Acquiring income producing property is one of the best ways to create wealth and achieve one’s long term financial objectives. However, at some point, many investors tire of managing their properties. If you are an absentee landlord, this may experience this soone r than later. Of course the natural question is…. if owning real estate is not as glamorous or as easy as is promoted, what else does one do to create wealth? The stock market? Well maybe not—this year’s average returns are roughly 2% with a lot of risk like playing in a casino.
For example two seasoned investor friends bought several lower price band rental properties in Birmingham, Chicago, Indianapolis and Milwaukee. They were convinced their target 20% cap rate was very a reasonable. Now after 2 years, multiple property managers, handymen, evictions, code violations, phantom tenants etc, they saw their very easy projected cap rate drop to more like 6-7%. The stress, worry and frustration really began to take their toll.
Friend #1, Jason, decided to just bail and sell. He is putting his money into group foster homes. If professionally operated he will generate a serious return and satisfy his passion-to help kids, get his wife out of work, not to mention the serious cash flow. Friend #2, Dan, has decided to sell his properties and be the bank with seller financing. He decided to turn all the tenant worries into mail box money. He doesn’t want a job, just the cash flow.
Dan and I discussed the variables. As a seasoned note guy and seller carry consultant I made several recommendations to Dan on how to structure the transactions. We discussed the pros and cons. How to structure the transaction– to make a long term play with minimal risk. I was able to utilize my years of real estate experience and note structuring basics to demonstrate to him how, if structured properly he could generate a safe and reliable 10%+ return on his investment. A quantifiable and predictable rate of return.
When structuring a seller carry back, Dan is taking a very proactive approach—focusing on six primary underwriting areas. While his goal is to quickly sell his rentals, above market pricing, he wants to mitigate risk and maximize his return and still keep his options open in the event he wants to sell his seller carry back note in the future and avoid a deep discount(haircut) on the note resale. He is not just selling to anyone with a pulse thus minimizing risk and no stress .
Dan is implementing the following underwriting criteria.
- The Borrower –pulling credit and making sure the borrower is putting down at least 15-20%, thus the buyer will be a bankable risk and has real skin in the game.
- The asset value—sell the asset at no more than 10% over market value
- Interest rate—charge at least 8% if not 10%, but still within the guidelines of Dodd-Frank
- Term—keeping it as short as possible-10-20 years
- Paperwork—use a title company to draft the note, deed of trust/mortgage and provide a closing statement proving the down payment. Utilizing a MLO to qualify the buyer and work within the current guidelines of the Dodd-Frank Act. FYI–buyer pays for this service.
- Escrow— Require escrows for taxes and insurance
- Proof of monthly payments—setting up a loan servicing company to collect the monthly PITI and disburse monthly as instructed. The buyer pays the servicing fee.
The net result is:
- Never worry about dealing with tenants or property maintenance
- Maximize the sales price
- Defer capital gains
- Keep your equity working for you usually at rates 35x higher than with a bank CD and significantly safer than the stock market
- Collect a predictable passive income stream
- Secured by a property you understand and whose value you know
- If you or your heirs need Cash, sell all or part of the note
Buyer defaulted? Take it back and sell again.
When it is all said and done, which is better a rental or a note?
Seller financing is an under utilized tool and is here to stay.
Dave Franecki is the Fund Manager of Capstone Capital USA.
Capstone Capital USA focuses on acquiring Performing and Re-performing 1st position notes and structuring seller financed transactions.