The Hidden Risks of “Subject To” Real Estate w/Eddie Speed

Dave:

Hey everyone. Welcome to On the Market. I’m your host Dave Meyer, and today with me is Kathy Fettke. Kathy, you’re bringing on one of your old friends today as our guest. Can you tell us about ’em?

Kathy:

Yeah, I’ve known Eddie Speed for years. He is an OG in the note business on his fifth decade of understanding notes, and that includes subject two where there’s been so much confusion about what that is and how to do it and how to do it properly. So I’m thrilled that he’s here today.

Dave:

Yeah, subject two, I feel like has skyrocketed to one of the most commonly talked about and perhaps even the most popular strategies or tactics that you can use in real estate investing. And so what we’re going to do today is talk to Eddie about first and foremost, what it is because not everyone is familiar with that. So we will break down the basics, but then we’re going to talk about some of the risks and rewards of this strategy because you may already know this and we will dig into this when we talk to Eddie, but I think there are a lot of questions about the legality or how to do this strategy legally, and Eddie is the perfect person to discuss that with us today. So it let’s bring on Eddie speed. Eddie, welcome to the show. Thanks for being here.

Eddie:

How you doing, Dave?

Dave:

Great. Very happy to have you. Thank you. Let’s have you start by telling us a little bit about how long you’ve been investing and when did you first learn about creative finance and specifically the subject to strategy.

Eddie:

Well, my original business was I’m a seller finance note buyer, and I started doing that in 1980, so I spent a lot of my career working with real estate investors who frequently created seller financing, and so I’ve worked with, I would say thousands of real estate investors on creative finance strategies including sub two for decades. This is about four and a half decades in for me now.

Dave:

Wow, that’s incredible. We got the right person here to talk about what’s going on in this creative finance environment and some of the risks and rewards of it. So thanks again for joining us. For those of our audience who may not know, can you just explain a little bit about what subject two is in the first place?

Eddie:

So subject two, the thing that most people call it is sub two, which it is just a shortened way of saying you are taking title to a property subject to the existing mortgage. You’re not assuming it. You’re acknowledging that there’s a mortgage, so you’re accepting deed to the title, subject to the underlying mortgage.

Dave:

And so the difference just so everyone’s is that when you assume a mortgage, you’re saying, I am taking over this mortgage. It is now mine. The original mortgagee is done, right? They’re completely off it, but subject two is different in that basically the original borrower stays on the mortgage, but the person who gets the mortgage subject to basically takes over the payments of that mortgage. Is that right?

Eddie:

Yes. They’re not technically legally liable for it. They’re taking it subject to, but they are fully aware that if they don’t pay the mortgage, then they could lose their interest in the property, right? It’s a legal maneuver. It’s not an assumption. There’s no qualification. Let’s be perfectly honest about it. They’re not trying to go wave a flag in front of the lender who probably has a due on sale clause, and so they are trying to take over the existing mortgage because of rates. They’re trying to take over a low interest rate mortgage and take advantage of paying that debt back versus paying cash or go getting a more expensive mortgage.

Kathy:

Eddie, that’s always been my concern and why I haven’t really looked into this that much because of that due on sale clause, but it sounds like banks haven’t been calling it, but they’ve also not had 2% interest rates. So is that a risk?

Eddie:

A hundred percent. I mean, that’s the risk. The risk is you’re taking over a very advantageous loan at a low rate. The risk is you do something and you now trip the due on sale clause and alert the lender, and we can talk about what those likely scenarios are to most likely trigger the loan. And that’s exactly what it is. This is not for amateurs, this is not for beginners. Your first deal probably doesn’t need to be a sub two. So it’s a market condition. Savvy investors do it. They’re usually in a position, Kathy, if something goes wrong that they can write a check and solve the problem and pay off the underlying mortgage. And so that really starts qualifying Who really is a candidate for this strategy?

Kathy:

Oh my gosh, that’s such a good point. Having that backup plan.

Dave:

Andy, I’d like to just talk about some of the basics of subject two for a minute here. Can you just tell us why would a seller agree to this?

