Seller Financing - Real World Deal

17 Replies

So I am working with an investor who is looking to owner finance a rental.  This is my first time using this approach and have some questions.  I want to ensure that I am understanding the deal correctly.

Purchase Price: $140,000

Down Payment: 10% ($14,000)

Interest Rate: 5%

Balloon Payment: "1 year Balloon payment of balance".

Rent for area: $1,400 / month

Taxes: $4,000 ($335/month)

Questions:

1. What is "1 year Balloon payment of balance"?  Would it be 12 months of P&I = $671.56 x 12 = $8,058.712

2. When determining "cash on cash return" how much should I factor into deal for closing costs (attorney fees) etc.

3. Any other factors that I am overlooking when dealing with seller financing?  I want to make sure that I am looking at the numbers correctly before determining cash flow and cash on cash return.

4. Advice would be appreciated.  This deal doesn't look good right now but may be a starting point in the negotiation.

balloon payment means the balance is due at that time.

@Joe Conklin- a 'balloon' refers to the loan balance needing to be paid in full.  Essentially a 1-yr balloon for you will mean a payment of $140,000 - $14,000 = $126,000 due in 12 months.  It will be a little lower with principle buydown over 12 pmts but you get the picture.  In case your lender requires 12 months of seasoning before the refi, be sure and get a 60-day extension or ask for 14 months up front.  Pretty short balloon in my opinion.

Closing costs in my area run about 2% of purchase price.  Some are buyer-paid, some seller. Depends on area customs.

Your instrument of seller-financing is hugely important.  DO NOT DO A LAND CONTRACT.  Structure it where you get title to the property on day 1.  Here it is a Note and Deed of Trust (mortgage). If not getting title anyway, I'd put down less up front (like 2-3% total) for an exclusive option to buy.  That's about all the protection you have anyway with a Land Contract.   

@Joe Conklin

 I would interpret #1 to mean that the entire remaining principal will be due in one year. A balloon payment refers to one last lump sum payment that pays off the entire loan. With this kind of loan, the investor wants to get all of his money out after a year. That means you'll have to refinance it with another lender or pay it off in full with your own cash or from another investor that you might partner up with.

You mentioned that the purchase price is $140k. What's the Fair Market Value? If your plan is to refinance the property, you'll probably need 20-25% in equity if you get a typical loan from a bank. Based on that and your down payment, the market value should be around $157,500, assuming that you don't pay down any principal during your one year. 

Originally posted by @Andreas Mirza :

@Joe Conklin

 I would interpret #1 to mean that the entire remaining principal will be due in one year. A balloon payment refers to one last lump sum payment that pays off the entire loan. With this kind of loan, the investor wants to get all of his money out after a year. That means you'll have to refinance it with another lender or pay it off in full with your own cash or from another investor that you might partner up with.

You mentioned that the purchase price is $140k. What's the Fair Market Value? If your plan is to refinance the property, you'll probably need 20-25% in equity if you get a typical loan from a bank. Based on that and your down payment, the market value should be around $157,500, assuming that you don't pay down any principal during your one year. 

 He mentioned that the property is assessed at 165K, it is currently being rehabbed - so once I refinance, lets say I'll be in for 25% = 41,250.  This seems like a lot to be in for, and it does not seem like a good deal.  Thoughts?

Originally posted by @Steve Vaughan :

@Joe Conklin- a 'balloon' refers to the loan balance needing to be paid in full.  Essentially a 1-yr balloon for you will mean a payment of $140,000 - $14,000 = $126,000 due in 12 months.  It will be a little lower with principle buydown over 12 pmts but you get the picture.  In case your lender requires 12 months of seasoning before the refi, be sure and get a 60-day extension or ask for 14 months up front.  Pretty short balloon in my opinion.

Closing costs in my area run about 2% of purchase price.  Some are buyer-paid, some seller. Depends on area customs.

Your instrument of seller-financing is hugely important.  DO NOT DO A LAND CONTRACT.  Structure it where you get title to the property on day 1.  Here it is a Note and Deed of Trust (mortgage). If not getting title anyway, I'd put down less up front (like 2-3% total) for an exclusive option to buy.  That's about all the protection you have anyway with a Land Contract.   

 Thank you for the  advice and explanation.  I will take that into consideration

You also need to budget for some vacancy in the property, maintenance/repairs you might incur, as well as any utilities you are paying before you do your projected returns.

