What type of financing is this called? Is it legal?
Appraiser · Birmingham, AL · Member since 2008 · 54 posts · 4 votes
I'm not sure the technical words to do what I want to do but I'm hoping you guys can shed the light (as always).
I want to sell some of my rentals through some kind of owner financing or a rent to own type deal.
What is the best way to structure this? I want to get a down payment and monthly rent for a 5 year period while the tenant is responsible for repairs and maintenance. I know that if it is a "sell" then I would have to foreclose which is an expensive and time intensive endeavor. But I was hoping to structure this and after they finish their payments I can just hand over the deed.
Is this legal? And if it isn't, what is the most profitable way to do this?
You are describing a lease option contract. First, the most important thing about this type of contract is it is actually two contracts...a lease, and an option.
1 - Lease: Typical Lease. Lease it to the tenant just like you would otherwise. Don't make it a 5 year lease though. Make it a series of one year leases that have to be signed 2 months before the end of the current lease. That gives both of you an out if you or your tenant decide either of you want out. You don't want to be locked into a tenant for more than 1 year at a time.
2 - Option: This is a contract that gives the buyer (tenant) the right to buy the property at an agreed upon price over a period of time...the agreement has a "shelf life"...usually 1 year, but again don't give a 5 year option. You can give a series of 1 year options with an escalating price per year.
Important point: DON'T CONNECT THE TWO CONTRACTS. KEEP THEM SEPARATE.
This is a very simple overview. It is more involved and before you enter into it you should get a better handle on how Lease Options work. My suggestion is to do a Google search for Wendy Patton.
The foreclosure process is lengthy and expensive. I don't want to have to do that. @Yvon N.
You are describing a lease option contract. First, the most important thing about this type of contract is it is actually two contracts...a lease, and an option.
1 - Lease: Typical Lease. Lease it to the tenant just like you would otherwise. Don't make it a 5 year lease though. Make it a series of one year leases that have to be signed 2 months before the end of the current lease. That gives both of you an out if you or your tenant decide either of you want out. You don't want to be locked into a tenant for more than 1 year at a time.
2 - Option: This is a contract that gives the buyer (tenant) the right to buy the property at an agreed upon price over a period of time...the agreement has a "shelf life"...usually 1 year, but again don't give a 5 year option. You can give a series of 1 year options with an escalating price per year.
Important point: DON'T CONNECT THE TWO CONTRACTS. KEEP THEM SEPARATE.
This is a very simple overview. It is more involved and before you enter into it you should get a better handle on how Lease Options work. My suggestion is to do a Google search for Wendy Patton.
@Joe Villeneuve Thank you for the detailed response. Could I make the lease for 5 years and then the sale price $1 on the separate contract?
I'm just not sure of a fair way to structure this for all parties.
@Christopher McGuire There are more moving parts to your situation than with a typical L/O deal.
What are you selling the property to them for?
What are you charging for Rent?
What is your cash flow when charging that rent?
House is paid off. I paid $10,000 for it. They have agreed to a purchase price (however I want to structure it) of $25,000.
Cash flow is poor. The fair market rent would only be about $400 and this house will need some capex over the next 5 years. It's not a house I want to hold long term.
@Christopher McGuire What I'm seeing on the surface is an ugly deal for you...but, that doesn't mean a little creativity can't make it work.
Let me see if I got this straight:
1 - You have $10,000 in cash in the property already, but no debt.
2 - You can only rent it at $400/month, and will lose money every month until you "unload" the property...which could be 60 payments of losing money (5 years).
3 - The Tenant/buyer has agreed to buy the property from you in 5 years for $25,000
4 - You anticipate losing more money over those next 5 years through added CAPEX
5 - You don't want to hold the house long term.
Questions:
1 - When you first bought this house, what were your intentions to do with it?
2 - How much would you be losing every month with that $400/month rent?
3 - How much is your buyer able/agreeable to paying up front for the house (it's called th option consideration)
when I have done this on some properties, I have a rental agreement that says that what the sale price is and that it is paid for in X per month for whatever months. I then have fine print, that they sign, that says that if they do not pay as scheduled, all payments including any down payments are considered rent and the contract is voided. They have to pay on time, maintain the house, etc.
I calculate the monthly payment with an AM schedule + tax and ins.
