Now she wants to sell the note to buy a piece of property all cash, and I made an offer to buy it.

Everything was going perfectly with processing the paperwork until I asked her to provide the payment history for the last 12 months, and proof of insurance listing her as Loss Payee or Additional Insured.  She had neither.

He pays her with a money order, and she simply cashes it.  No canceled checks, no bank statements.  Because she hasn't filed tax returns for several years, and doesn't want to show any income, she stays low on the economic radar.

So how do I know whether I'm buying a performing note, or a non-performing note?  Can I really just take her word for it?  That's a tough one.

Regarding insurance... she said that after 7 years, she no longer required him to have property insurance, because "he was taking such good care of the property".  So, if the house burned down, there would be no collateral securing the note.  Or if someone hurt themselves on the property, there could be huge liability issues compromising the security for the note. 

The value of that $145,000 note could evaporate overnight.

So, when you're carrying paper, and you want to maintain the value of your note in case you ever need to sell it, be sure to document the payments you're receiving (using a note servicer is a great idea), and make sure that hazard insurance NEVER lapses on the property.

Make sure each year you get verification that the Payor has renewed insurance and that you are still listed as Loss Payee.

Both investor and buyer will be beneficiaries in a trust that will hold title to the property.  If the buyer defaults, the investor will take over the property with a simple eviction action (not foreclosure).

Not a bad plan, but what do we do now that the investor's funds just aren't coming through, and escrow is delayed... AGAIN?  The seller is getting anxious and annoyed, and the buyer would just like to close on the house he is already living in (he's leasing for now). 

If all else fails, there are a couple of ways we could go... both involve the seller being willing to offer terms (instead of walking away with all cash):

1. The buyer will put down 20% ($460,000) and the seller will create a 60% LTV 1st (suitable for sale on the secondary market for a reasonable discount), and a 20% 2nd (that he will hold)... OR
2. The seller will put his property into a title holding trust and the buyer will buy into the trust with an initial contribution of $460,000, and subsequently lease the property from the trust.  That way, the seller will not have exposure to foreclosure, or capital gains liability, but his equity will remain locked in the property until the termination of the trust (you can't sell a beneficial interest in a trust the same way you can sell a note on the secondary market).

It would be a lot of fun to consult on this transaction, but I'm keeping my fingers crossed that they can close the deal the way they have been planning.  That would be the easiest way to keep everybody happy!

It's not my fault... really.  You simply want too much money.  You are the proverbial 'unrealistic seller'. You personally wrote in the discount the market is asking you to take by how you put your deal together way back when... I'm not being predatory, I promise!

Of course your note is the best one on the block, just like your house is worth more than your neighbors', but I'm sorry, I can't begin to get you $60,000 for your $80,000 note. 

What?  Why, you ask?

OK, for starters, the value of the property looks to be $69,000 -  less than the note balance (your buyer/payor is 'under water')... not good.  Many note buyers will not look any further than this.  But that's not all...

• The collateral (property you sold) is a 4 unit residential investment property in an edgy border town
• The buyer is a NOO (non-owner-occupant)
• He only put 6% down (20% is the least you should have taken)
• The buyer is technically an LLC and you don't have a personal guarantee
• The note only asks for interest-only payments, with a balloon payment in 9 years... no one likes to buy interest only notes!
• Your note doesn't contain either a due-on-sale clause, or a provision for late payments

The most I can get you is a little better than .50 cents on the dollar, or somewhere between $40,000- $45,000.

Why?

Because I have to buy the note knowing I will be OK if the buyer:

• keeps making the payments (even then the payments are very small as they are interest-only, and I am not sure he will be able to pay me off when the balloon is due), or...
• quits making the payments, forcing me to foreclose and sell the property to recapture my investment capital

Unfortunately, I always have to think in terms of worst case scenario.

Let me know if you change your mind... or maybe I'll just buy a few payments from you, but leave that scary balloon in your lap???

Sincerely,

Dawn

The perfect set up:

• Seller owns $500,000 property free and clear (or only has a small loan)
• Buyer offers seller full asking price if they'll accept $300,000 now and
• Carry a $200,000 note

I know... you're thinking, "So what's the problem???  That's a 60% down payment for cryin' out loud!!! I'd take that in a heart beat!  There's $300,000 of protective equity on this deal!  I HOPE they default so I can take the property back and sell it again for full value!"

Not so fast...

The $300,000 that the Seller received at close of escrow was a loan from the Buyer's Private Money Buddy, and the seller carry back loan was in 2nd position.

