What we learned about creative financing

Introduction

With the increase of the FED lending rates, the interest is renewed in creative financing for real estate. So I thought it might be of interest to write down some aspects of creative financing, whether useful or not.

Some definitions first. “Creative financing” in real estate is a collective term for getting debt for your real estate purchases that does not involve talking to a bank. For the past decade or so, typical lending rates for real estate were at or below 5% annualized percentage rate (APR). All the while, private money lenders were at anywhere between 10% and 15% APR, making private money less attractive when you have other, cheaper debt options.

In such a climate, you would turn to private money lenders only if you know you can not get a favorable loan from a bank for some reason. Typically, banks will only lend to borrowers with very good to excellent credit, and on properties that are squeaky clean. If you have less than ideal credit, or if your property needs extensive remodeling, banks are typically not eager to help. This is where creative financing becomes useful.

Today, however, private money has stayed at around 10% to 15%, and bank rates are anywhere between 8% and 10%, and private money has become a more attractive option. This leads to more people actively thinking how to make use of these options. But since information on these options are a bit chaotic, it seems hard to inform yourself of the ins and outs of the “creative” financing options. This is where this article is supposed to help. I will explain some of the creative financing options for an all-in-one introduction to creative financing.

Hard money

“Hard money” is a term used for borrowing from private lending institutions. That is, the lender is a company that pools individual’s money together and lends it out as a way to make a profit for the individual investors involved. The institution typically also adds a margin on top as compensation for being a mediator between the investors and the borrowers. And “hard” money is just a term, there isn’t anything specifically “harder” about this way of financing.

Since the investors are interested in a quick turnaround, hard money is usually short term debt. You would use it in a situation where you are currently unable to secure long term financing, but have a solid plan to be able to do so, some time after the purchase of your subject property. For example, if you are buying a run-down property with an intention of rehabilitating the property and refinancing it, and you want to use debt to buy the property, you will need to “bridge” the time between the purchase and the time when the property is fully operational. This is where hard money bridge loans become useful. Your hard money lender would typically give you a short term loan, and you would try to expedite your property rehab work.

As a result, hard money loans are typically on the expensive side. You will pay relatively much in upfront fees. The qualification process is similar to the process you would have when financing through a bank.

Typical term: 1 year, but more or less can be arranged.

Amortization: Typically interest only.

Typical rates: 10%-12% annualized (12% per year is 1% per month, which is easier to calculate)

Fees: 1-3 “points” (percent of the loan amount) upfront. Some lenders will

Third party fees (e.g. appraisal, filing fees etc)

Broker fees, e.g. 1 to 2 points to the broker who made the deal

Private money

Private money is slightly different from hard money in that there usually is no mediator. You make a deal with the lender directly. They give you money under conditions specified in advance. They then give you the money, and you repay them the way you promised them to.

This arrangement can be very uncomplicated. If you have a good private lender contact, they can be very lenient in what they ask of you to provide. A friend of ours, who lends private money out, is very relaxed about this. He requires to have the first position note, and asks for 1% per month, for as long as you need to. No fees, no surprises.

One thing to be careful about is when combining private money with bank financing, if you plan to take two loans to buy a property. Banks typically do not like lending on deals where more than a single lender is present. This may cause your bank financing to fall apart. Other banks could insist on signing a subordination contract. This is a document which details the precise ordering in which the creditors would be repaid in case of a default. Many banks will only accept to be first in line for repayment (this always means “first after any government lien holders”).

Seller financing

The shortest description of this financing approach is “the seller is the bank”. That is, the property seller agrees to accept a partial down-payment for the property, and a promise to repay the remaining amount over a period of time under agreed-upon terms. This allows the seller to collect not only the value of the property, but also the interest on the debt over a number of years.

