Avoiding "Due on Sale clause" with a convential lender. A saga.

[Spencer Hilligoss]

A popular topic for rookie investors (like me) on BP.com involves the dreaded "Due on sale clause" - aka: When you take out a bank loan in your name and later transfer it into other ownership (such as your own business entity, like an LLC, in our case)... resulting in a trigger of the "Due on sale clause" in your loan terms. If this happens the bank may call your entire loan balance due! Not fun. Not frugal.

Given how many new investors are out there working through this scenario, i'm putting this post out there to let others track our progress through this process and *hopefully* provide insight for other who either 1) haven't created a REI business entity yet, or 2) plan to take an investment property loan from a big bank for their next acquisition, and eventually want to transfer it to a business entity.

After reading countless articles, REI books and forum posts on this topic, we decided to take the soundest-sounding advice: Communicate openly with the lender and ask for permission, in writing, to transfer the property into an LLC.

Below, i've broken down the timeline and key events in the mini-saga thus far. For context, we'd already created a multi-member LLC earlier this year...

Week of 10/16/17

• Step 1: Closed deal
• Step 2: Contacted lender to request their written permission to transfer of property into LLC

Week of 10/23/17

• Step 3: Called lenders Servicing team - pulled from their company website. Asked "We're interested in transferring our property into our LLC. How could we work with you to make that happen?"

• Step 4: Reviewed requirements - Servicing rep provided a boilerplate 1-page list of requirements and we reviewed them. Frankly, I was relieved to see they actually had a formal process for this already outlined on a single page. Based on the many mixed messages on this topic, it’s tough to know if you have any shot of successfully completing this process.
  • The banks requirements have been included below, and they explained that we would receive a decision on our request in 7 business days, max. The banks requirements:
    • Requirement #1: "The members of the LLC must be the same people who signed the Note and the Dead of Trust."
    • Requirement #2: "The LLC must be for personal real estate holdings only; cannot be a mixed purpose LLC. For example, the LLC cannot be used for commercial rentals."
    • Requirement #3: "The LLC must not expire prior to the maturity date of the Deed of Trust."

• Step 5: Submitted our documentation the same day - We provided the lender with (what we thought were) LLC documentation, including Articles of Incorporation, Operating Agreement, Statement of Information

Week of 10/30/17

• Step 6: Crickets - A week passed by, and no response came in, so I called them. A servicing rep mentioned that the decision was in the mail and it was a rejection. I thanked him for the clarification and asked if they could provide more detail about why. Rep mentioned that he could only read the details outlined on the letter and "I should speak with someone at my local branch”
  • In our case, we failed to meet requirement #2, because we created a vanilla, standard mixed-use Operating Agreement… and that was our mistake/learning learning for this particular bump in the road.
  • At this point, we decide: "Well, we created this LLC for the purpose of investing, so let's amend the Operating Agreement. We're only planning on investing in residential real estate anyways."

• Step 7: I head to a local branch - I print out a copy of the bank's requirements that were sent to me and bring the entire LLC formation packet with it, with a simple goal in mind: Nicely request for the bank to explain, specifically, what they need the Operating Agreement for our LLC to say in order to meet their requirements.
  • I walk into the silent, large bank (in the middle of financial district, San Francisco.) No customers and two tellers. Both of which greet me warmly. I explain the situation. I explain that I was advised to speak with a branch by a member of their Servicing them.
    • Given the confused looks on their faces while reading through the document, I mention to them that “i’m totally comfortable if we need to set up an appointment with the appropriate person, if they aren’t available at the moment.”
    • They mentioned that they would speak with their manager, call corporate and get more info. They ask for for my info and the more senior of the two provides me with a business card, a firm handshake and assurance that they would be following up with me promptly. I leave.

• Step 8: A few hours later, I reach out to keep the conversation going (just in case) - I plug in the email for the teller I met at the bank and send a friendly note and thanking him for addressing my situation. He promptly replies with the following email:
  • "I have reviewed the document you provided me and spoke to our loan department, they told me that in order to move forward with your request all the guidelines and documents must be met. I also spoke to my manager and he suggested that you reach out to the number on the document you gave me to verify what else needs to be done. Unfortunately we don’t handle this at the branch level since there is only so much we have access to. I apologize for the inconvenience and hopefully this helps.”

• Step 9: Call bank (again) - Later that day, I give a friendly, calm call to the bank Servicing dept (again), in the hopes I’d speak to someone helpful - Thank my lucky stars: I spoke with someone helpful. They confirm that the language provided on the letter for that 2nd requirement was literally, exactly what needed to be on the LLC Operating Agreement. I thanked her and laughed at the situation. She apologized profusely and had a laugh with me about the situation.

• Step 10: Lawyer, help! - Today I reached out to our lawyer and requested an amendment to our operating agreement to align with the requirements

Week of ?

• Step 11: to be continued….!

If you read this far, you're likely a far more experienced REI than I am… and thinking: Man, this guys a rookie! He REALLY should just…

• … use private money
• … use hard money
• … use cash. Wait, why don’t you have cash? Be more frugal!
• … hold the property in his own name and use umbrella insurance. That’s sufficient anyways for liability protection.
• … Flip houses instead. Flipping is waaaaay more cool than holding.
• … etc

All that said, this tragic and comical saga must continue. It’s too great of a learning experience and far too validating of every big bank stereotype for it not to keep playing out. Also, I will forever learn my lesson: "Tailor your buy/hold LLC to meet big bank lender requirements if you want any chance of written permission to transfer title." Live and learn. I'll update this post as it continues to play out.

All of this, to avoid the dreaded "Due of sale clause."