Sunday, June 14, 2020

My First Seller-Financed RE Deal, Under Contract

What an incredible year it has been.  And we're only half way through.  Before I talk about my first seller-financed RE deal, the why, how, etc., I want to make something clear for anyone new to my blog:

I support BLM, police reform, science, education, the LGBT and immigrant communities, am pro-choice (not pro-abortion as some may like to spin), pro-capitalism, not very religious...actually not religious at all, but I support everyone's right to be religious, etc., AND I cut my sandwiches into rectangles.  There, now you know.  If that puts you off...see ya!

  House is 3 bedrooms, 1 bath and roughly 1,200 sq. ft.

Why RE Investors Seek Out Seller-Financed Deals 

There comes a time when a RE investor will have too many properties in the books for their income, and banks (who dole out conventional loans/financing) will consider the buyer "over-leveraged."  Even if a RE investor has very little in the form of debt (car is paid off, no other credit card balances, e.g.), if their W2 income hasn't gone up, they will cap out eventually.  It's also relevant to note that banks only count a certain percentage of rents as "income" for their debt-to-income calculation.

For example, as a middle-school teacher, my salary is around $94K.  Unless I ramp that up, by returning to administration (I don't want to do this) for example, I'm no longer able to get financing conventionally, despite having four rental properties each cash-flowing and providing me with "other" income.  If I add my wife, Jessica, to the loan application, our collective income is higher, improving my numbers.  Jessica is currently on month 18 of her new career as a realtor, however, so there is not much track record of her income yet.  Only one year's taxes so far.  Everyone's situation is different, of course.  But all RE investors face this "problem" of financing at some point.  This is where finding seller financing comes in handy.

What is Seller-Financing?

Simply stated, seller-financing is the equivalent of a home seller choosing to become the bank.  Other ways of saying this OR of looking for it online in searches include, "seller will carry" and "seller will hold."  For personal or business reasons, a seller may choose to carry/hold a note (mortgage) for a buyer.  The buyer pays the seller (not directly, usually a loan servicing company is involved) a monthly payment of principal plus interest.  Just like in a conventional loan, the buyer is responsible for insuring the property, paying property taxes on it, etc.  Unlike bank financing, the seller can negotiate a higher interest rate, length of the loan, and other lending terms with the buyer.  Because a bank is not involved, both buyer and seller pay less in closing costs.  Buyers also don't have to meet the stringent lending standards of a bank.  The seller decides what he/she needs in the form of financial support/statements/checks to qualify the buyer, i.e., the borrower.

My Deal...How I Came To It

About 10 days ago, I got on Craigslist in Little Rock, Arkansas.  Craigslist is a good place to find off-market RE deals.  First question:  Why Little Rock?  I have done business with two "turnkey" RE companies in the Memphis, TN area.  One of these companies started selling turnkey properties in Little Rock, and is heavily pushing the area to its vast network of out-of-state investors.  So, just reading the future here.  If this company keeps selling in Little Rock, at slight premiums, the market will go up in the area.  This company also asks that after your fourth deal, you do 25% down payment for each subsequent deal.  They work with banks that demand this of investors after deal number 4.  I don't like paying more than 20% on RE deals, preferably less if possible.

Now, because I'm not in the area, and I don't like flying across the country, especially to a hot and humid place like Little Rock in the middle of the summer, I look for particular properties on Craigslist:

1) They must be ready to be rented in turnkey rehab condition.  Images will show this.
2) The owner must be the one posting the ad.  You must confirm this.  I cannot stress this enough: MAKE SURE THE SELLER OWNS THE PROPERTY OUTRIGHT.  It won't work if the seller still has a mortgage on the property.
3) Communicate with seller by phone after the seller replies to your inquiry.  Get a feel for the property from the seller, e.g., the type of area it is in, what they rent the property for (if currently rented), and how the seller arrived at their sales price.  It's your job (once you have the property address) to find area property values, appreciation potential based on market outlook, and if anything major in terms of repairs are needed on the property.  *Note, sellers may volunteer all this info, but only a property inspection by a legit inspector can tell you for sure.

I found one property that met my visual and description criteria.  There were several pictures backing up what the seller was stating in the blurb.  I emailed him,

"Hi, X,
I'm interested in your 3, 1 home.  Would you consider a seller financing deal?  I could swing up to 20% down ($15K) and we can discuss terms for the remaining $60K?"

In retrospect, I should've left off how much I was willing to do for the down.  But, the reason I offered 20% immediately was because the seller hadn't specified he'd do seller-financing.  The ad mentioned two contractual options, a) cash purchase, or b) rent-to-own.  The seller boasted having put in a new roof, HVAC system, and kitchen cabinets.  He mentioned having had the hardwood floor resurfaced, adding new kitchen tile flooring, and installing a new water heater.  Lastly, he also stated that he had just painted both inside and outside.  This gave me the impression that the seller/flipper had perhaps over spent on the rehab and needed some money back badly.  I doubt he would've taken less than 20% down.  This allowed me to get his attention too.

