to determine interest rates; for example purposes, and a rule of thumb, I've used the Prime Rate.

A seller carrying back a 2nd TD will want to adjust the interest rate charged higher than say a 1st TD to account for the increased risk in lending to a buyer.

That interest rate increase above a 1st TD rate will in itself be anywhere from 2 - 5% higher.

So IMHO a rate of 10% is higher than necessary for a seller to account for their increased lending risk. In fact, you could possibly find a hard money lender to lend this at a similar or better rate on what maybe friendlier borrowing terms (interest only, etc).

A 2nd TD interest rate of 6-8% is reasonable given today's interest rates.

Jeff Kehl · Answer

I agree with the 5-6% rate. I've done several like that for 5-6% recently. He is not taking much risk to hold a note for 10% of the value and he can't get a safe return for 5% anywhere else. I would counter at 5% interest rate.

Do it for 5 years if you can also so he gets his money quickly. Keep in mind that a $70k loan at 5% for 5 years is $1321 a month so that will really eat into your cashflow for the first 5 years. Same loan at 10% interest rate is only $1487 so if he's really set on that it might still make sense.

Jamal Okon · Answer

5-6% is reasonable, so it can't hurt to ask.  But remember beggers can't be choosy, if this is the only way you can finance the property you may need to bite the bullet and refinance in the next 1-2 years or so.

What rate should I expect to pay on owner financed 2nd mortgage?

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