1. It kinda fell in my lap. It's worth about $17,000 as is. After it is fixed up, it will be worth about $20,000 - $23,000. That's why it seemed like a good buy.
2. I don't like the location of the house so I'd rather not have it in my rental portfolio. After expenses I'd probably make $100 a month.
3. He has agreed to purchase the price at $25,000 but can not obtain financing. He does have $2,000 - $3,000 to put down.
Thanks for your help @Joe Villeneuve
In residential transactions an owner may not pass repairs off to the tenant. There are tax benefits an owner enjoys by owning which offset the capital expense. So, that part has some holes. A lease option is a solution but extending out 3 years plus will provide the tenants with protections similar to foreclosure. Moral of the story, you can not circumvent foreclosure.
Barring details about the tenant buyers, why not just mortgage/deed of trust the property to them for the agreed price at a reasonable interest rate and be a lien holder?
You could structure the option in that manner where you credit certain portions of the rent over the term and upon execution of the option roles change, you finance them and credit that portion of the rent as their down payment, etc. That I would judge based on what they could offer upfront in a transaction.
One other general thought, the default concerns are valid and capitalizing the enforcement of secured interest or alike is always touch when dealing with lower value property. Such is the nature of that beast. If you ensure affordability to the best you can by the buyer, that will be your best defense against that risk. You will not fully be able to remove the risk though.
@Christopher McGuire As I look into my crystal ball (OK, it's plastic, but it looks good), here's what I see in your future.
1 - You sign an agreement for $400/month, and an option agreement for $25,000 to be paid in 5 years, and accept $3000 up front as an option consideration.
2 - Over those 5 years, you will have CAPEX that will cost you around $10,000 (I'm assuming a new roof, furnace, HWH, and at least one more larger expense). This will mean your overall numbers will be:
a - Income from Cash Flow = $6,000
b - Income from Option Consideration = $3,000
c - TOTAL income = $9,000
d - Cost to buy = $10,000
e - CAPEX = $10,000
f - TOTAL Cost = $20,000
g - NET Profit/Loss = (-$11,000)
3 - After 5 years, your tenant/buyer doesn't qualify, and you are $11,000 in the whole on a house that you don't want to hold long term.
So, now that I've ruined your night (or not), here is what I would do if this was my house. I'd either:
1 - Rent it to someone else, and sell it to another investor with the tenant in place as a Turn Key property.
2 - Rent to the current tenant, one year at a time, and when the tenant thinks they are ready to qualify, sign a 1 year option...or just sell it to them then.
If you ensure affordability to the best you can by the buyer, that will be your best defense against that risk. You will not fully be able to remove the risk though.
The wisest words from our real world lender/note expert. Happy New Year Dion!
House is paid off. I paid $10,000 for it. They have agreed to a purchase price (however I want to structure it) of $25,000.
Cash flow is poor. The fair market rent would only be about $400 and this house will need some capex over the next 5 years. It's not a house I want to hold long term.
You want to watch out for accidentally setting up your buyer to fail. You say the house has known repair issues in the near future,. Make sure you qualify your buyer so that they can afford the monthly payment to you and that they have access to cash/resources for the repairs, Buyers with a small down, low income and no savings default on these kinds of properties everyday.
I'd stay away from a lease option agreement on such a property. You can't put tenants in a property and expect them to pay/manage repairs. No matter what you've heard elsewhere. :) I'd go with straight seller financing. Get a downpayment, carry back a note secured by a mortgage for the rest, 5 year balloon. Be mindful that Dodd Frank applies if you sell to owner occupants.
I came in here ready to share. Instead, I find myself more educated by @Joe Villeneuve and @Account Closed . Thanks, guys!!
@Account Closed Agreed, which is why my solutions were:
"I'd either:
1 - Rent it to someone else, and sell it to another investor with the tenant in place as a Turn Key property.
2 - Rent to the current tenant, one year at a time, and when the tenant thinks they are ready to qualify, sign a 1 year option...or just sell it to them then."
You want to watch out for accidentally setting up your buyer to fail. You say the house has known repair issues in the near future,. Make sure you qualify your buyer so that they can afford the monthly payment to you and that they have access to cash/resources for the repairs, Buyers with a small down, low income and no savings default on these kinds of properties everyday.
