Is This Method of Creative Financing Legal and/or Ethical?

Question

In the very first real estate book I ever read, "From Janitor to Multi-Millionaire" by R. Mike Weese, I learned several methods for buying property with no money down, aka creative financing.

There is one method in particular that I just assumed was 100% ethical and legal, but my BIC seems unsure about because she has never heard of it or seen it done before. She wants to ask around before letting me do it. This is totally fine, of course, because if it's not ethical then I don't want to do it.

Here's the example from his book, but skip this for a quick summary next:

Let me give you an example of my early days in real estate. In the city of Brea, California, in the early 1970s, I was able to buy three and four bedroom homes for $50,000. In many instances, these homes would actually appraise for as much as $60,000. I remember doing some cold calling, or canvassing, as they call it nowadays, on homes advertised for sale by owner in the local newspaper. I remember finding one, where the seller told me he had a current appraisal of $60,000. He was willing to sell his home for a net of $50,000 to him. If I were to earn a commission, I would have to add it on top of the $50,000 that he had quoted me. In my negotiations with the seller, I confirmed that his only desire was to walk away with $50,000 from the sale. He acknowledged that was true. I then presented him an offer in the amount of $60,000. I told him to not get excited until he read the second page where I discussed the commission. On the second page I had entered the amount of $10,000 as the commission I would receive for selling his property! He then proceeded to tell me that he thought that my commission was extremely high. I told him that I agreed with him, but that was the only way I was interested in purchasing his property, and it really made no difference to him since he would still get the $50,000 he had required. I then went to the lender to ask him for a 90% loan based on the $60,000 sales price. Remember, we had a current appraisal placing the value at $60,000. The lender had no problem with the appraisal and agreed to make me a loan of $54,000. There were minimal closing costs involved in this transaction. I placed $6,000 into escrow, which represented a 10 percent down payment. At the end of closing, the Escrow Company cut me a check for my commission in the amount of $10,000! I had purchased this property for $6,000 out-of-pocket costs, and received $10,000 back at closing. I was then the proud owner of a new property and had $4,000 in my pocket from the commission that I had received! This is one instance where it pays to be a real estate licensee. A real estate licensee has tremendous flexibility in finding properties that he likes and being able to use his commission toward purchasing the property.

Summary:

Seller has property appraised for $60,000.

Buyer, who is a real estate licensee, discovers seller just wants $50,000 at the end of the deal.

Buyer makes offer for $60,000, where $10,000 goes to commission and $50,000 goes to seller (closing costs were minimal).

Buyer gets loan for $54,000 from bank and puts $6,000 (10% of $60,000) into escrow.

At closing, seller gets $50,000 and buyer gets $10,000.

Buyer put down $6,000, but then gets $10,000 out of his own loan via high commission.

Seller is happy and Buyer walks away with property without spending any money out of pocket AND now has an extra $4,000 cash that he pulled out of the $54,000 loan.

Is this legal and/or ethical?

It seems to me that the there are no issues between the buyer and seller, since they both agreed to it. Any ethical dilemma would be between the buyer/agent and the bank.

In the end, it allows me to purchase more property to buy, hold, and rent. This is good for the community and no harm comes to anyone (seller, buyer, or bank). I think the author of the book was probably not entirely up front about the amount of commission he was earning with the bank, and they probably didn't even notice what was going on. If that's the case, is it his job to point every little thing out to the banker? OR is it just his job to submit a loan application and see if it get approves or not?

This strategy was a significant factor when deciding whether or not to get my real estate license. It was also a HUGE factor when picking a company to work for. I finally found one that wouldn't take a percentage of commission on the deals that were for myself. (This method would NOT work if I had to share 20-75% of my commission with my broker! I'd just be giving them free money out of my own loan.) I'm going to feel awfully silly if this turns out to be a bad idea.

Thanks for reading and helping this newbie out!

Andrew Postell · Answer

@Cliff T. this type of lending was identified as one of many reasons to the housing crises a few years ago. Receiving cash back at closing on an investment property is not possible now (but you can receive your commission check) and you can only borrower 85% with a conventional loan on an investment property. For lending, the loan amount will be based on the appraised value or the sales price...whichever is the LOWER figure. But again, no cash back at closing on a purchase. Sorry.

Tom S. · Answer

@Vinay H. Typically you can't inflate the price to borrow more, because the banks use the lower of the purchase price or appraisal value. The example you provided could just be a true bidding war as long as it appraises (the realtor could have listed it low to create the bidding war). Or it could be cash buyers.