Eddie:

Because they need to get out of the trap.

Dave:

What trap is that?

Eddie:

We see it all the time. Somebody’s in the military, they get transferred, their life changing. You got to move. And so we’re now in a market where rates are much higher and affordability is very different and they need to get out of it. And I’ve been around the business, I’ve been around, I’m in three masterminds that I would say safely, probably 80% of the top 500 house buyers in those masterminds. And so I hear these stories a lot and the people just need to be in a situation where they can move on if properly done. They’ve been fully explained, have had fully explained to them exactly what’s happened and what you’re doing right now. Do you think that everybody that’s done a sub two has done a super clear job of doing that? I have some doubts, but I would say that if anybody that has done this that is taking responsibility and doing the right thing, they’ve explained the scenario and they saying This is a risk you’re taking. You need to fully understand the risk, and if this is an acceptable risk, then this might be a strategy to let you get out of the trap. And by the way, you’re not going off the mortgage and you’re not going off the credit report. You still are responsible for the debt.

Dave:

So if the person who assumes the mortgage just stops paying their mortgage, then the original borrower still on the hook, right?

Eddie:

Absolutely. And they didn’t assume it, by the way, remember they did it sub two.

Dave:

Okay. So now that we’re clear on what the subject two strategy is, let’s dig deeper into its potential risks, legality, and why people might consider this strategy in the first place. Eddie’s going to take us through it all right after the break.

Kathy:

Welcome back to On the Market. We’re here with Eddie Speed talking about what investors need to know about subject two. So let’s jump back in.

Dave:

Now, as Kathy said, the due on sale clause here is obviously one of the big risks that we want to talk about. So can you just tell us what the do on sale clause is

Eddie:

Today? They write into the mortgage that it has a due own sale provision, meaning it’s a covenant in the security document, the mortgage or the deed of trust, and it simply says if the transfer of title transfers, then that loan is due. Now there’s a provision in there that also allows for you to transfer the property into a trust under Garn St. Germaine. So there is a provision that says if Kathy Fed Key owns her house individually, she can then transfer that property into her trust. And this is why you commonly are hearing real estate investors are talking about using a trust. Now, to be clear about this, that’s Kathy’s trust, not Eddie’s trust. Kathy can have a trust and transfer the property into her trust. It doesn’t technically give her the provision to transfer it into Eddie’s trust. So it doesn’t really sidestep what that covenant in that security document says. Now, by the way, I’m not an attorney and I don’t play one on tv. I paid for about every high dollar law school in the business and legal fees. So I’m only repeating what the attorneys have explained to me. So there’s a disclaimer on that.

Kathy:

And has this been an issue? I mean, I’m even scared to transfer my own properties into an LLC because of that due on sale clause because it’s considered a different owner and I don’t want to have the loan called and I don’t want to lose my 2% mortgage. And people always say, don’t worry about it. They never call it. Is that changing? Are you seeing anything new?

Eddie:

The provision allows you to put it into a trust. That’s what I would do. You can put it into a trust. It doesn’t necessarily provide for you to put it in A LLC, so put it in a trust. You could have an LLC as the beneficiary for the trust. Yes. So you could figure out how to paper it. So people, if you’re listening to this, you’re going, Eddie, this is like a legal maneuver. This is a legal maneuver to acquire property that really isn’t totally cool with the servicer that you’re doing that. And the answer is that’s exactly what it is. So you’re saying are you a proponent of this? I’m saying to you that it is a common business practice for seasoned real estate investors in this environment that we’re in, that some of them are doing it.

Dave:

Eddie, I know you’re not a lawyer, so I won’t ask you to tell us the specifics of the legality here, but would it be safe to say that subject to properties are legally ambiguous? It’s not clearly legal.

Eddie:

This is what I’ve been told. This is not illegal. It is not illegal to do this. There are some things that can be illegal about it, which we can discuss, but in the spirit of it is not against the law to do this. You are breaking a covenant in the security document, right? That’s different than breaking the law.

