is it ever a good idea to pay 14% more for seller financing?

Question

I am looking at a 29 unit apartment building (brick/flat roof) that is worth $2.2M.  It is 100% occupied and needs $100k in upgrades (value added items only) plus parking lot pavement of another $60k cost.

The seller has offered to hold 85% of the purchase price with 5 year balloon, interest only at 5% rate, amortized over 30 years.  The catch is that I have to purchase the property for $2.6M.

$318k  Rental Income

$121k  Operating Expense

$202k  NOI

$110k Deb Service (interest only)

$92k   NET PROFIT

So for my investment of $390,000, I will get a sizable asset plus recover my initial investment in just over 4 years.

Any thoughts/comments would be appreciated.

Thanks,

Nilton Lisboa

Nathan Gesner · Answer

You're willing to pay an extra $400,000 in purchase price just to avoid 5% down payment through a traditional lender? I don't understand the math.

Joe Villeneuve · Answer

If this was PI and not interest only I would say yes, but all you're doing is paying $400k more for the property...out of your pocket.

The reason why I say I would do it if it was PI is (as long as it is still positive cash flow) the tenant is paying that extra cost...not you.

Now, if you plan on financing the balloon note at the end, then this is a great deal...as long as you are sure you are going to be able to get the needed financing at the time of the balloon.  If not, your balloon will burst, and this would be the worst thing you could do.

So, quote Dirty Harry, "do you feel lucky"?

Nilton Lisboa · Answer

Very Helpful guys... much appreciated.  This property would be the most expensive residential property in town of 15,000 people sold in the past 24 months.  I had assumed refinancing with traditional lender would be easy but I agree that it may not be as easy 5 years from now.  After further underwriting the property, I learned that it will still be positive cash flow even at 50% expense rule and P&I payments with owner financing.  However, the gross rent is mostly tapped out and will not be able to raise much more.  I do not believe I will pay his asking price but will at a lower value.  If not, we shall move on :-)

Thanks again,Nilton Lisboa

Joel Owens · Answer

Before even looking at the financing you need to underwrite the property. Seller by the numbers looks like about 38% expenses. That is VERY LOW and typically only seen in brand new apartment complexes built or full gut to the studs rehabs for the first 5 years of ownership when everything is new.

Typical expense is 50% of gross expected income and if landlord pays utilities 60% ESPECIALLY in cold belt states where properties tend to need more care and maintenance than many warm belt state areas. What the seller appears to be doing is juicing the numbers for over market value to provide seller financing.

With interest only there is no paydown of the note. When you go to cash the seller out in five years you might have a very hard time with a regular lender and regardless of what you pay in the contract the lender will look at current market value with the appraisal. You might be required to put down a large additional cash payment to get LTV where regular lender would do a loan. Interest rate in 5 years are likely much higher as well.

Flat roofs can be a lot more expensive than pitched roofs. You need to look at core samples as sometimes landlords put a cheap layer on top and it's a mess underneath. If too many layers are on the roof then insurance might not write the policy on the building. Owners can put lipstick on a property to make it look good on the surface but what is underneath can be the most costly and expensive to fix and drain cash flow to a neutral or negative position for years.

Is there anyway to drive value meaning current rents are say at 914 a month but market rents are 1,250 a month or are market rents 900 to 950 and this property is tapped out? How often do properties become available for this deal size? If you really want this property then likely try to work on less down to 10%, extend 5 year balloon to 10 years or minimum 7 years ( you want time to paydown extra on principal since interest only), get non-recourse loan from owner, get purchase price down more to current market value.

Analyze how much risk factor you have. Example if you are worth 3 million and putting down 300k for owner finance non-recourse but make 250k a year from job or business and things go bad the losses might be manageable. If however you are worth 400k leveraging into a larger deal putting down 300k and money is a chunk of change from a one time event in life (inheritance, sale of business, etc.) then if money is lost might be very hard to get to that point again. One mistake I see is people massaging the debt to try and make a deal make sense to purchase. If someone has to massage the debt in a way where everything has to go perfect with a property and cash flow projections to make it work then likely setting up for massive failure. Things will and do often go wrong with a property. Best case scenario for underwriting needs to be icing on the cake and more conservative underwriting expecting things to go wrong and still pencils for a good deal needs to be the norm.

You might could do a master lease option or option to buy upfront. This way over so many months you get to see how the property operates and if what the seller is claiming is true for tenants, payments, etc. During this time you would not want to put in expensive repairs or upgrades out of your own pocket. If everything looks good over 3 to 6 months then you might decide to buy. If not you have time in and walk away if things look bad.

It's a sellers market in many parts of the country so seller might balk at some of these strategies but do not saddle yourself with high amounts of mediocre debt with limited future upside on a property. The seller is trying to get cash upfront and relieve themselves of managing a headache, have you spend your own dime fixing up the place, and then later on get the equity upside you have worked hard for. Really nothing left for you much as a benefit.

No legal advice given.

Steve Rozenberg · Answer

I would say it depends on your current financial situation. Normally it is either price or terms. Cash can normally command a lower acquisition cost as opposed to loan or owner financing

Also I would say more importantly it depends on if this deal aligns with your goals and your strategy and what your exit strategy is. I would not focus on the % you are charged but more on your end goal

is it ever a good idea to pay 14% more for seller financing?

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