Chapter 14 - Creative Financing


1. Chapter 14

Creative Financing


2. Creative Financing Techniques

More common in periods of rising interest rates

May also be used by borrowers who cannot qualify for other types of loan

Examples:

Seller financing

Wraparound loans

Installment Sales Contracts

Shared appreciation loans


3. Seller Financing

With seller financing, the seller agree to take payment of all or some portion of the purchase price after closing, rather than receiving all of the purchase price at time of closing

The seller usually requires:

interest on payments made after closing, and

a deed of trust on the property to secure the buyer's promise to pay the balance of the purchase price


4. Agreement for Seller Financing


5. Seller Financing Terms

Seller financing typically:

is in a junior lien position

may be junior to a new loan or to the seller's existing loan if the borrower agrees to make payments on the seller's loan (assumption/subject to)

has a relatively short term (3-15 years)

Sometimes a longer amortization with a balloon payment

has a higher interest rate than the first-priority loan

seller financing is not subject to usury laws


6. Example of Sale With Seller Financing

Purchase Price: $350,000

Buyer gets new loan with 80% LTV, makes 5% down payment, seller finances remaining 15%

Seller has existing loan of $235,000 to be paid at closing

Seller has $24,000 in closing costs

Buyer pays $350,000 purchase price with:

Down payment of $17,500 +

New loan of $280,000 +

Seller financing of $52,500


7. Risks to Seller with Seller Financing

Borrower fails to pay loan to seller

Seller may need to foreclose

Seller cannot get a deficiency judgment for any balance due after foreclosure

Borrower fails to pay senior loan

Foreclosure can eliminate the seller's security interest in the property

Seller may not be able to get a deficiency judgment


8. Seller Financing Disclosures

Disclosure required for sales of 1-4 family residential property where the purchase price is paid either:

with a finance charge (interest, etc.); or

in more than four installments

Seller financing includes transactions with a:

promissory note and deed of trust

lease with option to buy, or

installment sales contract (contract for sale)


9. Disclosure Obligation

"Arranger of credit" has obligation to provide disclosure

Arranger of credit is a person, other than a party, who is involved in negotiating terms or completing documents, or receives compensation in the transaction

Arranger of credit is usually a real estate licensee (broker)


10. Disclosure Form (CARĀ® form)

See text pages 407-409


11. Required Seller Financing Disclosures (see disclosure form on text pages 407-409)

Description of loan terms

Paragraphs 1, 4, 5, 6, 7, and 14

Buyer's credit information

Paragraphs 3 and 21

Title insurance

Paragraph 11

Description of prior liens on property

Paragraph 20

Balloon payment warning

Paragraph 23

Etc.


12. Converting Seller-Financed Loan to Cash

Seller who has a seller carry-back loan can get cash in exchange for the loan by either:

Selling the loan in the secondary market

Usually involves selling the loan at a discount (seller receiving less than face value)

Deed of Trust assigned using assignment form like in Text page 395

Using the seller's loan as collateral for another loan

Seller gets loan from a third party lender

Seller assigns loan and rights to receive loan payments from buyer to other lender as security for the loan

If seller does not pay loan, seller's lender can take over the seller-financed loan


13. Income Tax Considerations with Seller Financing

Seller can use installment tax treatment to spread the capital gain (and any capital gains tax) over the carry-back loan term

Seller carry-back loan must have a rate equal to or greater than the Applicable Federal Rate (AFR), or some of the carry-back loan payments will be treated as interest

Known as "imputed interest"

Prevents the seller from treating as capital gains the part of the selling price that really represented interest on delayed payments by omitting interest from the contract and raising the price instead


14. Applicable Federal Rates

1-3 years, > 3-9 years, > 9 years


15. All-Inclusive Trust Deed ("AITD") Loans (also known as wraparound loans)

A type of junior financing that:

Leaves an existing first-priority loan in place

Has the junior AITD lender make a loan that includes the balance due on the first priority loan

The AITD borrower is responsible for making payments on the AITD loan, which includes the balance on the first priority loan

The AITD lender is responsible for paying the payments on the first priority loan


16. AITD Structure


17. AITD In-Class Exercise

Seller's Original Loan:

$160,000, 30-yr. fixed, 5.5%

12/1/2003 first payment date

AITD Loan:

$230,000, 27-yr. fixed, 7%

12/1/2006 first payment date


18. Wraparound Example


19. Uses of AITD Loans

AITD may be proposed when:

lock-in prevents prepayment on existing loan

borrower cannot qualify for a new loan

interest rates on new loans are higher than rates on the existing loan

AITD use has diminished because:

most loans have a due on sale clause

loan interest rates have been on a decline


20. Risks of AITD Loans

Risks for the seller:

If the buyer does not make AITD payment, seller has no money to pay original loan

Buyer might "milk" rents

Due on sale clause in original loan gives lender on original loan right to call original loan immediately due

For the buyer:

Due on sale clause

If seller does note make payments on original loan, lender on original loan can to foreclose even though buyer has made payments to seller


21. Installment Sales Contracts

Also known as real property sales contract, land contract for sale, contract for deed, conditional sales contract

Typically used as a substitute for a sale of property and new loan to the buyer

Terms:

Seller is called the Vendor

Buyer is called the Vendee

Installment sales contract is also used in CalVet financing


22. Installment Sales Contracts Sale Structure

Vendor keeps legal title to the property

Vendee takes possession and makes payments to vendor

Vendor agrees to convey property to the vendee at some future date upon payment of the purchase price (all of the price or some specified percentage of the price)


23. Installment Sales Contracts CalVet Structure

Veteran borrower locates property for purchase

CalVet purchases property

CalVet contracts to sell property to veteran/borrower when veteran/borrower fully repays the contract for sale


24. Installment Sales Contract Risks

Risks for vendee:

Vendor may not be able to deliver good title

Vendor may refuse to deliver title

Risks for vendor:

Vendee may default, but still be in possession

May not be able to use foreclosure

May be required to credit vendee with part of payments


25. Lender Participation Loans

In addition to the interest on the loan, the lender gets a share of property income, a percentage of increase in property value when property is sold or refinanced, or both

Borrower should get lower interest rate

Borrower should be permitted to recover costs (or value) of improvements made before equity split with lender


26. Shared Appreciation Example

Buyer purchases property for $500,000

Loan: 80% LTV, 25-yr. fully-amortized, 5% interest rate

Lender gets 15% of net appreciation on sale or refinance

Property sells 5 years later at $800,000

Costs of sale = 7% of the sales price


27. SAM Example (continued)

Increase in equity:

$800,000 - $500,000 = $300,000

Net equity increase:

$300,000 - $56,000 costs of sale = $244,000

Lender's share of net equity increase:

$244,000 x 15% = $36,600

Lender's yield on loan:

Loan (pv) = -$400,000, Pmt = $2,338.36, Term (n) = 5 years (60 mo.), FV = $390,920.76 ($36,600 + $354,320.76)

CPT %i


28. Sale-Leaseback

Typically used only with commercial properties

Property owner sells property to investor and leases the property back from the investor

Advantage to owner/tenant:

all of the lease payment is deductible on income tax return

No capital tied up in real estate, can be used for other business needs

Advantage to investor/landlord:

Tax advantages of ownership

Higher yield compared to other investments

Possible appreciation


29. Other Financing Techniques

Open-end loans

Original deed of trust secures future loan advances by the lender

Construction loans and some home equity loans (with line of credit) are open-end loans

Blended rate loan

Lender with existing loan agrees to make an additional advance at a higher rate

Existing loan balance has original interest rate

Rarely used by institutional lenders