While this approach seems very appealing, it won’t work in all situations. A typical showstopper is if the seller still has debt on the property. While the seller may be willing to do seller financing, their lender typically won’t be. The seller typically would not want to be out of pocket for the transaction, so will require a large down payment to repay the existing debt on the property. This means that seller financing works best where properties have little or no existing debt on them. Another necessary condition is that the seller should be willing to delay their payment over possibly multiple years. Most buyers are not willing to wait that long, so there must be something about the deal that makes them agree to delayed payment. Typically, this would be for a problem property that is not acceptable to more conventional lenders. For example if the property is struggling, and the seller knows that the buyer pool would dry up if they insisted on a cash purchase.

A nice feature of seller financing for the buyer is that the financing terms are almost completely up for negotiation. You get to tune any parameter you’d like: the amount, the down payment, the interest rate, the term, the amortization. For example this is one way to bridge the spread between asking and offering prices. If the seller wants more for their property, you can match the offer price, but lower the interest rate. Or lower your monthly payment by adjusting the amortization.

In this arrangement, the seller also has an opportunity to save some on taxes. Some people who tout the savings over-emphasize the savings. If you actually calculate the tax obligation, you will see that you “only” get to spread the tax obligation across a longer time period, and the seller may end up paying a little bit less on interest income from the seller financing if they end up in a lower tax bracket as a result of the sale. This, however, is not overly attractive, although it’s still better more money versus cash purchase provided that the seller is willing to wait.

“Subject to”

A “subject to”, or more fancifully called “sub to” purchase refers to buying a property subject and retaining the mortgage on the property. The buyer promises to continue paying the existing mortgage, the mortgage stays in the name of the seller, but the buyer gets the property title.

I happen to think that this sort of a deal is shady as hell. There is no reason for a seller to accept this arrangement, unless their back is somehow against a wall. For example, if they are behind on their mortgage payments, and are in danger of losing the home to foreclosure. So, having someone else pay for their obligation could seem to them as a way out of foreclosure proceedings, and perhaps as a way to continue living in the same property after the sale, this time as a renter instead of as an owner. On the other hand, the buyer gets the house at favorable valuation, typically at a deep discount resulting from the seller’s hardship. They get the deed to the property, but take on no liability. Some sellers who regularly do these types of deals take advantage of the sellers situation, or lack of financial education, or just general hopelessness in a distressing housing situation.

The seller stays on the hook for the mortgage repayment, and even worse, if they happen to get their financial act together, they are still bound to a potential multi-decade agreement with the buyer related to their mortgage repayment. There is zero incentive for the buyer to repay the mortgage ahead of time, which makes the seller beholden to the buyer’s whims possibly for many decades.

Due to the exploitative nature of “subject to” deals, these are ones we will never ever make.

Cross-collateralization

Also known as “walking the mortgage note”. This is a mortgage note feature which allows the borrower to substitute the collateral. Let’s step back, however, and explain everything from the beginning since not everyone knows the details of how mortgages work.

Some of my friends say that the bank owns their home, because they had to take out a loan from the bank to buy it. I can see how in a parabolic sense one could say that. But strictly speaking this is not true. Typically, houses are bought by transferring a lump sum of money to the account of the seller, in exchange for the seller signing a “deed” which is an enforceable document that says the seller is transferring the interest they have in the property to the buyer. Since most buyers don’t have the entire lump sum of money to buy the house with cash, they go to a bank and ask for help. Sometimes it is also a good idea to get the bank’s help with financing as a way to deploy the saved cash better in another endeavor. When the bank agrees to lend the money for the purchase, two documents are signed as the money exchanges hands. One, where the seller transfers the property rights to the buyer. This is a “deed”. And another where the buyer promises the bank to repay the lump sum of money, with some interest, under some predetermined conditions. This promise has a clause which says that the buyer agrees to pledge the subject property to the bank in the case they are unable to repay the debt. The exact way this is done can not be arbitrary as it is subject to regulation, but not all that detail is interesting to us here. The important part is that the bank does not “own” the property, in the sense that the bank does not have property rights. The bank, however, does hold a “lien” i.e. an interest in the property. This means that should the property be sold in the future the bank has the right to get a part of the money obtained in the sale.