Dave:

Okay, I see. So it’s just basically you’re breaching a, you could be, let’s just say in theory you could be breaching a contract

Eddie:

A hundred percent.

Dave:

Okay? And maybe this is a silly question, but if that’s the case, why would an investor want to do this?

Eddie:

They’re trying to take over a low rate loan,

Dave:

Okay, so that’s the incentive.

Eddie:

And if you have the horsepower to go fix the problem, then it may not be that big of an issue. If you don’t have the horsepower to go fix the problem they call the note, then you might be putting yourself and the guy you bought the property from and potentially somebody you may have sold it to on a wrap or a lease option. You might be putting all the parties at risk.

Kathy:

Yeah, so yeah, let’s talk about that. Let’s say that they call the note. And again, my last question, are we seeing this? Are banks calling notes? Because I keep hearing people say, well, of course the banks are going to want to get out of their 2% rates, but is that true? Do they still even hold the note or was it sold? I mean, is that even true?

Eddie:

So the is not a lot of people think they’re out running title. That’s not what they’re doing. They’re not running title trying to go find these things. Something has triggered them doing it and then they’re under a fiduciary responsibility to investigate it. That’s really where I think the rubber meets the road. So the question becomes how does a servicer figure this out? What is the trip switch? There’s a couple of things that can happen, right? The borrower could get just nervous and just call the lender and go like, oh my God, I can’t believe I did this like 60 days later, I just did the dumbest thing that could happen. You ever seen that happen, Eddie? I’ve seen it happen. So they go and rattle themselves. You wouldn’t think they would, but I’ve seen it happen. That can happen. Here’s another thing. This is very common.

Mr and Mrs are getting a divorce. They’re walking away from each other. Let’s just let somebody take over the mortgage. We’re going to walk away and we’re going to live our own life. Okay? Well, the MR is now two years later, she meets a new mister, she’s getting remarried and things are going good, and they’re going to buy a new house, Dave, and they go down to the mortgage company and the mortgage company, ask them Texa loan app. And Mrs never mentions the existing mortgage, not hers anymore. And then all of a sudden they pull a credit report and they go, what about this mortgage you’ve got? And she goes, what? Mortgage? Oh,

Kathy:

Yeah.

Eddie:

Do you see what I’m saying? So what if she hasn’t signed off that she’s fully been disclosed and fully a hundred percent understands it’s on her credit report that she’s liable for it. There could be an issue with the insurance where all of a sudden that triggers somebody to make phone calls and what happens? That could be a scenario. 90% of the time it’s going to be the insurance.

Dave:

Okay, and why is

Kathy:

That? Yeah, I had not heard that before.

Eddie:

Who’s the insured?

Kathy:

Now I’m confused. Well,

Eddie:

Kathy, Kathy’s rich and probably doesn’t have a mortgage, but for us

Kathy:

Other, you’re sweet

Eddie:

That might have a mortgage. We are going to have to send our insurance policy to the lender every year, and it’s going to say, to protect your interest, Mr. Lender, we’ve made sure that we insure the property. And so this is property insurance. This isn’t title insurance. This is property insurance. And the debt page of that insurance insurance is going to say, who is the insured? And if you want to know what likely is going to cause the trip switch, somebody who is not necessarily a decision maker at that servicing shop is responsible for clicking the button and saying, yes, Kathy has insurance, blah blah. Here we go. And she takes it over to her supervisor and she goes, well, Kathy’s no longer the insured. What do I do with this one?

Dave:

The person who purchases subject to needs to get new insurance. And that creates confusion with the servicer. And that could trigger just an investigation internally.

Eddie:

And there are some things that are stated in the marketplace that are solutions for this that I think are well not correct, act. So here’s what we’re going to do, Kathy, I’m going to buy this property sub two from you. We’re going to keep your insurance and I’m going to pay your insurance premium, and then I’m going to go put another policy against it where I’m the insured. Let me ask you a question. What if the house burns down? Who’s going to pay the claim?

Dave:

That’s why we need you, Eddie. We don’t know.

