Anyone who has tried to buy a commercial property right now has run into issues with financing. Banks still want to make money, and they do it by making loans. But they have to have a certain amount of cash on hand to do so. The rest they borrow. Which is one reason that the rate you get goes up and down as the federal funds rate goes up and down. Walk into a bank right now and it goes like this:
“Hi, I’m an buying real estate and I’d like to get a loan.”
“Great, we can do loans with as little as 3.5% down with a 6.4% rate,” brags the banker.
The investors eyes light up. This is going better than expected.
“I had no idea these rates were so low. Looks like I can buy something way bigger than I thought. I’ve been looking at this 8 unit apartment building.”
“Whoa, now, you can’t get that low of a down payment on an apartment building,” says the banker disappointedly, “The best we can do is 25% down with an 8% rate. I thought you were talking about buying a house for yourself.”
At this point, the deal the investor has been hoping for goes down the tubes. Not only does he not have enough cash to make the down payment, but he realizes that the mortgage payments will be so high, he will have negative cash flow on the property. While neutral cash flow might be right for some people, negative is the kiss of death. With a heavy heart, the investor calls up the seller to cancel the deal.
It’s Time for Creative Financing
Many deals like this are lost or never even considered in a high interest rate market such as we are in right now. Many will sit on the sidelines waiting for rates to go down, but what they don’t realize is that sellers are coming around to the fact that buyers aren’t falling all over themselves to buy their properties. The increased interest rates result in decreased values, and this can provide great opportunity for those willing to think creatively.
I’ve been working on a deal for the past two months on a three million dollar deal. Banks have quoted me rates between 7.5% and 8.5%. This causes the cash-on-cash return to go very low. That might be OK if I wanted to buy this for myself and sit on it for 30 years, but I have investors to pay back. That’s not going to happen because we have to pay back so much in mortgage. The deal is dead. Or is it?
What if we were to cut out the bank? Or decrease it’s involvement? The bank that takes so long to decide to fund a deal. The bank that wants appraisals, mountains of paperwork, prepayment penalties, and down payments.
Don’t get me wrong – I’m a huge fan of the bank and how it can help you purchase much more than you could alone – it’s just a tough time right now. The bank is usually your best investor. The bank asks for lower return than typical investors, but they do ask for more in other ways: collateral (recourse) and paperwork.
Creative financing can be a way to have the seller step into the role of the bank. They don’t have the regulatory and financial overhead that the bank does. They are more willing to entertain unusual payment structures. It can be a win for both of you. Here are a few types of creative financing to explore:
Types of Creative Financing
- Owner Financing: In this structure, the seller acts as the bank. There is typically a down payment, which the seller receives in cash, and the rest is financed just like a bank would. This has a tax benefit for the seller because the money isn’t coming back in a lump sum in one year. If the buyer fails to make payments, the seller can foreclose and take back the property.
- Wraparound Mortgage: This probably wouldn’t work in the scenario I have laid out above, but I’ll include it for completeness.In this one, the buyer gets a new mortgage from the seller. It will have typical loan terms like rate and amortization and down payment. The buyer takes ownership of the home and pays the seller monthly payments. The seller keeps his current mortgage and receives payments from the buyer that are higher than what the seller’s current mortgage is. Banks don’t usually like this because they now have a loan out to a person who doesn’t own the property any more.
- Master Lease Option: The buyer and seller sign a lease that allows the buyer to make any changes to the property that the buyer sees fit. In return, the buyer pays rent to the seller. The buyer gets to keep any rent the buyer gets from renting out the property. They both agree on a predetermined time that the buyer will have the option to either buy the property or walk away. They set the price and date up front. The seller retains ownership of the property and pays his own mortgage until such time as the buyer buys the property.
- Mortgage Assumption: This happens often on larger properties, usually ones that have a mortgage through Fannie Mae. Typical bank mortgages usually don’t allow assumptions. An assumption is where a new party takes over the mortgage of the property and takes ownership. They take the role of the current owner, along with the requirements to pay back the loan. Usually, this involves the buyer paying extra to the seller because the mortgage principal is less than the sale price. This is done when the current interest rates are higher than the current mortgage (like right now!)
- Syndications: This is what I do. I pull together money from investors to bring a down payment on a property that is much larger than I could buy myself. It takes experience and a good lawyer to put it together but can be rewarding for the investors.
- Joint Venture: A few people pool their money and split the risk of loss and can buy a bigger property than they could otherwise. This is similar to syndication, but syndication involves less risk to investors. Joint ventures have a greater potential return, though.
- Seller Second Mortgage: Similar to owner financing, the seller agrees to finance a portion of the sale price rather than the whole thing. This happens when a buyer can get a mortgage for a bank, but the bank and down payment doesn’t meet the entire value of the property. The seller finances the rest like in owner financing. The seller then has second lien, right after the bank. Liens are claims to the property if the buyer should default on payments. They get paid back in order, so everyone wants to be first.
- Seller Buydown: This is a way for the seller to pay some money on the loan to buy down the buyer’s rate. The seller pays the bank ‘points’ up front and the bank agrees to decrease the rate of the loan. Why do this? Because instead of simply decreasing the price to make the sale happen, the seller causes the buyer’s monthly payment to decrease. This has the net effect for the seller of being the same decrease in sale price, but the buyer pays substantially less over the course of the loan.
There are many more ways to creatively finance. Sellers generally want to get rid of the property as quickly as possible and get a big payout. These ideas only work if the seller is distressed in some way, and they need another option to make it happen. They are also great ways to allow the buyer to make the purchase without decreasing the sale price. Give one a try before walking away from the next deal that isn’t going right.