In my opinion, a traditional deal set up like this is a formula to fail.  Here are a few points to consider:

- it is very challenging to refinance and close on the refi within 12 months unless you have significant experience and/or additional capital to do so.  The balloon is the failure point if the seller decides to take the hard line and foreclose if you miss the date.  If you have, or are very confident that you WILL have enough to pay in to refi with roughly 25% of the purchase price to close, then maybe this is an option.  Then again, if you have the capital to close with 25% down, why not just go to the bank now?  I suspect that you don't have the 25% down, hence the owner financing option being discussed.

- if you have a great relationship built with a local bank, run the scenario by them to see what circumstances they may refi under.  That balloon clock is very fast and you will find yourself racing to beat the clock.  Know ahead of time how you will deal with the balloon.

- a quick glance at the numbers - you won't create enough positive cash flow (might not create any at all) from the property to help close any gaps, so the money to do the above options will have to come from somewhere else.

A few alternatives to consider:

- negotiate a longer balloon period, ideally 3 or more years out as that buys you some time and breathing space.  Never wait until the last minute to start figuring out the refi!

- lease/purchase agreement - you become a "master tenant", get the rental income and buy some time to put together money to close

- seriously consider passing on this deal.  You mention it is another investor offering this deal to you.  With the short balloon period, I'm assuming the investor has some experience.  It appears to me that you are being drawn into what could become an ugly situation by focusing on the wrong numbers (low interest rate, low down payment) which is being used to draw your attention away from the short balloon as well as what is going to be marginal cash flow.  This investor might be gambling that you miss the balloon date, he forecloses, he keeps the down payment, and he repeats.  You can make every payment on time for the whole year and in month 13 you will be in default.

I don't mean to be discouraging.  Sometimes your favorite word needs to be "next".  At the very least, I would get a copy of the proposed financing agreement and run it by an attorney and see what his/her thoughts are.  I do a LOT of deals with owner-financing in the beginning and a refi down the road, but something about this one smells funny.  Keep your eyes open and look at ALL of the numbers.  Don't rush in just for the sake of getting any deal done.

Good luck and happy investing!

Originally posted by @Adam Johnson :

In my opinion, a traditional deal set up like this is a formula to fail.  Here are a few points to consider:

- it is very challenging to refinance and close on the refi within 12 months unless you have significant experience and/or additional capital to do so.  The balloon is the failure point if the seller decides to take the hard line and foreclose if you miss the date.  If you have, or are very confident that you WILL have enough to pay in to refi with roughly 25% of the purchase price to close, then maybe this is an option.  Then again, if you have the capital to close with 25% down, why not just go to the bank now?  I suspect that you don't have the 25% down, hence the owner financing option being discussed.

- if you have a great relationship built with a local bank, run the scenario by them to see what circumstances they may refi under.  That balloon clock is very fast and you will find yourself racing to beat the clock.  Know ahead of time how you will deal with the balloon.

- a quick glance at the numbers - you won't create enough positive cash flow (might not create any at all) from the property to help close any gaps, so the money to do the above options will have to come from somewhere else.

A few alternatives to consider:

- negotiate a longer balloon period, ideally 3 or more years out as that buys you some time and breathing space.  Never wait until the last minute to start figuring out the refi!

- lease/purchase agreement - you become a "master tenant", get the rental income and buy some time to put together money to close

- seriously consider passing on this deal.  You mention it is another investor offering this deal to you.  With the short balloon period, I'm assuming the investor has some experience.  It appears to me that you are being drawn into what could become an ugly situation by focusing on the wrong numbers (low interest rate, low down payment) which is being used to draw your attention away from the short balloon as well as what is going to be marginal cash flow.  This investor might be gambling that you miss the balloon date, he forecloses, he keeps the down payment, and he repeats.  You can make every payment on time for the whole year and in month 13 you will be in default.

I don't mean to be discouraging.  Sometimes your favorite word needs to be "next".  At the very least, I would get a copy of the proposed financing agreement and run it by an attorney and see what his/her thoughts are.  I do a LOT of deals with owner-financing in the beginning and a refi down the road, but something about this one smells funny.  Keep your eyes open and look at ALL of the numbers.  Don't rush in just for the sake of getting any deal done.

Good luck and happy investing!

 Thank you.  I agree, this guy is way ahead of me skill wise.  In my opinion there is nothing different from this deal and going to the bank for a conventional mortgage (like you mentioned).  I don't feel comfortable being under the gun like this, his goal is obviously not to have a steady stream of passive income.

One difference is that it sets you up for 2 sets of closing costs in a year, further increasing the cost of the deal and lowering the return.  If it were a home run deal, definitely worth considering.  But what I see at first glance is that this is a marginal deal at best, even before you consider the financing portion.