I'd stay away from a lease option agreement on such a property. You can't put tenants in a property and expect them to pay/manage repairs. No matter what you've heard elsewhere. :) I'd go with straight seller financing. Get a downpayment, carry back a note secured by a mortgage for the rest, 5 year balloon. Be mindful that Dodd Frank applies if you sell to owner occupants.
Agreed with K. Marie...
And from a purely financial standpoint, a straight sale with $400 monthly payments for 60 months will generate a healthy 39% IRR. Even if he only pays for three years, you earn over 20% compounded, and if he only pays for 2.5 years, you earn nearly 11% compounded.
So, as long as you set him up for at least short-term affordability (hard to tell what 3 years will bring to a lower-income buyer), a reasonable return is pretty secure.
@Account Closed Agreed, which is why my solutions were:
"I'd either:
1 - Rent it to someone else, and sell it to another investor with the tenant in place as a Turn Key property.
2 - Rent to the current tenant, one year at a time, and when the tenant thinks they are ready to qualify, sign a 1 year option...or just sell it to them then."
I think the turn-key option would be misleading. Nothing turn-key about a property with known pending repair/capex issues. Is turn key with $400 rents even a thing?
@Account Closed never stated what these repairs were. I just assumed about $10k over a 5 year period.
If he does what's needed now, and he has positive cash flow ($100/month still qualifies), it's a Turn Key deal to an investor.
What are the repairs? Can your buyer afford them?
For the transaction you are describing this sounds more like a Contract for Deed or Land Contract. with a land contract you retain title but sign a contract that says you will transfer title after the last payment is made. In most states, under a CFD/LC there is not foreclosure, if the borrower defaults they have a cure period and then you can file for eviction. Since this would be a sale you need to make sure they qualify under Dodd Frank and ability to repay requirements.
@Christopher McGuire stated earlier that they could not obtain financing, they may still be able to meet ability to repay requirements.
A side note to sell for 25,000 with 3,000 down and 60 months at 4% gives you a payment of $405.16. If you change the terms to 8% for 100 months the payment drops to $302.13.
PS I am not a lawyer and don't play one on TV so check your local laws on this one.
Thanks! I'll see if it is legal in Alabama.
I will disagree with the advice to pursue this transaction as a Contract for Deed or Land Contract. There is not a trend in a majority of states to treat those contracts as executory (not secured by collateral) as opposed to secured. It is indeed quite the opposite. Even further to that regard, bankruptcy court will also tend to treat those contracts as secured as that seems to follow the intent of Congresses rules for distressed home owners.
Without debating the semantics of it all, the short and easy is actually for you to treat the transaction as a secured financed sale. Alabama allows for a Deed of Trust instrument which will grant you a power of sale. Within that notion the idea of a Contract for Deed or a Land Contract arrangement is just too cumbersome and legally problematic. There is a higher chance of having to defend a Contract for Deed/Land Contract for the treatment of an excutory contract than it would take to enforce a Deed of Trust. So to that regard it really doesn't make sense.
In addition, from the thread the intent which seems to be fairly clear is the OP wants to remove in full his on-going and future liability to the property and its repairs. That is precisely what a secured financed sale would do and the opposite of what a LC/CFD would do.
Right there is the recommendation issue that often occurs. One can not have the best of both worlds. LC/CFD tend to be a little misleading in the public eye in that sense. They are seen as shortcuts or circumvention to equities which are afford either through law or through interpretation of function of the contracts themselves. You can not act like a Mortgage/Deed of Trust one minute and then act like an Tenant Agreement the next. The court will look past the what the name of the agreement implies to how it was supposed to work and if it quacks like a mortgage they will treat it as such.
I also do not want to gloss over an important concept in the thread. The As Is Where Is value of the subject property is $17,000. It also needs repairs. Upon repairs it is believed it will be worth $23,000. So, if the OP is not going to capitalize those repairs, which could be done and still finance the property then the sale price should not reflect a future value contingent upon those repairs. That is predatory in nature. It is asking for the Buyer to not only do the repairs on their own dime but to pay for the repairs that are not even done. A double whammy, if you will. That is also barring the additional $2,000 that I have no idea where it came from if the talked about sale price is ultimately intended to be $25k. That is all just a bad idea.
