Actually, I lied! There are literally dozens of ways to finance the sale of real estate without using Bank Financing. The reason that I only mention five in the title is that this Blog will discuss the “Five Pillars of Creative Real Estate”. These Five Pillars are individual, independent Creative Real Estate techniques, but when one or more are combined, they provide dozens of ways to structure a real estate transaction. By learning the basic techniques of the Five Pillars, and then applying your individual creativity in combining them, you will be able to finance real estate transactions even if no bank financing is available!
Following is a brief description of each of the Five Pillars and examples of their use:
SELLER FINANCING: This is the most commonly used technique and one which was in use long before the first bank ever opened its doors, and was in use even before money was invented! The basic technique involves the Seller relinquishing title to the property to the Buyer in exchange for a down payment at the time of the sale and an agreement to make future payments. The documentation of the transaction can be in any contractual format, but the recommended practice is for the Buyer to give the Seller a Promissory Note outlining the amount to be paid, the interest rate on the unpaid balance, and when and how payments will be made. The Note is secured by a Deed of Trust, mortgage or real estate contract (depending on the laws of the various states) against the property being sold so that the Seller can repossess the property if payments are not made as agreed. In addition, to the property being sold, the Note can also be secured by other property owned by the Buyer.
Right here and now, I want to shatter the common myth that, “Seller Financing can only be used for Free and Clear properties”. Nothing could be farther from the truth! While the technique is an excellent way to sell Free and Clear properties (which according to the Census Bureau constitute 1/3rd of all residences in the United States), Seller Financing can be used when the property is subject to existing financing through means of an Assumption and a junior Seller Financed Note to the Seller or existing financing can be included in a Wrap Around (or all inclusive) Note in which the Buyer makes payments to the Seller and from those payments the Seller makes payments on the existing financing.
ASSUMPTIONS: This technique involves the Buyer taking title “subject to” existing financing and can involve: 1) Taking title only subject to the existing financing without a formal assumption of liability and thus, providing the Buyer with non-recourse financing: 2)Taking title with a formal assumption agreement in which the Buyer agrees to assume full liability for payment and agrees to hold the Seller harmless; and 3) Taking title with full substitution in which the beneficiary of the existing financing agrees to release the Seller from liability for payment and substitute the Buyer with the liability for payment. (It should be noted that the consent to the sale without invoking the “Due on Sale” clause, is not a substitution).
Because most existing financing made by institutional Lenders contain a “Due on Sale” clause, a common myth has developed that “Assumptions are illegal”. Again, nothing could be farther from the truth! There is nothing illegal about an Assumption. However, unless the beneficiary of the financing containing the “Due on Sale” clause consents to the sale, it has the option to call the full balance of the loan due upon its discovery of a sale made without approval. This has led to a number of methods in which the Buyer and Seller attempt to hide the fact that a sale has been made. I strongly recommend against attempting to hide the sale due to the fact that the subterfuge may actually constitute fraudulent conduct that is far more serious than having the loan called due.
Parties to Assumptions should either get the consent of the beneficiary (if they are concerned about the risk) or openly accept the risk. While it is always best to get the consent, in this day of hundreds of “brain dead” Lenders and no one knowing who actually owns the loan because of securitization, it is usually very difficult to get the consent, or to even find someone who actually has the legal authority to give consent. What I recommend is clear headed risk evaluation. With millions of properties in foreclosure, it is important to make a decision of “how likely is it that a Lender will call a loan due (and thus forcing another foreclosure if the Buyer can’t refinance) if the payments are being made, real estate taxes paid and the property being insured and maintained?” In my opinion the risk is so low as to be insignificant!
With millions of low equity, or no equity, properties available for sale, Assumptions, today in 2011, are an excellent way to acquire property without having to apply to a bank. Because many of these properties are subject to existing, low interest rate, fixed rate long term financing, in some cases it makes sense to pay more than the current market value of the property by simply agreeing to assume the Buyers debt. In such cases there will be no down payments, minimal closing costs and no reimbursement to the Seller for tax and insurance reserves. In such cases the Seller may throw in appliances, drapes, blinds and other personal property not normally included with the property, so that the true cost of purchase may be quite reasonable.
