Would you "overpay" to obtain seller financing?

Question

Howdy All,

I've recently been focusing on seller financing models and the determination of a maximum allowable offer. My commercial lender will provide up to 75% LTV and will allow the seller to carry back the difference, thus eliminating the need for a down payment.

With the help of these forums, I built a model that sensitivity tests MAO as function of capital structure, DSCR constraints, and cash flow per door thresholds. One drawback of the model is that inexpensive credit and/or long amortizations may result in a proposed MAO that is substantially higher than fair market value. That is, the calculator will determine that you can "overpay" and still hit key cash flow metrics. However, in doing, so it places the asset underwater from a liquidity perspective.

Fixing this is easy: just add a price not to exceed based on a cap rate valuation, CMA, or other manual input.

My question for the group is: Would you be willing to pay a purchase premium in order to induce seller financing? On the one hand, you may close with little/no/negative equity if you pay a premium, which adversely affects liquidity. On the other hand, you may generate substantially higher deal volume. As long as you have staying power through a healthy DSCR and conservative reserves and allowances, it would seem that the willingness to hold the asset for a potentially long period of time becomes a primary consideration.

Looking forward to hearing people's thoughts on this.

Pat L. · Answer

@Christopher Freeman they all had tough legal representation & the majority assumed some young kid would never have the drive to completely rehab a home & go for alternative financing in such a short period of time. In fact I was told a couple of the attorneys advised their clients they would be taking back the homes when I reneged on payments. They dwelt on the high % rate minutia not the on a drive to succeed.

The shortest was 3 months before I refinanced, then he & his daughter asked to tour the home after the complete rehab. It was a classic old 2 story home with amazing patterned plaster walls & medallions on the ceilings. Solid wide oak floor that we refinished & all the built-in natural wood cabinetry had leaded glass doors as were the windows.

When we originally entered this home my GF walked through the kitchen, with walls covered in spattered food (he heated cans of food on the stove) & threw up in the back yard. It was very bad. We paid $72k for that home, (& we still own it). The bungalow on a smaller lot next door just sold for $599,900.

Many of my 'JOB' colleagues would drop by nights & weekends to drink my beer & watch me bust my azz & tell me how much money I was going to lose on that piece of trash. 10 years after I bought this one & several more I retired. Even though conventional financing dried up (after too many mortgaged  properties), I have never had to renegotiate owner financing I just cashed out period.

I could write a book on these types of homes we acquired.

Account Closed · Answer

Your comment: "My commercial lender will provide up to 75% LTV and will allow the seller to carry back the difference, thus eliminating the need for a down payment."

Your lender will require an appraisal and will lend the LESSER of the Appraisal or the Contract Agreement.

So, for instance, your agreement with the seller is for $250,000 and your 25% carry back is $62,500 and your lender will lend you 75% or $187,500 based on the preliminary paperwork. This is what is agreed to but the appraisal hasn't been done yet.

Next, your lender will have an appraisal done but say the value comes in at $200,000 not the $250,000 you've agreed to. Remember, the appraisal is the basis of the loan to a commercial lender, not your contract price. The lender will drop the amount they will lend to 75% of the appraised value of $200,000 or to $150,000 and you have to make up the difference of the sales prices of $250,000. So, $100,000. But that now becomes a 40% carry back, with the lender now providing 60% of the funding of the original $250,000 if in fact the lender will allow you to over encumber the property which most won't.

Also, Balloons and Adjustable Rates destroy the value of owner financing in most cases.

Christopher Freeman · Answer

Your comment: "My commercial lender will provide up to 75% LTV and will allow the seller to carry back the difference, thus eliminating the need for a down payment."

Your lender will require an appraisal and will lend the LESSER of the Appraisal or the Contract Agreement.

So, for instance, your agreement with the seller is for $250,000 and your 25% carry back is $62,500 and your lender will lend you 75% or $187,500 based on the preliminary paperwork. This is what is agreed to but the appraisal hasn't been done yet.

