Seller Financing Valuations

[Brandon Bohland]

I'm having a hard time valuing seller financed deals. I've had a few come accross my plate, and I'm thinking I had it valued lower than I should have. I understand a couple good rules of thumb:

1. Cash Deal: ARV - 70% - Repairs = Purchase Price
2. Buy and Hold: I like to use 1 month rent x 50 = Purchase Price

These are probably for all cash deals. What if the seller agrees to do a land contract or 'subject-to' deal? Is there a rule of thumb on this?

Here is a quick example: There is a motivated seller who's house is worth $80k. He owes $63k and is willing to do a 'subject-to' deal. It probably needs $15k of repairs/reno. What kind of value should I add for the seller doing the financing assuming it's a 6.25%/30yr fixed. Or, in general, any good rule of thumb?

Thanks!

[Bill Gulley]

Originally posted by @Brandon Bohland:

In general though, I agree that it depends on the exit strategy. But you have to value seller financing higher than you would cash, right? So is there a general rule of thumb for a flip exit and a buy/hold exit? To me seller financing is worth more than using my own cash, but I'm not sure how much? Is it more of an art (deal by deal) than a science (rule of thumb)?

Brandon, this has been discussed at length on BP:

Scam artists use seller financing (SF) to get a higher price, they love your thinking, those who can't borrow are attracted to SF as a solution and predators take advantage of the situation.

Financing, of any kind, does NOT add value to the property, it is what it is, period.

What many get into are combining two different aspects, the "value" of a deal to you from an economic point of view and the value of the deal as a fair market value price being paid for the property. You need to keep these two aspects separate as they do not mix.

The value of anything is based on an alternative and looking at the opportunity cost between the two alternatives. In other words, financing is worth what it would cost you to obtain other financing, that's all it's worth.

Consider too the value of SF to the seller, avoiding gains on the sale deferring taxes over the term and obtaining a higher interest rate than they could invest elsewhere with similar risk along with the ability to sell part of that note for cash requirements, they can use that note as collateral and there are few annuity contracts they could ever get into that offered these benefits. The seller is not doing you any huge favor! Unless they really need the cash, they are better off providing the SF in an installment contract!

It's when buyers are faced with no alternative but to use SF is when the get screwed over, paying a premium for financing that attaches as a lien to the property. Holding long term can consume the premium paid by appreciation. Basically, the seller is stealing future appreciation of the property and charging interest on it until the market value and financing plus your equity (repairs, maintenance and other factors) meet, depending on how much you over paid will determine when your equity begins to accumulate.

The issue is, what happens if there are "life events" that may require you to refinance and you are owing too much against the property, you're underwater! This is more of an issue with buyers who intend to sell more than with buy & hold, but financing also effects your debt to be covered by rents, your lender is also stealing future rents if the premium paid is too high.

You can usually pay about 3% more for SF as that is close to what alternative costs might be, a slight premium can be consumed rather quickly even buying at a market value that is near (or at) an asking price. I don't want to get into defining market value for 276th time, but basically saying buying at the asking price if it would appraise out.

You can't pay lending fees on seller financed transactions, which could be a solution, but you can't charge on financed equity, so you're left with making an value contribution of your economic benefit being attached as a lien.

The value, economically, is viewed in light of the terms, rate, amortization and payment structure, the lower the rate, the longer the amortization and the more stable payments are the greater the economic value to you. This also must be met with the risks, those life events that may cause you to not enjoy that loan over the expected term.

"Life events" include, not limited to, death, incapacitation, bankruptcy, divorce, health issues and disability as well as law suits. These matters apply to both the borrower and lender in different ways but such matters can effect either party, lenders are people, not institutions.

All in all, if you feel that SF is more valuable to you, I'd suggest you not pay more than 3%. You can also adjust the interest rate, so long as you stay below any legal limit, usury, and you can shorten the amortization providing higher payments if that is an advantage for the seller. Another way to increase the value to the seller on a commercial note is to agree to a no prepayment period, be very careful you don't do this out too far, 5 years nor more than 7 should be enough of a benefit. This allows the seller to be assured of a stated amount of interest over the term as well as a more predictable tax liability schedule. Your financing from any economic benefit should be more than paid for with these approaches rather than encumbering the property with a higher debt load.

Read posts on the ARV, here on BP, that too is well covered. J. Scott has a good book on this matter as well.

Your plan to lease-option needs to be considered as well, there are predatory issues involved with every aspect of RE investing, read posts on this matter as well. Stay away from guru books to base your transactions on, they might be good for marketing and sizzle, but fail in serving up the meat, legally and ethically in many cases. Your SF needs to exceed the terms you are obligated to sell under, otherwise if you fail to refinance you could be in breach of your agreement.

Use an attorney and use a "loan servicer" you can read about them as well here and why loan servicing is critical to a buyer. Since this is not an owner occupied dwelling type sale, Dodd-Frank will not apply to you buying as a commercial venture. Good luck :).