THERE WAS NO DOWN PAYMENT!!! 

Zip, zero, nada.  No "skin in the game."  And there's no problem if the buyer is 100% ethical and lives by the Golden Rule or the Golden Fleece or Fibonacci's Golden Mean... but if the Buyer only lives for GOLD, here's what they do...

They tell their Private Money Buddy, "Hey Dude, I'm not going to pay you according to the terms of the note, so... you might as well foreclose on me, right?" (wink wink, nudge nudge)

The sellers/note holders (holding that 2nd lien position, right?), if they're not sophisticated and don't take precise and definitive action, they'll get wiped out at the Trustee Sale, and the Buyer and his Buddy get the property for a total investment of $300,000 plus foreclosure costs. 

Sweet, huh?  I thought you'd like it.

So how to avoid it:

Use a professional note consultant to engineer your transaction (or an attorney or accountant or someone you trust who understands how real estate and notes work)

Use a highly professional and diversified note servicing company... they'll help you keep on top of things and advise you on how to proceed if anything goes wonky

If you're thinking of taking a 0% down deal from a buyer... have your head checked

Owner financing is an effective and powerful tool when used

• Legally
• Ethically and
• Intelligently

Wishing you the best!

Dawn

The offending language in HR 4173 (Wall Street Reform and Consumer Protection Act of 2009; now designated as the Restoring American Financial Stability Act of 2010, aka DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT; aka DODD-FRANK Act) was taken from the previous monster bill, HR 1728 (MORTGAGE REFORM AND ANTI-PREDATORY LENDING ACT), which passed the House a year ago May, and has apparently been tabled in the Senate since that time.

HR 1728 limited seller financing to once every 3 years, unless you were a licensed mortgage originator.  HR 4173 now says that you can finance up to 3 residential properties per year without worrying about licensing or the SAFE Act. 

At this latest version of HR 4173, the former offending section of HR 1728 is now found in Title XIV of the joint bill :

TITLE XIV--MORTGAGE REFORM AND ANTI-PREDATORY LENDING ACT
SEC. 1400. SHORT TITLE; DESIGNATION AS ENUMERATED CONSUMER LAW.
(a) Short Title- This title may be cited as the `Mortgage Reform and Anti-Predatory Lending Act'.

SUBTITLE A--RESIDENTIAL MORTGAGE LOAN ORIGINATION STANDARDS
SEC. 1401. DEFINITIONS.
Section 103 of the Truth in Lending Act (15 U.S.C. 1602) is amended by adding at the end the following new subsection:

(2) MORTGAGE ORIGINATOR- The term `mortgage originator'--
(E) does not include, with respect to a residential mortgage loan, a person, estate, or trust that provides mortgage financing for the sale of 3 properties in any 12-month period to purchasers of such properties, each of which is owned by such person, estate, or trust and serves as security for the loan, provided that such loan--
`(i) is not made by a person, estate, or trust that has constructed, or acted as a contractor for the construction of, a residence on the property in the ordinary course of business of such person, estate, or trust;
`(ii) is fully amortizing;
`(iii) is with respect to a sale for which the seller determines in good faith and documents that the buyer has a reasonable ability to repay the loan;
`(iv) has a fixed rate or an adjustable rate that is adjustable after 5 or more years, subject to reasonable annual and lifetime limitations on interest rate increases; and
`(v) meets any other criteria the Board may prescribe;

The opposition to HR 1728 seems to have done some good, as the defined exclusion has been substantially softened, and is much more seller friendly than the original version. Whereas the original "Defined Exclusion" appearing in HR 1728 and at least one previous version of HR 4173/ S 3217 read as:

(E) does not include, with respect to a residential mortgage loan, a person, estate, or trust that provides mortgage financing for the sale of 1 property in any 36-month period;

the language in HR 4173, as illustrated in House Report 111-517, has been softened to read:

(E) does not include, with respect to a residential mortgage loan, a person, estate, or trust that provides mortgage financing for the sale of 3 properties in any 12-month period to purchasers of such properties, each of which is owned by such person, estate, or trust and serves as security for the loan.

So here's an update synopsis of how owner financing seems to be affected at this point:

You DO NOT have to worry about the SAFE Act/licensing when you’re offering terms to someone when you are selling:

• Your primary residence
• A residential property to a family member
• A residential property to someone who will use it as a rental or vacation home
• Non-residential property
• According to HR 4173, you are allowed to owner finance up to 3 residential properties a year without worrying about licensing

If you’re an investor and you’ve used up your 3 freebies, the SAFE Act suggests that you have to be a licensed mortgage originator (LMO) to sell your residential property with seller financing to someone who intends to use the property as a primary residence.

