The New Era of Seller Finance: Creative Finance Options for a Down-Market
by John Stege, Esq.
Today real estate Sellers are facing the most challenging market in over a decade. The FED is relentlessly raising interest rates in a deliberate targeting of the housing market, since home price rises are a leading indicator of inflation. In response to higher rates and falling prices, banks are tightening up and cutting back on lending, which leads to buyers, even buyers with good credit history and reasonable income being unable to qualify for the homes they want. The self-employed have always had difficulty obtaining home-buying credit, now it's worse than ever.
To top it off, home-buyers are reluctant to buy in a down market, both because of volatility and because of anticipation of significant price reductions in the coming year as recession and interest rate hikes take a further toll on housing prices.
Seller Finance: In this kind of market what can investors and sellers do to lock in their preferred price, attract buyers and offset the tightening credit market? One answer has been to resort to Seller-finance in order to bypass tightening credit markets and incentivize buyers who may either be reluctant to commit to buy right now or locked out of the credit market because they now cannot qualify for loans that were previously available to them.
The Advantages of private, off-market seller-finance deals: One potential solution for these problems is Seller financing. Using seller financing, (1) Sellers can potentially lock in their preferred selling price, (2) buyers can obtain favorable financing at below market rates where they might not be able to obtain credit, (3) Both parties can negotiate their own terms as to initial deposit and other terms, (4) Brokers can act as transaction agents reducing the transaction costs for both parties.
Problems of Seller-Finance and How to Overcome Them: Dodd-Frank Regulations: as attractive as this technique can be to sellers, there are a number of pitfalls to be aware of, and careful advising by a knowledgeable real estate attorney will be needed to avoid potential problems. This is in part due to the impact of Dodd-Frank rules and regulations (Regulation Z) issued by the Consumer Finance Protection Bureau (“CFPB”) restricting the kinds of Seller-finance loans Sellers may use, the terms they may offer, with potentially expensive and far-reaching penalties for even un-intentionally violating these rules.
Dodd-Frank requires that all mortgage loan originators be licensed, and virtually all states including Colorado have state licensing requirements as well. After much complaint, exemptions were created for seller-financers with some restrictions. These exemptions vary from state to state, but in Colorado there are exemptions for seller financers who sell residential dwellings with 1-4 units (so it includes 1-4 unit multi-family properties):
- sellers who offer seller finance on no more than 3 properties in any 12 month period don't have to be licensed. So, homeowners selling one, two or three houses in a year, can offer seller financing, without having to be a licensed mortgage broker. (The Seller can, of course, simply hire a licensed mortgage broker and pay a fee for them to process the loan), but they don't have to.
- However, the seller-finance loan must still comply with Regulation Z rules.
- These restrictions essentially mean there can be no balloon payments.
- The seller can sell no more than 3 properties per year using seller financing.
- Sellers who sell more than 1 property in a year will have to verify the buyer's ability to pay.
How To Escape From These Rules: Dodd Frank rules do not apply to commercial property sales or sales of vacant land where the buyer does not intend to establish a dwelling unit. Crucially, it also does not apply to sales of residential property to a business like an LLC.
So, if the Buyer is an LLC, and will sign a Dodd Frank waiver indicating that they have no intention to use the property as their residence (including a second or vacation home) Dodd-Frank restrictions do not apply at all. And you can have whatever balloon payment you want!
So, what if you are a seller who wants to use seller finance in order to facilitate the sale of your personal residence? There are several options:
- Hire a mortgage loan originator, do straight seller finance with no balloon. The downside to this is that the seller is locked into long term mortgage and won't get their money soon.
- Sell to a business entity like an LLC.
- Sell to an individual who intends to use the property for investment purposes and is willing to certify in writing that they are buying for investment purposes.
- Create a partnership between buyer and seller, transfer the deed to the property to an LLC, taking back an interest in the LLC with the buyer, and then agree to buyout conditions in the partnership agreement under which the Seller will take back a note and deed of trust on the property, and exercise a right to be bought out at a fixed price at a fixed time in the future (say 5 years).
- That partnership arrangement effectively functions like a note and deed of trust agreement with a balloon payment but won't run afoul of Dodd-Frank rules. And, as a member of the LLC, the seller can make sure that their rights are protected (buy-sell provisions in the operating agreement).
What this means in practice is that there are lots of ways around the regulations, but you need to talk to an experienced real estate attorney who is familiar with these rules and can advise you regarding your options and deal structuring.
Summary: Preliminary Step 1. Examine The Buyer's Purpose.
Dodd-Frank and Regulation Z are concerned with loans provided to buyers who will live in the property. So, if the buyer is an investor and thus the loan is for a commercial purpose, you can simply negotiate whatever promissory note and deed of trust you want, without having to worry about these regulations. (Unless, of course, the Buyer is intending to “house-hack” the property and live in it, but treat it as a business loan transaction).
Keep in mind there is also an overriding situation called a “high cost mortgage” that will disqualify any seller finance loan from fitting into either of the two exceptions. The “high cost mortgage” analysis considers a bunch of different things, but the easiest to determine is the interest rate. If your loan APR is more than 6.5% above the prime rate you need to fully examine the loan to determine whether it's a high-cost mortgage. However, few seller finance loans will be more than 6.5% above prime. If the seller is considering such financing, they should consult an attorney about alternative deal structuring.
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