8 Factors to Consider When Structuring a Real Estate Seller Financed Loan
Seller financing is exactly what it sounds like: the seller or owner of a property will finance the deal for you, just like a bank or traditional lender.
If a seller is openly advertising seller financing, be careful. The property is likely in bad shape. Don’t immediately discount a deal if it is advertised with available financing, but do expect a fair amount of distress. Once you have analyzed the deal, you’ll be ready to make an offer for seller financing.
Here are eight factors to consider when structuring the loan.
#1: Interest-Only Payments
If a deal does not have good cash flow at the beginning, try negotiating interest-only payments. This allows you to keep more rental income to service the property and to allow for cash flow. You can even offer to make interest and principal payments when the deal begins to make more money.
An interest-only (IO) loan is ideal when the monthly payment is less than if you were to pay principal and interest. The lower payment will allow you to produce more cash flow while maintaining the same amount of rent due.
#2: Defer All Interest and Payments to the End of the Loan
If a property needs renovations, then defer all or some of the payments to the end of the loan. If the seller wants to receive a check at any point, you may also try deferring payments during the repositioning of the property.
For example, if you decide a property needs X amount of repairs that will take X amount of time, then you’d inform the seller that payments will be added to the purchase price and paid at the end of the loan. This will allow you to complete the necessary repairs while the property is not cash flowing.
#3: Interest Rate
Try to get the best interest rate you can negotiate. You also need to offer an interest rate that will be attractive to the seller.
It’s not unusual to pay 2-3 percent more in interest than the current rates at your local bank. This isn’t expensive when you consider the benefits of the seller financing the deal. Whatever interest rate the seller may want, you need to make sure the interest plus principal allows you to cash flow the property after you’ve completed the repairs and leased the units.
#4: Down Payment
Try to put down as little money as possible but just enough to make the seller comfortable with the deal. If a property needs repairs, then follow this rule: use the down payment to make the repairs.
Decide how much cash it will take to complete the needed renovations. You will make this decision during your analysis and inspection period. Instead of giving the seller the down payment directly, use that money to fund the needed repairs. You don’t want to give the seller a cash down payment and then be in need of money to do the repairs.
Once you obtain the property, you’ll likely be responsible for the repairs and cost of operations. This is okay because you’ll be using the income the property produces to do these repairs. The difference between the expenses and what the property produces is the cash flow.
Be prepared for any larger repair expenses. These are capital expenditures or cap ex. Budget for them by setting aside a capital expense reserve account. Take a portion of income from the property and set it aside to pay for these expenses. Set up an escrow account outside of your normal operating account for this money.
If you’re going to be a new owner with seller financing, you’ll likely need to get your own insurance policy. Contact local agents to get the best prices. Make sure price is not the only factor you consider when getting insurance. Cheap insurance won’t come with much coverage. It’s hard to give a rule of thumb for insurance pricing per unit as the information changes so quickly, but in general, it’s important to talk with insurance agents when you’re analyzing deals.
#7: Tax Benefits
As the new owner of record, you will now receive the tax benefits of the property. This is good for you. If the owner wants to retain the tax benefits, then a Master Lease Option (MLO) may be better than seller financing. Consult an accountant to discuss your tax strategies before the closing. I suggest you do this during your due diligence period on the property.
#8: Record the Title
This is a tremendously important step in seller financing. I suggest you have a real estate attorney create the contracts and documents for any deal. You’ll be able to find seller financing documents online, but you must have your legal counsel review everything.
Next, have an attorney or title company conduct the closing. They’ll do a property title search to make sure the seller can convey a clear title to you. An attorney/title company will clear the title. If any existing liens appear, then you will be notified before you close.
This article was adapted from the book Creative Cash, written by Bill Ham and presented by Jake Stenziano and Gino Barbaro. With over 25 years experience operating vertically integrated real estate businesses, and over $100 million in assets under management, Bill, Jake, and Gino strive to teach others the strategies that have allowed them to become financially free.