Next, your lender will have an appraisal done but say the value comes in at $200,000 not the $250,000 you've agreed to. Remember, the appraisal is the basis of the loan to a commercial lender, not your contract price. The lender will drop the amount they will lend to 75% of the appraised value of $200,000 or to $150,000 and you have to make up the difference of the sales prices of $250,000. So, $100,000. But that now becomes a 40% carry back, with the lender now providing 60% of the funding of the original $250,000 if in fact the lender will allow you to over encumber the property which most won't.

Also, Balloons and Adjustable Rates destroy the value of owner financing in most cases.

Great point on appraisal. In our particular scenario, there is fortunately no balloon or adjustable rate.

Stephen Akindona · Answer

Yes I would! Terms are a very critical and crucial part of any real estate deal! Overpaying can be another strategic tool you use to beat out the competition and otherwise acquire properties you wouldn't have been able to. Again it goes back to all the investment fundamentals! Does it cash flow? Are you sufficiently capitalized? What are future market trends telling you? What is the eventual exit strategy? If I can buy a deal that cash flows today and has some potential appreciation upside, with "0" down then I am usually all for that! I don't mind holding properties for the long term so market value becomes less important if you are willing to hold long term!

JD Martin · Answer

Maybe. It depends on what I think the long term prospects are for the property and how much cash flow it generates, and how it affects my overall net position. You never really know if you "overpaid" until it's all said and done - i.e., you've sold the property or held it to death.

Example: Your market has 3/2s for $100k average market price. You pay $120k. You overpaid, right? But let's say this market is on the verge of a takeoff. 5 years from now 3/2s are $350k. Did you overpay? No, you just got in a little later than the $100k people.

Geordy Rostad · Answer

@Christopher Freeman

It's hard to judge without the numbers but yes, I might consider "overpaying" if the seller financing was really sweet. Keep some things in mind:

1) Seller financing usually has no closing costs/points associated so there's huge savings at the signing table

2) Sellers could offer better than market interest rates and terms which would also equate to savings

3) Sellers can offer whatever LTV they want. I was working on one the other day where the seller only wanted 15% down which was substantial compared to the market of 25%.

4) No appraisal required. Another huge cost saving.

Considering all these factors, YES, if you agree on a price, you will eventually have to pay that principal one way or the other but for a long term hold, I'd certainly consider it if the numbers made sense.

Randall Weatherall · Answer

This is predominantly a question for people that don't plan on keeping it very long or grossly overpay.  Generally, seller-financing comes with a ton of benefits over traditional and if it doesn't, then why try to get it?  Those perks will almost always come at a price, so it's up to you to decide if the proposed amount  tomorrow's money is worth it numbers-wise compared to traditional financing (which usually costs you more of today's money).  Remember: spend tomorrow money any time you can!

I will say that I've noticed it's a lot less common in our current market to find seller-financing options, but when they pop up, then tend to be way inflated; inflated to the point that I will advise a client that we can find a traditional lender and save money!

Christopher Freeman · Answer

Were you upfront during the negotiations process about the possibility that you would cash them out early? I definitely intend to market based on a combination of cumulative returns and/or NPV, but I have mixed feelings about lubricating the deal with an offer of solid fixed income and then cashing them out at the earliest opportunity.

I do, however, think that an early pay-off is an opportunity for further negotiation in the form of offering to buy the note from the seller at a discount.

Pat L. · Answer

When I started investing seller financing was all I could get. I'd agree to 10% down but squeeze the price down then offer a much higher rate of return. Most jumped at that & even though there was usually a balloon I always made sure there was no pre-payment penalty. This was because most required a lot of rehab to get them to appraise high enough for conv. financing months later. Invariably I'd get the required appraisal & pay off the loan well before the balloon was due or before I was swamped with high interest payments.

I continued this for many years, especially if I wanted the deal & was viable. BUT I'd still throw out the higher % teaser rate than going higher in price because when they see the return after 5 years they appreciate that they are going to get the price via expected cumulative interest payments. Then once the rehab is done & the property is livable/flippable I'd simply payoff the loan cash then either kept it or flipped it CFD.

Strangely enough the majority were simply glad to get the cash earlier than wait the compounding profitable 5-10 years..

Bryan Devitt · Answer

@Christopher Freeman 80% of something is better than 100% of nothing

Would you "overpay" to obtain seller financing?

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