California Real Estate Finance, 9th edition

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California Real Estate Finance
Bond, McKenzie, Fesler & Boone
Ninth Edition
Chapter 14
Creative Financing Approaches
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Objectives
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After completing this chapter, you should be able to:
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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.
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Outline
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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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Secondary Financing
Techniques
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Second Trust Deeds carried by seller
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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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Collateralizing Junior Loans
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Use seller-carried note and second dead of trust
as an asset
They are pledged at collateral for a loan through
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Private parties
Mortgage brokers
Commercial banks
At a discounted value
Seller receives cash
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Seller Sells the Second Loan
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Instant cash
Deep discount
Who buys?
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Escrow companies
Loan brokers
Holders of maturing junior trust deed loans
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Broker Participation
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Broker becomes a lender for part of the equity
Break note into two parts
Assignment of seller’s note and trust dead for
the portion of the broker’s interest
In default, broker can foreclose
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Combination or “Split” Junior
Liens
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Create second and third trust deeds
Can sell a smaller second easier
© 2011 Cengage Learning created by Dr. Richard S. Savich.
All-Inclusive Trust Deed
(AITD) (aka wrap-around)
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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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Characteristics and Limitations
to AITDs
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Can increase the seller’s 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 California’s 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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
All-Inclusive Trust Deed
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Equity payoff
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Buyer takes over prior loans after seller’s equity has
been paid off
Full payoff
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Buyer continues to pay until entire balance is paid
© 2011 Cengage Learning created by Dr. Richard S. Savich.
All-Inclusive Trust Deed
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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
 Trustee’s sale is speedier
 Income tax advantages
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Similar to installment sale
© 2011 Cengage Learning created by Dr. Richard S. Savich.
All-Inclusive Trust Deed
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Benefits to buyer
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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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
All-Inclusive Trust Deed
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Precautions for sellers
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What about impounds?
Timing of AITD payments
compared to first mortgage
Limit another AITD upon
resale by buyer (due-onsale clause)
Reserve right to have
buyer refinance at later
date
Approve leases on income
producing property
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Precautions for buyers
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What if seller defaults?
Request notice of default
and notice of sale
Set up payments to cover
any liens against seller
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Procedures in Setting Up AITD
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Examine existing trust deed clauses
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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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Installment Sales Contract
(aka conditional sales contract or land
contract)
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Title remains with seller
Until contract is complete
Lawsuit is necessary for foreclosure
Significant income tax benefit to seller
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Prorate capital gains over life of the note
Can be used for any real estate including
vacant land
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Lender Participations
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Participation in revenue of project
Equity participation
Charge one time fees or points
Profit Participation
Multiple lenders
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Sale-Leaseback
(aka purchase and lease-back)
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Investor buys property
Develops land
Sells to major investor
Leases back property
Could be used for just land, just
improvements, or both
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Advantages
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Seller
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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
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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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Disadvantages
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Seller
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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
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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?
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Open-End Trust Deed
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Add on to principal
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Either until original loan amount
Or until fair market value
Not used too much due to seconds
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Commercial Loan
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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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Stock Equity/Pledged Asset
Loans
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Marketable securities are used as collateral
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Blended-Rate Loans
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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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Benefits
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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
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Could be combo with lender and seller
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Creative Financing Disclosure
Act
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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 seller’s role in case of buyer’s
default
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Imputed Interest
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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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Questions and Comments?
© 2011 Cengage Learning created by Dr. Richard S. Savich.
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