Many attorney's believe that it would be more than adequate to have a LMO (licensed mortgage originator) put the deal together for you if you are owner financing more than 3 residential properties a year.

Stay tuned for more 'calls to action' as we try to fight to maintain private property rights.  If the banks aren't lending, then we REALLY need to make sure owners/investors are able to provide it without red tape and extra expense.



You’d think at the outside they would say, “OK, if you’re going to carry paper on a residential property, then you need to have a LMO (licensed mortgage originator) negotiate the terms  and put the appropriate paperwork together for you.”

Not so.  Technically, as the federal regulation stands, the owner of the property has to be licensed; however, in some states (Texas, for instance) they’ve got the state entities to formally grant this concession.  Investors can still offer owner financing to families who can’t get bank loans if they run their deals through a LMO.  And many attorneys agree that this is adequate compliance with the SAFE Act across the board.

According to a recent conversations I’ve had with long time investors and note buyers in Montana and Missouri, their state governments think some of the federal regulations are nonsensical and prohibitive, and have decided not to adopt the federal language word-for-word as disseminated from Washington.

They feel they already have adequate protections in place and aren’t going to be bullied into over-regulating.  It probably helps that many state officials own rental properties,  and owner financing is a very common way of selling property in those states.  They don’t want severe limitations placed on what they can do with their real estate portfolios!  Imagine that.

The SAFE Act defines a residential property as any dwelling with 1-4 units, vacant residential lots (that could potentially be built into  homes), mobile homes (this is throwing the mobile home industry into a tailspin), and even trailers (if they’re going to be lived in).  Way to severely limit the accessibility of low-income housing!

Imagine all those RV retailers who don’t know they’re in violation of the SAFE Act when they sell a motorhome to someone who might end up living out of it!  Woohoo!  What a ride.

Here’s more wording from HUD:

“Notwithstanding the broad definition of “loan originator” in the SAFE Act, there are some limited contexts where offering or negotiating residential mortgage loan terms would not make an individual a loan originator. The provision in the definition that loan originators are individuals who take an “application” implies a formality and commercial context that is wholly absent where an individual offers or negotiates terms of a residential mortgage loan with or on behalf of a member of his or her immediate family. State legislation that excludes from licensing and registration requirements an individual who offers or negotiates terms of a residential mortgage loan only with or on behalf of an immediate family member will not be found to be out of compliance with the SAFE Act. The commercial context implied by the taking of an ‘application’ is also absent where an individual seller provides financing to a buyer pursuant to the sale of the seller’s own residence. The frequency with which a particular seller provides financing is so limited that HUD’s view is that Congress did not intend to require such sellers to obtain loan originator licenses. Accordingly, state legislation that excludes from licensing and registration requirements an individual who offers or negotiates terms of a residential mortgage loan only to the buyer or prospective buyer of the seller’s residence will not be found to be out of compliance with the SAFE Act.”

So, here’s when you DON’T have to worry about being licensed when you’re offering terms, offering seller financing to someone buying your property:

• When you’re selling your primary residence
• When you’re selling a residential property to a family member
• When you’re selling a residential property to someone who will use it as a rental or vacation home
• When you’re selling non-residential property

Otherwise, you’re technically on the hook for licensing, RESPA and TILA, etc, etc, etc.

So, what about the people who have acquired a small portfolio of properties over the years, and have planned all along to sell with owner financing when they were tired of managing, and were looking to take advantage of IRC 453 and defer capital gains using the installment sale?
These people are in a bit of a fix...technically.

Personally, based on the ‘commercial context’ mentioned by HUD, if I were selling off a small portfolio of properties I had acquired over the years, or had inherited through an estate, I wouldn’t be too concerned about the SAFE Act, but  for ‘safe’ measure, I might have a LMO process the paperwork anyway.

Alternatively, I could use the Title Holding (Land) Trust and get around the whole conversation altogether!

Some aspects of the SAFE Act are most likely unconstitutional, and definitely represent an attack on personal property rights.  It also restricts free trade and commerce (do we still care about a free market in America?  Or do we just want to be guaranteed our TV and a 6-pack?)

Some unfortunate (and hopefully unintentional)  consequences of the legislation is that buyers who can’t qualify for  bank loans are going to have a harder time acquiring homes for their families.  Banks won’t finance them, and government is making sure it’s harder for sellers to finance them.  Nice.  So is this really about consumer protection or government control?  Huh.