BARTER & EXCHANGE: When the terms, Barter & Exchange are used in reference to real estate, most people think only of “Tax Deferred Exchanges” allowed under Section 1031 of the Internal Revenue Code. Actually, Barter & Exchange are the foundation of every transaction if you examine the human motivation of the transaction. Every transaction occurs because a person desires something that they currently don’t have more than something they do have. In a simple real estate transaction, the Buyer desires the Seller’s real estate more than the cash they have, and the Seller desires the Buyer’s cash more than the real estate that they are selling.
However, real estate transactions happened long before money was invented and all pre-money transactions involved barter. But even today the foundation of the transaction is barter, its just that money makes the accounting easier. As a result, when financing is difficult to secure one way of making transactions is to barter goods and/or services for all or part of the purchase price. The key to finding ways of using Barter & Exchange is to find out what the Seller would do with the cash if the property were sold for cash and then have a Buyer offer to make an exchange of what they own (or can acquire through Barter & Exchange with others) and then transfer that to the Seller in exchange for the property. Remember that services can be exchanged.
One of the most creative Barter transactions that I have heard of, involved a developer accepting a $1,000 worth of gift certificates for haircuts from his barber as the down payment on a lot he sold to the barber. He used some of the certificates for his own haircuts, but traded others for items he needed or wanted. This was a real “win-win” transaction for both parties. It allowed the developer to sell one of his lots and start receiving monthly payments (the balance of the purchase price was Seller Financing) and it allowed the barber to buy the lot he wanted while advertising his services to people receiving the gift certificates from the developer.
SHARED EQUITY: I define a Shared Equity transaction as one in which two or more persons, not from the same household, join together to acquire real estate. As such, a Shared Equity transaction could range from the acquisition of a large commercial transaction by a Real Estate Investment Trust, with thousands of share holders, to a purchase of a rental home by one party providing money and the other providing services. The fundamental principle, is that two or more persons establish a business relationship in which benefits and obligations are shared in a way that allows a real estate transaction to occur that neither party would do alone.The three major types of Shared Equity transactions are:
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Group Ownership: This is the broad category of investment entities such as REITs, LLCs, Corporations and Partnerships. This is a whole subject on to itself and often involves the securities laws and is therefore beyond the scope of this article.
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Investment Ownership: A typical example of this form of transaction involves the party who provides services of finding, acquiring, managing and selling the property in return for a share of the profits and an investor who provides the money to acquire the property. In the simplest case this would involve only two parties, but often the investor role may consist of several persons. There is no limit to the ways in which such transactions can be structured. A good example of a co-ownership agreement for this type of acquisition is included in the Forms, Letters & Contracts workbook published by Fixer Jay. You can get this at Fixer Jay’s Co-ownership Agreement.
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Occupancy Ownership: During the double digit interest rates of the late 70’s and early 80’s, Shared Appreciation Ownership was fairly common. In these arrangements, an investor (often a parent) put up a large down payment in return for a share of the value appreciation and the party occupying the home made the monthly mortgage payments and took care of the property. Examples of this type of ownership are described at Shared Appreciation Ownership.
OPTIONS & RENT TO OWN: Actually Options can exist by themselves without any rental, but since Rent to Own Agreements (sometimes called Lease Option Agreements) always contain an Option to Purchase, I have included them as one topic.
Options are a very powerful and flexible form of contract that grants one party the right to purchase property at some time in the future at an agreed upon price and terms. Typically the person acquiring the option makes a payment to the owner of the property for the purchase of the option. Because it is a deferred transaction, neither party experiences income tax consequences as a result of the payment until the option is exercised or it expires without exercise. Options are a great way to use maximum leverage to benefit from anticipated appreciation in property values. If the property appreciates in value as anticipated, the holder of the option can exercise the option and acquire the property, or sell the option to another investor at a profit. Although not as common, there are also put options in which the owner of the property would pay an investor for the guaranteed right to sell the property in the future at a guaranteed price and terms.
In periods in which financing is difficult to obtain by potential buyers, Rent to Own Agreements are used. They allow the Buyer to immediately occupy the property as a rent paying tenant, with the option to purchase the property in the future at an agreed price and terms. In such arrangements some portion of the rent may be credited against the purchase price and timely payment of rent is usually a pre-condition to the right to exercise the purchase option.
DON’T WORRY IF THE BANK SAYS “NO”! By using the Five Pillars of Creative Real Estate, it is always possible to find a way to finance a transaction between willing and motivated Buyers and Sellers who are willing to be creative and flexible.