Lynn McGeein · Answer

I believe you are describing a net listing, which is now illegal in most states, where the seller just wants a net amount and agrees to pay you anything over that amount if you sell it. However, there is no set commission rate, so I do not imagine anything wrong with bringing an offer to a FSBO that has a $10,000 commission built in. If he didn't want to sell, he wouldn't have to. However, there may be agency issues involved as if he complained later that he thought you were establishing an agency with him by telling you he only wanted $50,000 and you could keep anything above that. If he decided he was taken advantage of and complained to the real estate board, you could be in some hot water as that is an extreme commission. As a licensed real estate agent, if I buy a listed home and do not reduce my selling commission, I will receive a payment from my broker after the sale has closed, paid from commissions the seller paid to my broker. It is done frequently and lenders usually have no issue with it.

Trina S. · Answer

As a self employed realtor you will have trouble getting a loan for an investment property unless you are extremely established and have great net tax return income over many years. Many self employed people cannot even get loans for their own primary homes... So even if legal or ethical, probably not doable with a bank.

Greg Scott · Answer

The key phrase here is "in the early 1970s". This sort of deal is no longer possible using conventional financing. It is possible with a private lender, but then a private lender can do whatever they want.

Dustin Lavender · Answer

Cliff T. I have seen it done where there is a closing incentive written into the contract in which you pay a certain amount for the property and as a closing incentive the seller pays you X amount at closing. In another note, I get cash back at closing all the time but it is because I leverage equity from one property to buy the next. I use equity as closing costs, down payment, and cash out the rest in a fat check at closing.

Cliff T. · Answer

I didn't know you could not respond/reply to individual comments, so this may be a bit lengthy as I try to thank and reply to each person. Please read the example at the end!@Greg Scott: That is indeed a very good point. Is there a specific law that now makes it impossible to do with conventional financing, or is it just less commonly done? Thank you!@Trina S. As a self employed realtor I can still buy properties for myself, rather than through my LLC. I can keep it in my personal name for a while and then sell it to my LLC at a later date, right? Also, I have a great W-2 job which keeps me on good terms with the bank. Investing will hopefully be full-time eventually. I just need to determine if this is a tool I can employ to help make that happen, or not. Thanks! :)@Lynn M. You are absolutely correct and a net listing is against the law in my state (SC). I don't think it would be a net listing, though... I'm not listing anything. I'm the buyer. I think you are also correct that this would be more likely to work on a FSBO, since there is no listing agent to get an extra chunk of the inflated sales price (60k instead of 50k). I REALLY appreciate your point about agency, too! I had not yet taken that into consideration. I would have to be very upfront with him about that from the very beginning and have him sign a document stating that he understands it before we close. Thank you!@Vinay H. I guess there are several possibilities with that one. I'm not an expert on this (yet), but maybe it was a 203 k renovation loan? Then again, according to @Andrew Postell, the loan could only be for the appraisal price or the sales price (whichever is LOWER). I think @Tom S. nailed the 2 most likely scenarios, though. @Andrew Postell Thanks! I have found out the hard way that the most I can get for an investment property is 85%. If I find a motivated seller who is willing to take a 30% discount on his asking price (and let's assume his asking price is based on an appraisal), then it could still work even with 85% LTV, right? Just not as well as a 90% loan?I kind of feel like your point is going over my head, sorry if that is the case! Let me ask you this:What if I employ this method on my next primary residence!? Would that make it a viable option? Thanks!!My takeaway notes so far are that this is not as easy as it sounds, and perhaps not even possible. Also, not one person has made a case for it being unethical. So if I do get an opportunity to use it on my next primary residence, then it's worth considering. It may also be worth considering if I'm buying an investment property with a significant discount (30% or more). For example:Asking price $60,000Appraised value $63,000Motivated Seller agrees to $42,000Buyer/Agent makes offer of $60,000 with $18,000 commission85% loan is $51,000 and 15% down is $9,000So, the buyer/agent fronts $9,000 for the loan, but then walks away with $18,000 in commission that came out of the loanWhat do you guys think? Could it work? Would it be breaking any laws or trust?Yes, No?I really enjoy and appreciate you all helping me out with this topic!! Thanks a million!!!!

Vinay H. · Answer

Had a similar thought when I saw this listing that went for 126k over asking. I was wondering if the buyers were "inflating" the transaction price to either borrow more or even receive funds/commission at closing.