It's practically impossible to spout off numbers like that because there are so many variables involved, such as: type of property, owner occupied vs. non-owner occupied, hard cash down payment, payor's credit, payment history, interest rate, term, etc., etc., etc.

In addition, what many sellers who have carried paper (or who are thinking of carrying paper) fail to realize is that a note buyer has to base their purchase of the note on the value of the collateral (the asset securing the note), not just the note balance.

Real life example: 

Property seller knew they would want to sell the note they were creating, and they wanted to get the highest possible price for it, so they figured that they would maximize the face value of the note... hey, they were going to get 80 cents on the dollar, right?  So why not make the note balance as high as possible?:

• Face value of note: $101,000
• Interest rate: 0%
• Term: 180
• Monthly payment: $561.11

Hmmm.... 80 cents on the dollar should get him about $80,800, right?

Wrong.

Here's why... the property was only worth $60,000.  But the seller/note holder thought, "Well, if I take $5,000 down and only have a face value of $55,000, then 80 cents on the dollar will only get me $44,000.  No thanks, I'll take the $80K."

Well, Joe, the thing is, as a note buyer, I'm always looking to the worst case scenario... if the buyer/payor defaults and I have to foreclose, will my investment still make sense?  Why would I pay $80,000 when the property is only worth $60,000, and I would likely lose $30,000 or more in the event of payor default?

Many note buyers, institutional and otherwise, will not even quote a note for purchase if the face value of the note exceeds the value of the collateral.

Here's what the seller should have done:

• Selling price: $60,000
• Down payment: $5,000
• (Make sure the credit score is decent)
• Face value of note: $55,000
• Interest rate: 9%
• Term: 180 (fully amortized - or with 7-10 year balloon)
• Monthly payment: $557.85

Now that's a note I could consider buying.  Very similar monthly payment for the buyer/payor, very different note for the seller to hold or sell.

To preserve his asset(s) even more, the seller could create a $48,000 first (which he will sell), and keep a $7,000 second for cash flow.  An 80% LTV (loan-to-value) note will fetch a smaller overall discount than a 92% LTV note.

Sellers should seriously consider hiring a note professional before the ink is dry on their seller carry back transaction to insure that they have a note worth holding or selling.

Undoubtedly, many of those 2007 closings were refinances, but still, there are many transactions that just aren't coming together these days.  Buyers either can't or won't put down the 30% the banks are requiring (even from people with 800+ credit scores), and the appraisals aren't coming in, necessitating a significant price drop from the seller to get the deal done.

So how can sellers of high-end residential properties get their price (and defer capital gains)?  By offering terms.

If the seller is willing and able to 'become the bank' on their own property, and a buyer does not need to do a song and dance routine for an institutional lender, sellers can get their price and buyers can own a home otherwise unavailable to them.

The only thing that the seller needs to know is how to intelligently underwrite their own transaction.  Banks have whole underwriting departments . . . sellers need to hire someone to help them structure an owner carry scenario.

There are 3 legs to creating a note worth holding or selling: 1) properly engineering the transaction, 2) underwriting and documenting the buyer, and 3) making sure the note documents themselves are correct and complete.

Not long ago I was working with a doctor in Santa Maria that owned a property he insisted was worth $1.7 mil, because his appraisal said so.  It didn't seem to matter that the market said otherwise (he hadn't had any offers in 2 years, and his neighbor's house sold for $1 mil). 

However, there was a buyer who was willing to pay $1,425,000, but they only had 10% down and would never qualify for a bank loan (and it would never appraise even if they could).  So, if the doctor was willing to offer terms / carry paper for the buyer, then he could sell for a price that exceeded what the market was willing to give him in general right now.

I worked with the seller to structure a transaction that would meet both his short and long term objectives, and fit within his risk tolerance.  Structured properly, I would be able to buy at least part of a first note and deed against the property, which would provide more cash than available from the buyer's down payment.

Ultimately, he backed out of the transaction, sure that he would find someone willing to pay his $1.7 mil all cash.  Good luck, Doc... you'll be lucky if your property is worth $900K by this time next year.

For those luxury home owners who have attractive existing financing in place, we're structuring the owner carry transaction differently, and using a Title Holding Trust to achieve many important benefits.

The Note Queen Blog will cover all things related to creating, selling, buying and brokering seller carry back notes or seller financing.  You are more than welcome to post a comment on any of the articles or ask follow-up questions, but please no solicitations or SPAM posts.

The author is Dawn Rickabaugh and is the Note Queen.