Now, banks are typically very conservative and will stipulate a few things. Firstly, if the property is sold, the bank is within their rights to demand that the remaining debt be paid at once. This is called a “due on sale”, after a contract clause which gives the bank the right ot do so. Furthermore, the banks typically require that the collateral for the loan be the subject property for the entire lifetime of the loan, and that it is never changed.

But, not all loans are made this way. With a sufficiently lenient lender, you could arrange that the collateral for the loan is substituted for a different property. This is colloquially known as “walking the note”, and can be done if the lender and borrower agree to do so.

This opens up options for a chain of financial steps that end up incrementally improving the buyer’s position, if used creatively. It does require that you have the money for down payment on potentially two properties, so it may not be viable for everyone. This is an approach I first saw outlined by one Casey Mericle. The specific approach is as follows:

1. Find a possibly undesirable but overpriced property A that sits unsold for a long time.

2. Arrange for seller financing with the owner. Arrange for a favorable (low) interest rate in exchange for paying the full list price for the property. Ensure that you can walk the note, this should also be arranged with the seller. This hinges on the assumption that the seller of the undesirable property is open to creative arrangements.

3. Enter a purchase contract for a desirable property B. Walk the note from A to B to close on B. Then sell A, potentially even at a loss.

4. Now you secured a low interest rate debt for a desirable property B. You may have lost some money on the sale of A, but B and the low interest rate should more than compensate you for that, provided that you operate B well and hold for long enough.

Equity lines of credit

Equity lines of credit are typically secured loans, requiring you (the borrower) to pledge something in return for a line of credit. A well known collateral is pledging your primary residence in case of the home equity line of credit, or HELOC, so I’ll dwell on HELOC specifically here.

A HELOC, once you get one, works mostly like a credit card. You can draw amounts up to a certain maximum, and usually also subject to a certain minimum. Then repay at leisure. There are some finer points around max amounts, the length of the draw period, the max amount etc. The catch is, most such lines of credit only work for primary residences. We have not yet found a bank willing to issue a line of credit on a different type of real estate.

A line of credit allows you to tap the equity that’s built into your primary residence. On the flip side, an unrepaid home equity line of credit could lead to foreclosure and losing a home. However, while this may be a dreadful predicament for most people, residential real estate investors may have an alternative place to live in, should their HELOC crash and burn. And relatively favorable rates make HELOCs a good way to have access to sometimes considerable amounts of cash on short notice. For this reason, I believe that a HELOC should be in every investor’s financial toolbox. Now whether this exactly counts as “creative” financing, I don’t know. But I am also not bothered by semantics. If it helps you on your investing journey, it is probably worth mentioning here.

Stairway fund

I first learned about this approach from my colleague Austin. This is his approach to raising debt. I am calling it Stairway, after his company Stairway Invest LLC. I am not sure if Austin invented it or if this is something I just learned with a long delay, but it surely seems useful.

Stairway is a debt fund. Investors buy the debt at 8% per year. The fund owner then invests that raised debt as they see fit, mostly in real estate. They pledge all their assets as collateral for this debt. Stairway also offers financial education, focused specifically on the same fundraising model for those who are interested, as a perk of being a client. Austin is also extremely open with all financials, offering an unprecedented insight into the operations of his investment business.

The approach is interesting to me for a few reasons:

• It decouples the “front end” aspects of debt raising with the “back end” aspects of real estate. This means that the investors do not need to understand the finer aspects of real estate investing. They need to trust the fund owner, and will get compensated with a fixed yearly interest for that trust.

• It becomes a good vehicle for putting to work undeployed investor funds. That is, if you have friends and family whom you know have money sitting idle in a bank account, it is an opportunity for them to put that to work, and help themselves.

• The invested funds are fully liquid. That is, from the perspective of an investor, the amount they invested behaves like a savings account. This again reduces the complexity and anxieties that investors may have about investing in real estate, and shortcuts the liquidity and expertise concerns.

Of course, such a debt fund requires proper filing with federal and state financial authorities.

Conclusion

I hope you now have a little better understanding of some creative financing approaches. If you have questions or comments, feel free to contact me at the links at the very bottom of this page.