By John J. Merchant, J.D, EMS
Here is an outline of the elements that should be considered when
creating and structuring a cash flow note which the note holder/payee wishes
to sell at or shortly after closing.
Credit of the Property Buyer(s)
The better it is, the more valuable the seller carryback note is
going to be to a prospective note buyer. Don’t know what the
property buyer’s credit is? Then don’t bet the barn on a great note
sale, because the note buyer will want to know the buyer’s credit.
And if the property buyers are husband and wife, or more than one
buyer, demand credit and financial statements from everyone.
These days it’s common for the wife to earn more than the husband,
and you want to know all about both. If the noteholder is not
equipped to obtain a credit report, ask your bank or local credit
agency. They’ll help you get it.
Sales Price of the Property
This should be at or LESS than the provable/establishable
value of the property. Is it more than the actual value of the
property? Then expect your note to sell for LESS than you want,
because the experienced cash flow note buyer wants the property buyer to
have some equity in the property so the property buyer isn’t
likely to default.
Provable Value of the Property
Don’t know? And the property buyer hasn’t demanded an
appraisal of any kind? Great, if the property is selling for all
cash — but if you’re taking back a note and you want to sell that
note simultaneously, be aware that the note buyer is going to want
to know the property value. And many problems are created if your
note sale is AFTER the property sale, and the property is
now inaccessible to an appraiser.
Zero down deals are done all the time but are not popular
with cash flow note buyers. They want to know that the buyer has immediate
equity in the property, something to protect, so the less the
down payment you’re taking, the less the cash you’re going to be
selling your note for.
Terms Of The Carry-Back Note
A. Interest Rate: The higher the better, but not so high
as to gamble with usury law violations. Many states have usury laws
that govern personal, consumer loans (e.g. Washington State has a
12% “do not exceed” rate); however, not all states have usury laws.
So check before you structure your deal. Don’t know what a good
interest rate is for your deal? Ask a mortgage person or residential
agent. They live with this on a daily basis and they’ll give you
some good advice. The lower the rate, the poorer the deal for the
note buyer, and he’ll just make it up by charging you more of a
discount when he buys it.
B. Length of Note: Again, ask what is normal currently.
Probably the typical length is 5 years, or maybe 10 to 25 years
but with 3 to 5 year balloon. This is important to the note buyer,
because he doesn’t want to wait forever to get repaid. But not too
short…I’ve seen notes with 6-12 months go begging for a buyer
because the note buyers feared the property buyer couldn’t pay
it off in that time period.
C. Balloon: Again, the cash flow note buyer wants to have this on
his books for no more than 3-5 years, so even if the new note has
a 20-25 year amortization period, to keep the monthly payments
within reason, the note should have a 5 or so year balloon for full
payoff in that time.
D. Loan-To-Value Ratio (LTV): Total loan-to-value, of
both the first and new second, must be considered, and typically
not to exceed 75% of provable value, for the buyer of the new
second to be seriously interested. Also, many second buyers want
the ratio of the first to the second to be no more than 4:1.
Translation: they don’t want a little second that’s behind a huge
first, which might have a much bigger RATIO than 4:1. (e.g. $100,000
first and $10,000 second would be 10:1; but $30,000 first and
$10,000 second would be 3:1). Do some shopping and learn what note
buyers would accept before you structure your property sale. Of all
the elements listed here, this is probably the one most ignored by
note buyers. If they like everything else, they might not care at
all about the LTV.
E. Will the Lender on the First Permit the Second You’re
Willing to Carry? Frequently, the lender on a new institutional
loan inserts a clause to the effect that it is permitting NO
carryback loan by the seller, and you’d better hammer this out
up-front if you plan to carry a second and are expecting to sell it.
F. Security For Your Second: Normally it should be a
recordable deed of trust, or mortgage in non-D/T states, drafted to
comply with laws of property situs (where it’s at!) to secure
payment of the second. And to be recordable in deed records it
should normally be signed and acknowledged by a notary. Further,
it should normally have provisions to the effect that any
default on buyer’s part in payment of his first note is also a
default in the carryback second. And, although frequently omitted,
it should contain explicit, written permission for its holder to
verify the current status of the first.
G. Buyer’s Identity: If the payors are husband and wife,
make sure they ARE husband and wife and have both executed the note
and deed of trust individually. Don’t permit one to sign for both.
This is not permissible or binding on the spouse in every state,
and you don’t even know for sure they’re still married. If you’re
selling to a corporation or LLC, make sure you’re also getting the
buyers on the note and deed of trust INDIVIDUALLY. I see too many
notes where ONLY the corp/LLC is on there, and the people signing,
sign ONLY as corporate officers — this doesn’t bind them
individually and your note isn’t going to sell.
One element that has not been addressed in this article
is “seasoning,” or aging. While there is no doubt that a note
that has a few years successful seasoning is a more valuable note,
of course this element is completely absent in a “simultaneous”
sale, where the note is purchased as the property sale is closed.
Finally, if you are in doubt about any of these elements
in your deal, give me a call (253-228-2277) or e-mail me
(firstname.lastname@example.org) and I’ll help you structure a note
you CAN SELL. I stand ready to advise any note seller on how to
structure and create his or her own sales transaction and/or an
owner’s carryback note so it will be LEGALLY marketable and
sellable and not carry with it those explosive qualities that stand
ready to kill and maim deals, note buyers or brokers.
John J Merchant, J.D., EMS, is a graduate of SMU School
of Law. He practiced law for a number of years before leaving law
practice to devote his time to a variety of business interests
and investments. He has been very involved in investment real estate
since before graduating from high school, and he has owned and
managed a plethora of properties in several states, including
ranches, oil leases, gas stations, rentals, both single family and
multiplexes, office buildings, warehouses and even fast food
John is owner and broker of MesaRoya Properties, in
Tacoma, Washington, a commercial real estate brokerage. He is a
Gold Card member of National Council of Exchangors, (EMS –
Equity Management Specialist) and a member of various other real
estate exchange and marketing groups. His articles appear often
in THE PAPER SOURCE JOURNAL
He is the author of the guide, “HOW TO USE YOUR IRA,
403b(TSA) OR PENSION PLAN TO BUY REAL ESTATE, NOTES, JUDGMENTS…
AND OTHER THINGS.” See http://store.papersourceonline.com/your-ira-can-buy-notes-more/