Eddie:

You don’t think those insurance companies are going to have a problem with the fact that we are insuring Kathy, although she has no other interest in the property, you don’t think they’re going to have an issue with that, right? Or you don’t think another insurance company is going to say, oh, wait a minute, you have two insurance policies on this house. That’s a black hole that I don’t even think about. But I know I’ve been told this many times, Kathy, from some people that you and I mutually know, I’ve been told that that’s how you fix it. My guys that give me counsel and legal advice on this say that is definitely not how to fix it.

Kathy:

Well, I think that really does bring back to this is sophisticated and you should be getting your legal advice from an attorney

Eddie:

And one that didn’t get it in a cracker jack box

Kathy:

Would be especially helpful.

Dave:

This is great information and it’s certainly clearing up some of my personal questions about subject to, but who might consider taking on this risk and what actions can investors take to protect themselves if they’re going to pursue it? Eddie gives us his expert insights right after this break.

Dave:

Welcome

Dave:

Back to our conversation with Eddie. Speed. Let’s pick up where we left off. So Eddie, this has gotten popular over the last few years, obviously because the change in interest rates, it is very perhaps more appealing than it ever has been to take over someone else’s mortgage. Given everything you know about this, what is the profile of an investor who should think about this type of strategy?

Eddie:

I think you need to be operating at a level where you are making a very informed decision about the strategy and the process and the documentation and the risk associated with it, and that you are prepared for something not to go right, and that you’re in a position to fix it. Now, there’s another issue here that we haven’t really discussed that’s very important, and that is state statutes relative to borrowers that are delinquent on their mortgage. Because a lot of times the reason people do a sub two is they’re behind on their mortgage. So about 50% of the states have mortgage foreclosure protection laws. That means if you’re delinquent on your mortgage, Kathy, in your state for sure, there’s consumer protection laws that says in the state of California, if you’re delinquent on your mortgage, you’re a protected class, you’re like a minor.

Kathy:

I thought the opposite was true because in California you can foreclose in 28 days or something unless the laws have changed. I dunno. It was very, very quick here. Really? Yeah, it’s shocking. Now there are places like Pennsylvania where I would never hold a note because you can’t foreclose. Florida has been shockingly very difficult considering the color of that state so to speak. But California I always thought was pretty easy. But you’re right Eddie, every state is different.

Eddie:

Alright, so let’s go back in history and let’s talk about why this happened. Kathy, you remember the old short sale days?

Kathy:

I do. You

Eddie:

Remember all these kind of panhandler that would go get somebody to pay them a fee to go arrange a short sale and they were sort of scamming, they really weren’t going to go work and get ’em a short sale. You remember those days?

Kathy:

Yeah. Oh yeah. Wild wildlife.

Eddie:

Well, a lot of states then adopted delinquent mortgage protection laws. So that borrower is a protected class. Now you are in a fiduciary responsibility in dealing with that borrower. So you can imagine, Dave, I’m going to bust out there and go in these states. Now I don’t have a clue whether my state is one of those states You’re not, right? I don’t know what the statutes say. We’re just going to ignore all that. Or we never even knew to ask. Now all of a sudden I find somebody, they’re delinquent on their mortgage and I’m going to write ’em a check, get ’em to deed the property to me and I’m going to buy the property at a discount. Right? Now you go back and say, I wonder if some of those mortgage foreclosure protection laws said that my fiduciaries could do that because now they’re in a fiduciary responsibility in dealing with me.

Oh, that could be an issue. So this is also risen. Its ugly head. These are stories that I’ve heard pretty common where people have gone out and wake up one day and find out, well, apparently this is one of those states, about half of ’em have this law and they’re all different within the state, so you can’t say they’re not all written exactly the same. But basically the concept is this. The borrower who is delinquent, sometimes they say foreclosure has been initiated. Sometimes they just say delinquent. But now you’ve gone out and you’ve realized that person you did business with that then allowed you to do a sub two was a protected class. I hope I’m making you nervous. No,

Speaker 5:

Yeah,

Kathy:

You are. That’s

Speaker 5:

My quiet.