I think Adam hit the nail right on the head. You can always ask your seller for a modified owner finance agreement, extending out to three years, you have nothing to lose by doing so.     If he won't accommodate, your next move would be to seek out a community bank,  or just move on.

Originally posted by @Joe Conklin:

 Thank you.  I agree, this guy is way ahead of me skill wise.  In my opinion there is nothing different from this deal and going to the bank for a conventional mortgage (like you mentioned).  I don't feel comfortable being under the gun like this, his goal is obviously not to have a steady stream of passive income.

 Actually, there is something a little different here than going to the bank.  Banks don't lend to own (hoping for borrower failure).  Banks don't do one year balloons.  Banks lend on value from 3rd party appraisals. Banks don't quote tax appraisal amounts as relevant to value amounts.

This might be a deal from a legit seller.  But it's your job to do all the diligence work.  What's it really worth? What are the true costs?  What are the real rents?

Don't worry about the investor's intentions.  Worry about your skill level to analyze the deal properly.

Okay, I want to ensure that I am analyzing this correctly because currently I am not seeing it as a deal.

Cash Flow = Rent - Mortgage -  Insurance - Taxes - Vacancy&Maintenance (15%)

Cash Flow (initial) = 1400 - 675 - 50 - 335 - 210 = + 130

Cash on Cash (initial) = 130x12 = 1560 / 17000 (14000 + 3000 attorney & additional costs) = 9.17%

Hypothetically, after a year I refinance and property is accessed at 165K.  I refi and have to keep 25% equity in the home.

Now I am in for 41,250 and my cash flow stays the same.

Cash Flow (after refi) = 1400- 665 - 50 - 335 - 210 = +140

Cash on Cash (after refi) = 1680/41250 = 4.7%

Not a deal for a buy and hold.

What I should do is get in cheap and flip it myself if its truly accessed at 165k.

How is this even close to a deal? Am I missing seeing value here?

Originally posted by Kristine Marie Poe:
 Actually, there is something a little different here than going to the bank.  Banks don't lend to own (hoping for borrower failure).  Banks don't do one year balloons.  Banks lend on value from 3rd party appraisals. Banks don't quote tax appraisal amounts as relevant to value amounts.

This might be a deal from a legit seller.  But it's your job to do all the diligence work.  What's it really worth? What are the true costs?  What are the real rents?

Don't worry about the investor's intentions.  Worry about your skill level to analyze the deal properly.

 All great points here.  

Joe, you have not included property management (even if self-managed) and your vacancy/maintenance number seems low.  I always like to include some for rent loss too.  Even though it is occupied, doesn't always mean the rent is going to be paid.

You have also not included anything to justify the final value of the property, such as decent comparable sales.  Just because the tax assessor says it is worth "x", does not mean it can be sold for "x", which is the truest indicator of value.

I did not spend much time analyzing your figures, other than a quick glance.  I would have passed on the deal already simply based on rental income versus purchase price.  I don't have a magic formula to offer, but I know that I buy for far less and collect far more.

I learned how to analyze deals by "pretending".  I would look for what I thought was a deal, analyze the heck out of it, then see if it made sense.  Get good at making every figure as accurate as you can before you pull the trigger.  I still use this exercise every day to analyze deals and I don't act until I figure the deal can't lose.  Sometimes favorable terms will push the purchase price up a little bit, but it still absolutely has to make sense as and investment.

@Joe Conklin

 Assessed value should not be assumed to be fair market value. Assessed value may reflect fair market value but most of the time it does not. You need to determine fair market value yourself by finding sales comparables of similiar properties (age, size, quality, etc) within the last 90-120 days.  To evaluate fix and flips or buy and holds, it's critical that you're accurate with your assessment of fair market value.

Would the balloon be legal under Dodd Frank? Yes, because it's not OO?

Originally posted by @P. Martin:

Would the balloon be legal under Dodd Frank? Yes, because it's not OO?

Balloons are still a thing.  Financing to investors for a commercial purpose often will include balloons.  Balloons are allowed to consumer lenders as I understand it, but the I think the shortest term is 5 years. 

So Freddie Mac requires that rental income show on two years worth of tax returns for rental income to be counted toward your income, or that you have 2 years of experience as a landlord. Conventional lenders will use overlays, so even if they were thinking Fannie Mae, they will still overlay the more restrictive Fredfie Mac requirements on rental income. So the advice to get at least three years before a balloon is worth considering if you think you want to go conventional. 

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