To my surprise, the seller agreed to consider the possibility of carrying the paper.  He gave me his telephone number and name so we could talk off Craigslist.  Why was I surprised?  Many sellers don't want to take on the responsibility of loaning to random people.  They may not understand the process, and are fearful about being scammed.  I lucked out though.  The seller would convey to Jessica and me while on the phone that he looked up seller financing on Google, learning how it works, prior to sending me his reply via Craigslist.  That was a great sign.  One of the difficulties of doing these types of deals is having to educate the seller.  Many sellers turn to family, accountants, friends, etc., who may not understand anything about real estate, and end up getting misinformed.

Deal Terms

On the phone we talked terms.  First a little friendly conversation to relieve the tension.  Jessica and I shared a little about ourselves and our goals.  The seller was willing to share a little about himself too.  Then we got to business.  Questions we asked him:

1)  Why are you looking to sell?
2)  How did you arrive at your selling price?
3)  Do you own the property outright?
4)  If we did a title search would there be any liens to his knowledge?

The seller was savvy enough (to his credit) to understand his position of leverage.  Namely, how to get a better rate on the note.  For example, we started by offering him 5% on a 30-year amortized schedule for payments with a balloon payment due at the end of the 5th year.  This would've been the best case scenario for us.  We had already agreed to the 20% down so we were stuck there.  He countered: "For 30-year amortized payments, I will need at least 7.5% on the loan with 5-year balloon payment."  See...he was smart enough to know the amortization was his leverage.  If you're lost, a 30-year amortization leads to smaller monthly payments.  Sellers in a seller-financed deal can ask for 15-year amortization or even 10-year!  The payments would've been too high for us.  As an investor, you want to pay the least amount every month so you can cash-flow.  Jessica and I countered with 7% rate, but he wouldn't take it.  Thus an agreement was reached with terms being:

Sales Price: $75K
The property is in a B to C class neighborhood, so it appraising right now at this price is probably not happening.  Comparing similar properties in the area, sales that is, I think the property is worth at least $65K, maybe a bit more.  Again, without an appraisal, there is no knowing for sure.  The Zillow forecast (I know you can't trust Zillow) calls for 11% appreciation for 2021.

Down Payment: $15K
Loan: 5-year, 7.5% interest rate, on a 30-year amortized schedule
Earnest Deposit: 1% of sales price or $750, to be applied to down payment

Now What?

We had no idea how to proceed beyond this.  This was our first seller-financed offer.  The seller too was doing this for the very first time.  I knew a written offer was next.  But how to go about getting a legal sales contract for the state of Arkansas?  I looked online.  I found some decent templates.  Jessica and I thought about just doing it ourselves.  But then we reconsidered.  We considered hiring a RE attorney next.  One RE attorney gave us a quote: $2,000 retainer and $300/hr. thereafter.  Ha!  No way.  In theory, hiring a lawyer for your very first time sounded like the prudent thing to do.  But they charge way too much.  If the deal had been for a $500K or more property, then maybe.

Then Jessica got the idea of talking with a local Keller-Williams realtor.  Jessica works for Keller-Williams in Carlsbad.  She found an agent there.  The agent happened to also be an investor.  That's what you want!  If you're not going to travel to the state to visually check out the property yourself, having an investor-realtor is the next best thing.  Not only will they advocate for you, but they will be present during the inspection, and tell you if the property is a dud or not.  Just because you agree to terms doesn't mean you can't back out.  The sales and purchase contract specifies all sorts of contingencies (termite clearance, etc.).

We hired the agent (agreeing to 2% commission) and she came with a network.  For example, she asked us to work with Stewart Title.  Stewart Title has an in-house lawyer who charged only $200 for the promissory, mortgage note portion.  The seller normally pays for this since it behooves them to have ownership of this part of the process.  Both buyer and seller have closing costs, and we agreed to pay our own side.  Our closing costs are roughly $954.  That's it!

Bottom Line

I expect to put at least $20K into this deal.  Here is a breakdown:

1) Down payment: $15K
2) Title and closing costs: $954
3) Home Inspection: $500
4) Realtor: $1500
5) New dishwasher: $500-$700
6) New stove: $500-$700

I used Bret Whissel's amortization calculator to estimate my principal AND interest payment: $419.53.

My cost to insure the property will be: $718/year or $59.83/month.

The property management company I will hire charges 8% of the rent amount.

Properties in the area rent for $750 to $800.  So, let's say it rents for $775.  Prop. mgt. fee would be 0.08 x 775 or $62.

Property taxes are currently $444.0/year or $37/month if impounded.

Total monthly costs (not including any maintenance) are:

419 + 59 + 62 + 37 = $577/month

Cash-flow: $775 (using conservative rent amount) - $577 = $198, call it $200.

Cash on Cash return =

$200 x 12 = $2400.
$2400/$20000 = .12 x 100 = 12%.  Not bad.  And it would've been better if I didn't have to buy the two appliances.

Realize this.  Most of the above expenses, with the exception of the down payment, will be tax deductible!  Also, my exit is going to be a conventional refi loan in about two years.  Will interest rates be crazy high in 2022?  Heck no!  We're barely starting our Covid19 depression.  So, in two years or less, I will seek out a cash-out mortgage (to pay off the balance of the loan to the seller) and lower interest rate, improving my cash-flow position.  Maintenance expenses aren't going to be that bad with all the new upgrades to the house. 

 I will keep you all up to date on this deal.  I've learned so much already, and I hope that by reading this, so have you!  Until next time.

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