Eddie:

This is why you can’t this, you have to get good advice before you go do this

Kathy:

And not take it so lightly. The pitch has been, and I know people who’ve done sub two that have done well and have become wealthy and I’ve been jealous and why can’t I have the nerve to do this? But the pitch has been this is a no money down way to build a pretty massive portfolio with low rates. I, and of course it’s not always the case, but it’s solving a problem. Like you said, this person is backed in a corner, they’re going to lose the property anyway possibly and lose everything. So again, that’s the pitch. But the reality is there is risk and people need to know about it. And so let’s go back to that of the risk to the seller. Well, we’ve been talking about the risk to the buyer, to the sub two person. Other risks are there because now they’re on title, they’re a fiduciary, so they better have given a fair deal.

Eddie:

Half the states have this, half the states don’t have it, and not every bite does a sub two is delinquent. So this doesn’t mean every person in every state and every scenario has this scenario, but that’s a level of awareness. I’m very intentionally bringing to the conversation because I found out this is not a commonly understood thing. Once again, I’m not an attorney, but Kathy, I’ve had quite a bit of dealings with people that specialize in this. I have been brought in many times to go help evaluate the risk management side, even from the attorney’s perspective, because I’ve seen this so much. I’ve seen so many people that have done it sort of seen what can go wrong. As you said, Kathy, I’ve seen people that have done it really well with it. I’ve seen people that have not done so well with it.

Kathy:

Yeah, I mean, really to me it comes back to ethics. If you are giving a fair deal to this person and you are acting as a fiduciary where you do give them some cash, if there’s equity in the project or if there’s not equity, you’ve just relieved them from this debt and you can prove that. But how could it go wrong even if you’ve kind of done it right in that regard, what if it doesn’t perhaps perform the way you thought and you can’t make those payments or I dunno, what are more risks?

Eddie:

The first thing I would say to you is, Kathy, go up in front of a judge and here you are, a real estate investor that came up with this really clever idea, and then you got these people that you got to essentially sign over your property and take their mortgage. Now something’s gotten messed up. Who’s going to be perceived as the opportunistic person here, right? Who’s going to be perceived as not so reasonable? So now you can see where lawyer in this up becomes pretty important.

Dave:

Yeah. That’s the only real way to protect yourself, right? Yeah. There’s no shortcuts to this. If you’re going to do this, you need to be speaking to an attorney and making sure that everything you’re doing is legal, ethical, all of that.

Eddie:

And this is not something that most real estate lawyers have a high experience in, or I don’t want to say they’re incompetent, but they’re not specialized in this field. So this is not something that just you go in the yellow pages, they still have yellow pages. They don’t have those anymore, right? Kathy? I don’t know if they have those. Yeah, you go look for a lawyer and okay, well this guy, he’s not the guy. And so that’s kind of the areas that we’ve seen. So you can do this where you believe that you have identified the risk and you’ve managed the risk. Identifying there is a risk, right? Kathy, very clearly identifying there’s a risk associated with this, and then there’s a way you can do it where you’ve kind of blindly not even assumed the risk. And that’s somewhat like crossing the highway with a blindfold bone. It just may not work out for you as an industry person. That’s what I want people to get. I don’t want to make this sound like it’s so easy that anybody that can spell real estate can do it. I don’t want to sound like it’s so impossible that I think I haven’t seen people that are successful because I have. Right.

Dave:

All right. Well, Eddie, thank you so much for sharing this information. This is really helpful. You bring a level of expertise on this subject I had not heard before and really appreciate your words of wisdom and caution to real estate investors. If you want to learn more about Eddie, we will link to his website and information in the show notes. As always, thanks again, Eddie.

Eddie:

Thank you very much.

Dave:

On the market was created by me, Dave Meyer and Kaylin Bennett. The show is produced by Kaylin Bennett, with editing by Exodus Media. Copywriting is by Calico content, and we want to extend a big thank you to everyone at BiggerPockets for making this show.