Have you ever had a deal where you were "light" the funds to close ("light" can mean that you don't have the funds or that you simply did not want to cut a check;-)? Here is one tool that I have used in the past to help my parents close a deal that solved this problem.
A few years ago my parents were performing a 1031 exchange. If you are wondering, a 1031 is an exchange where one sells a property and puts all of the proceeds from the original sale and uses them to purchase another property. What is great about this transaction is that the party is able to defer the taxes that they would have to normally pay if they sold their original property and simply "cashed out" without buying a new property, thereby allowing them to put all the pre-tax proceeds into the new property. (Please note: consult with your tax professional before relying on this information)
During this exchange, my parents found a replacement property, but they were going to have to come up with the extra cash to close the deal. The cash would have been approximately $24,000. Rather than cut a check, we started to brainstorm other methods to close the deal. We did not want to go to a bank for a loan as the cost, hassle and slowness of a bank loan were not at all appealing. Additionally, we wanted a longer term loan that was fully amortized with monthly payments that could easily be covered by the rent of the new property, and because of these requirments we were not finding private lenders who would meet that criteria.
Thinking Outside the Box!!!!
So, we asked the seller whether he would be willing to carry a loan on the property. To carry means that my parents would owe the seller the $24,000, which they would pay him monthly over a period of time with interest. The money owed to the seller would be secured to the property, much like a traditional mortgage, meaning that if my parents did not pay, then the seller could foreclose.
My parents would pay this loan from the rent collected on the new property, thereby not having to come out of pocket. However, as the seller was a full time flipper, he needed the cash for his next deal so he was not inclined to carry.
After more brainstorming, I contacted a friend of mine, the "Note Queen", Dawn Rickabaugh and we discussed our options. (to learn more about Dawn and her services with notes, click here)
During one of our talks we discussed a technique that I first heard from Peter Fortunato. (Side note: for those of you who do not know Pete, I would strongly encourage you getting to know him and taking one of his classes, as he is possibly the smartest investor that I have ever met. Here is a link to his page.)
The idea that Pete Fortunato taught had two parts:
- First, have the seller carry back a note in the first escrow where the property will be sold.
- Second, immediately after the property is sold create a second escrow where a third party note buyer puts funds to buy the newly created seller financed note from the seller immediately after close of the first escrow. This would give my parents the property, the property seller cash and the third party note buyer would own the note and my parents would make monhtly payments to the note buyer.
Fortunately, Dawn Rickabaugh had extensive experience in these types of transactions and was able to put the logistics together and find the end note buyer looking to add to their note portfolio.
I understand that this may be a little confusing, so here I will do a step by step showing how the deal was structured to make it easier to follow:
- My parents sell their first property.
- My parents identify a second property which they agree to buy from the property seller.
- My parents pay the seller the proceeds from the first sale. Then, the seller agrees to carry back a note to my parents for $30,000. This note is secured by the property, meaning that, much like a traditional mortgage, if my parents default then the note holder can foreclose. Title transfers to my parents. This entire part of the transaction was performed in the first escrow.
- As the seller wanted to be cashed out, he sold the note immediately after the close of the property to a 3rd party note buyer. The note buyer paid the seller $24,000 for the note, thereby cashing the seller out of the transaction. This transaction occurred in the second escrow.
- Since the sale, all of the monthly payments on the note have been made from my parents to the 3rd party note buyer, with the rents collected from the property.
From this transaction, all three parties won:
- My parents completed the 1031 without having to come out of pocket with extra cash and without getting a bank loan.
- The seller sold his property and got the cash he desired.
- The note buyer got an investment with a very good return, that is secured by a nice piece of real estate.
This is a great technique that can be employed for any type of property and sale and not just 1031s. It is important as investors that we keep looking for solutions that do not simply involve cash as there are so many options that allow us to close deals, and this is one of the many techniques at our disposal to do so.
This is an awesome post!
My brain is going 100 miles an hour now…
Tony, glad that I can help. I know the feeling because my brain was doing the same thing when I first heard of this concept. Good luck!!!
Love it, Buddy! Very creative. Thanks for sharing in a clear, step by step way.
Thanks, Chad! Really glad that you liked it!!!!
Hi Buddy, I like the idea here but it sounds like they had to pay $30,000 for a $24,000 loan. Wouldn’t it have been better to finance with the bank?
Hi James, thanks for reading the blog, I really appreciate it. That is a great question, and I will do my best to answer, which was touched on briefly in the blog. Here are some of the reasons.
(1) it was a 1031 exchange that they were in, so time was of the essence. Granted, they still had a couple of months to close. However, as I am sure that you are well aware, banks are not known for their speed in processing, so we wanted to avoid having to deal with the potential delays in funding, especially since we needed the money fast.
(2) Banks will do it, but getting this type of a loan from a bank would have been costly as there would have been points and other fees charged as well, so it would have been more expensive than the $24,000 needed.
(3) With this loan, my parents could set the terms of the loan, which was beneficial for them to structure around their cash flow needs. When dealing with a bank, there is very little (if any) flexibility in setting the terms of the loan. Terms of debt are often more important than the amount of debt. While they got a $30,000 loan and only needed $24,000, they were able to set the terms of how that is paid back. Additionally, as mentioned in No. 2 above, banks would charge a bunch of fees/points, (none of which were needed here) so the difference in loan at the end of the day would have been negligible.
(4) The general hassle of dealing with banks. My parents are retired and did not want to deal with all of the background checks, credit checks, financial documents needed, tax returns needed, tons of signatures required on intimidating legal document, etc. This transaction required none of that information or hassle, rather my parents simply had to sign on the note, that was it.
I hope that this answers your question. Let me know if you have any follow ups. Thanks again for reading, James.
Thanks Buddy, that makes sense! I can see how flexible terms (including interest rate) can make this very beneficial.
Definitely, James, the flexibility is huge!
Thanks Buddy for the Great Insight!!!
Absolutely, Kevin! Glad that you find it helpful!