California Real Estate Finance Fesler & Brady 10th Edition Chapter 13 Creative Financing Approaches © 2016 OnCourse Learning Objectives • After completing this chapter, you should be able to: – Differentiate between traditional and creative financing techniques. – Identify at least five ways in which real estate can be financed through ways other than the traditional methods. – Contrast the all-inclusive trust deed to the installment Contract of Sale, citing at least three differences. – Apply the formula to calculate blended interest rates. – Name the instruments required to close a sale using the creative techniques presented in this chapter. – List at least six items that must be disclosed under the Creative Financing Disclosure Act. Outline • • • • • • • • • • • Secondary Financing Techniques All-Inclusive Trust Deed (AITD) Installment Sales Contract Lender Participations Sale-Leaseback Open-End Trust Deed Commercial Loan Stock Equity/Pledged Asset Loans Blended-Rate Loans Creative Financing Disclosure Act Imputed Interest Secondary Financing Techniques • Second Trust Deeds carried by seller • • • • • • • • Referred to as “gap loans” Carried back by seller Helps buyer to purchase home Due in shorter time frame than first trust deed Buyer may renegotiate the second Secure a new loan to pay seller Refinance the entire loan In mid-2009 Fannie Mae and Freddie Mac eliminated seconds Collateralizing Junior Loans • Use seller-carried note and second deed of trust as an asset • They are pledged as collateral for a loan through – Private parties – Mortgage brokers – Commercial banks • At a discounted value • Seller receives cash Seller Sells the Second Loan • Instant cash • Deep discount • Who buys? – Escrow companies – Loan brokers – Holders of maturing junior trust deed loans Broker Participation • Broker becomes a lender for part of the equity • Break note into two parts • Assignment of sellerʼs note and trust deed for the portion of the brokerʼs interest • In default, broker can foreclose Combination or “Split” Junior Liens • Create second and third trust deeds • Can sell a smaller second easier All-Inclusive Trust Deed (AITD) (aka wrap-around) • Junior deed of trust to original loan • Seller will pay off loans from monies received from buyer • Used when – In lieu of installment sales contract – When existing loan cannot be paid off until later date – Buyer wants income tax benefits – Seller has overpriced property – Low down payment – Low interest existing loan – Seller firm on price but not terms – Buyer cannot qualify – Heavy prepayment penalties – When severe money crunch hits mortgage market • Cannot be used to avoid due on sale clause Characteristics and Limitations of AITDs • Can increase the sellerʼs rate of return • It is a purchase money transaction, subject to encumbrances, to which it is subordinate • The buyer become a trustor-grantee • The seller becomes a beneficiary-grantor • Subject to Californiaʼs antideficiency statutes so buyer-trustor is held harmless should foreclosure occur • Legal title is conveyed by grant deed and is insurable by title insurance • In event of default and foreclosure, the seller-beneficiary follows normal foreclosure procedures All-Inclusive Trust Deed • Equity payoff – Buyer takes over prior loans after sellerʼs equity has been paid off • Full payoff – Buyer continues to pay until entire balance is paid All-Inclusive Trust Deed • Benefits to seller – Only way to dispose when lock in clause – Broader market because seller is willing to carry back – No loan fees – Higher sales price – Defer recapture of equity – Retain favorable terms of first – Increase net yield – No interest rate limitations – Know immediately about default – Trusteeʼs sale is speedier – Income tax advantages • Similar to installment sale All-Inclusive Trust Deed • Benefits to buyer – – – – – – – – – Get property not qualified for Larger property for same down payment Only one monthly payment Closing costs reduced Extra long terms can be negotiated No points No prepayment penalties Lower capital gain at resale Grant deed at beginning, not end All-Inclusive Trust Deed • Precautions for sellers – What about impounds? – Timing of AITD payments compared to first mortgage – Limit another AITD upon resale by buyer (due-on-sale clause) – Reserve right to have buyer refinance at later date – Approve leases on income producing property • Precautions for buyers – What if seller defaults? – Request notice of default and notice of sale – Set up payments to cover any liens against seller Procedures in Setting Up AITD • Examine existing trust deed clauses – Due on sale – Alienation – Acceleration • Ascertain outstanding balances, periodic payments and balloon provision • Who collects and disburses payments • Spell out default and foreclosure procedures • Get title insurance • Get insurance coverage Installment Sales Contract (aka conditional sales contract or land contract) • • • • Title remains with seller Until contract is complete Lawsuit is necessary for foreclosure Significant income tax benefit to seller – Prorate capital gains over life of the note • Can be used for any real estate including vacant land Lender Participations • Participation in revenue of project • Equity participation • Charge one time fees or points • Profit Participation • Multiple lenders Sale-Leaseback (aka purchase and lease-back) • • • • • Investor buys property Develops land Sells to major investor Leases back property Could be used for just land, just improvements, or both Advantages • Seller – Lease payments are tax deductible – Rent is lower than loan payments – Improvements may be tax deductible – Frees up capital – Long term leases not shown as long term liabilities – Cash today, payments later – Could buy back at later time • Buyer – Higher yield than loan – Appreciation to lessor – In default can go after other lessee assets – Lease payments cover original investment and leave lessor with title – Lessee could pay for repairs, maintenance, insurance, utilities, taxes and operating expenses. (triple net lease or net-net-net) – Could do sale-leaseback with another party for same property Disadvantages • Seller Long term contract No participation in appreciation Rent may exceed loan payments Expiration of lease could lead to problems – Improvements may cost too much – – – – • Buyer – Lease payments are taxable income – Rents could go below market – If default, must operate property – May not get depreciation deduction if only land lease – Capital is tied up – Only lessor, not creditor in case of seller insolvency – Did lessee develop property for special purpose? – Inflation – Is repurchase option below market? Open-End Trust Deed • Add on to principal – Either until original loan amount – Or until fair market value • Not used too much due to seconds Commercial Loan • • • • • • Personal loan from bank Borrowers of substance Usually less than three years Purchase real estate Finance home improvements Purchase a foreclosure, when cash is required Stock Equity/Pledged Asset Loans • Marketable securities are used as collateral Blended-Rate Loans • Existing loan interest rate • Market interest rate on new loan • Somewhere in between (Existing rate X Existing loan balance) + (Market rate X Net new money) Blended yield = ________________________________ Total financing Benefits • • • • • • Buyers receive below market rate Borrower qualifies more easily Cash proceeds are greater Seller does not carry back as much paper Lender increases yield on old loans More creative – Could be combo with lender and seller Creative Financing Disclosure Act • Description of terms of loan • Any other financing • Warning about negative amortization • When AITD, then who is responsible • Terms of balloon payments • Credit information about buyer • Warnings about sellerʼs role in case of buyerʼs default Imputed Interest • If project >$4,217,500, then interest rate >9% or applicable federal rate (AFR), whichever is lower • AFR is rate on federal securities with same maturity • Does not apply to seller carry back loans when buyer uses property as principal residence • Changes capital gain into ordinary income Questions and Comments?