It is always better for everyone to just do a good deal and not take advantage of folks. That is what all that inflated price is, taking advantage of a less than credit worthy buyer.
For the sake of not being Dion the Grinch here is what I would propose:
- a closed end loan with a one time additional advance
Sale Price: $17,000
Down Payment: $2,000
Loan Amount: $15,000
Rate: 8.0%
Am/Term: 60 months
P&I Pay: $304 (gives room for tax and insurance)
LTV: 88%
Pocket the Down Payment.
After 12 consecutive on time payments as agree then you additionally advance $3,000 (or as agreed) specific to the needed repairs. At that time, the loan balance will have been paid down to $12,458. You will have received $2,542 of your principal back from a total of $3,650 in total payments. Within these 12 months you have earned back over 50% of that initial investment. (Down payment plus period payments) Technically, they financed the repairs for you as you received $5,600+ in 12 months. You are just taking a little over half of that and putting it back in the deal to earn more interest. (You can still go spend $2,650 +/- somewhere else)
So, then, why hunt for a new investment to secure your money when you already have one you are working with? Answer - Don't use this one.
Recast the loan adding the repair total to the loan amount so it looks as follows:
Loan Amount: $15,460 (rounded up)
Rate: 8.0%
Am/Term: Plus 12 months (60 months for this loan again)
P&I Pay: $314
LTV: 77% (at $20k ARV - 62% at $25k)
So, with the right kind of creativity, you can 'actually' create a real win-win and not just talk about it.
You take a prudent approach to lending your money, making them earn the second advance of funds by making 12 on time payments. You are secured your interest with moderate equity at first (12%) and then much better equity in round two (22%+). You give the Borrower/Buyer a better incentive to pay. As such they have pride of ownership actually being invested in their house and making it better at the same time paying you.
No need to try and make a dollar on equity that does not exist with an inflated price. By playing with a variance of $10 (difference in the two payment amounts) in the Borrower's capacity to pay and earning interest for an additional 12 months, you earned more equity in security (15% @ ARV $25k) while they earned more equity in their home through both payment and improvement. It saves you the 'hassle' of finding something additional to do with your return while making you more return. (Obviously ensure you have the second round advance set aside when it is due) Most of all, I hope you also see, we did not (intentionally) max the Borrower out in down payment or in period obligation and we still come out pretty far ahead.
Best of all, you just earned a nice 35% return on your $10k over 6 years. (Includes re-advances)
You may have to tweak that a bit but I am guessing you see the point.
Happy New Year and Best of Luck.
You must be very careful with this transaction. AL Courts will be in favor for the tenant or potential buyer in the case all day every day. I've done a few deals as you are describing and I won't do any more. Reason being, the tenant/potential buyer talks a good game up front but they always run out of money along the way. In the Metro area most who own homes are investors. I strongly suggest you mark up the house a little and sell it or as described before, place a tenant in the house and sell it as a turn key model. You will save yourself loads of stress and money along the way.
Feel free to reach out if you want to discuss further.
You must be very careful with this transaction. AL Courts will be in favor for the tenant or potential buyer in the case all day every day. I've done a few deals as you are describing and I won't do any more. Reason being, the tenant/potential buyer talks a good game up front but they always run out of money along the way. In the Metro area most who own homes are investors. I strongly suggest you mark up the house a little and sell it or as described before, place a tenant in the house and sell it as a turn key model. You will save yourself loads of stress and money along the way.
Feel free to reach out if you want to discuss further.
Christopher,
Help me understand what you mean here.
How in one breath is the OP supposed to be careful of courts ruling/siding with tenant injustices or inequities and on the other sell something for what it is worth?
How is that justified?
Should I sell something to you at an inflated price because I can't actually handle the inherent risk of venture I wish to participate in?
Selling at FMV is fine. Selling with Owner Financing is fine as long as you don't get squeezed by the Dodd Frank Law. Selling with a lease option or rent to own has a strong chance of getting messy in Alabama.
Selling at FMV is fine. Selling with Owner Financing is fine as long as you don't get squeezed by the Dodd Frank Law. Selling with a lease option or rent to own has a strong chance of getting messy in Alabama.
Well, what do you mean when you say "I strongly suggest you mark up the house a little..."? Inflate the price? How is that justified?
Also, how is Dodd Frank "squeezing" you?