The benefits and burdens of behaving like a bank

Selling a house with owner financing may be unfamiliar territory for many real estate investors, but anyone who plans to sell property against the current background of tough lending conditions may want to brush up on the basics. Understanding the concept of seller financing is easy: the seller assumes the role of a bank and finances the buyer’s purchase. The decision to provide seller financing, however, can be much more difficult; although providing owner financing could mean the difference in being able to sell a house, it could also mean a great amount of risk for the seller if the buyer eventually defaults on the loan.

As the country struggles with a sluggish real estate market, seller financing presents a way for buyers and sellers to close deals that might not be possible with conventional financing.

“There are some deals that just simply cannot get done [with conventional lending] because the credit markets [are]…too tough for a particular buyer to qualify or because the type of transaction [is] too risky,” Brian Moore, a partner with Roetzel & Andress, LPA and chairperson of the Ohio Real Estate Practice Group, said.

There could also be a situation in which a buyer may not have sufficient capital for a down payment, Moore added. Partial seller financing, in that case, can help fill in the gaps in closing a deal.

In addition, the benefits of owner financing can appeal to sellers who are trying to unload property, Moore said. Closing a deal on a house, for example, may take considerably less time with seller financing than with conventional financing. While a conventional lender will scrutinize the collateral property to determine the level of risk, a seller who is already familiar with the property can form his or her own risk assessment relatively quickly.

Financing as an installment sale can have tax advatanges

Seller financing may also be an attractive choice for investment, potentially offering high rates of return. “A seller can negotiate an interest rate that the buyer will pay them that is more favorable than would be available for other sorts of investments,” Moore said.

Furthermore, seller financing can provide some tax benefits by spreading out a large gain over time.

“If [the seller] structures [the loan] as an installment sale, there can be certain tax advantages to the seller as well in terms of. the timing of recognition on the [capital] gain,” Moore said. The seller would need to discuss the details with a tax advisor.

Seller financing can be used to pay for a property either in full or in part. The terms of a full loan look similar to those of a conventional loan; however, a seller has a great deal of freedom in setting the terms, such as the interest rate and the duration of the payment period. For instance, a seller might wish to provide seller financing as a short-term arrangement of five years, after which the borrower is expected to refinance the loan, “presumably with conventional financing,” Moore said.

While sellers can be more flexible than banks in considering prospective buyers, they should nevertheless think like a bank when reviewing potential buyers. Examining documents and reports such as tax paperwork, proof of employment and credit history is prudent in determining a buyer’s ability to pay off the loan.

Although partial seller financing offers similar flexibility, it can be more complicated because of the three-way relationship created between the seller, buyer and conventional lending institution. In most cases, the conventional lender will assume first position in a default scenario.

“[The] conventional lender is. going to. make sure that whoever holds that second mortgage doesn’t. disrupt the buyer down the road, in a way that would prevent that buyer from paying on the first mortgage,” Moore said.

Thus, the seller and the lender will often need to reach an intercreditor agreement outlining how and when the seller can collect his or her debt in different default scenarios. Such an agreement might include a standstill obligation, for a situation in which the first lender is receiving payments, but the second lender (the seller)is not, Moore said. A standstill would ensure that the second lender is not able to institute litigation against a delinquent buyer, thereby disrupting the first lender’s income stream.

A seller who provides seller financing will need to get the mortgage recorded in accordance with the specific execution and acknowledgement requirements of the state. Sellers should also work with a title insurance company to perform a title search and purchase title insurance to secure the right priority for the mortgage, Moore said.

A title insurance company can also serve as a good resource for understanding how much it will cost to record the mortgage–an amount that can vary substantially depending on which state the property is located in. In some states, the cost to record a mortgage or deed of trust is minimal, consisting of a basic administrative fee added to an amount that varies according to the number of pages, Moore said. “Other states may have stamp taxes or documentary fees that can be much more significant, or can be based on the amount of debt secured by the instrument,” Moore said.

Generally, the cost will “depend on how many documents are involved and how sophisticated those documents need to be,” Moore said. The size of the property and the intensity of due diligence procedures factor into these costs.

“If it’s. a simple scenario [such as a] small little residential deal, it might be under a thousand bucks,” Moore said. “If you [provide seller financing for] a sophisticated apartment building or strip center. it can be multiple thousands of dollars.”

Documentation for simple deals can cost less than one thousand dollars

Documentation is perhaps the least of a seller’s worries. For most sellers, the initial decision to provide seller financing can be the most significant hurdle they encounter.

“Documentation–that’s not a big deal. It’s done all the time, there’s [a lot] of good lawyers that do it,” Moore said. “It’s deciding to do it, and deciding on how to manage the risks inherent in providing seller financing when you’re a casual seller–that’s the biggest difficulty.”

In most cases, sellers prefer to have cash instead of a promise by the buyer to pay them later, Moore said. In addition, sellers who consider seller financing “need to understand the risk that the buyer might not pay you in whole or in part, or might have financial distress situation arise down the road, where after a year or two. the payment stream to you is disrupted by their financial distress.”

Because sellers do not have the same resources as conventional lenders, financing a buyer can be even more intimidating. While banks can absorb the risk of nonpayment by spreading it across their entire loan portfolios, an individual seller isn’t typically able to do that, Moore said. Furthermore, it’s more difficult for a seller to choose the best loan terms in accordance with the perceived risk/return.

“There’s no science to that because you’re not a conventional lender,” Moore said.

Because of the serious risks involved with seller financing, sellers should do their homework ahead of time and decide whether it is an option within their level of risk tolerance. Preferably, a seller should make this decision early in the process of selling a property, well before any offer is on the table.

“You need to decide that up front so that you can package your materials in contemplation of what you’re willing to do relative to seller financing,” Moore said.

Lawyers who are familiar with financing and financial documents can be critical resources in the time preceding and immediately after making the decision to offer seller financing, Moore said. A lawyer can help a seller understand the ramifications of seller financing and design the appropriate paperwork.

“[Sellers] just need to be prepared for. what happens if [the deal] goes south,” Moore said. Sellers can then adjust the language and terms in their loan documents accordingly, such as setting a higher interest rate that’s reflective of the higher risk, or requiring personal guarantees and other forms of credit enhancements.