There are a lot of things that can go wrong with owner financing if you don’t know what you’re looking at. In this episode, Scott Carson breaks down why he is not a fan of using owner financing to sell real estate. He explains how it can cost you big in the long run if you don’t know your market, your asset, or your long-term strategy as an investor. If you want to avoid falling into the many traps of owner financing, listen in!
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WARNING: Owner Financing Should Never Be Your Number One Exit Strategy
In this episode, I want to share a little insight into what is one of the most overhyped exit strategies as a real estate investor and that’s creating owner finance. I don’t want to sound like a Debbie Downer out there for everybody. I get phone calls all the time from investors that they have taken a one-day class on owner financing or they watched a YouTube video. They’ve got up-sold into somebody’s class talking about how awesome owner financing is and how you can make so much money with owner financing and go from there.
As an active note investor, this is going to sound a little bit hypocritical when I’m talking about investing. Not to be wrong, I love note investing but I love it when it works right. I get tons of phone calls from real estate investors who have a piece of property and they got sold on the idea of offering owner financing. They offer owner financing but they screw up the terms of the deal. What do I mean by that? The interest rate is too low. They over calculate the value of the note.
What do I mean by these two things? These are the two most important things. One, they often hear people talk about, “If you are the bank, you can set the value of the note higher since you are carrying financing.” That’s a yes and no answer to that. Yes, you can set it higher but what is your strategy for the goal? What’s your strategy for the property? If your goal is that you need to recoup that capital or you need to sell the property and make a profit, owner financing is not the strategy for you. If the house will appraise at let’s say $100,000, you set the price of the home for $110,000 or $120,000 because you are offered owner financing and you get somebody to agree to it, that doesn’t mean you are going to get the $110,000 or the $120,000.
I often am talking with so many people who have offered owner financing. They have offered or had the loan be above the value of the actual as-is value of the property and they get upset when I tell them that they have to take a discount because the property is not worth $110,000 or $120,000. It is worth $100,000 or $95,000. They get upset about that. They were like, “What can you tell me?” It goes to the second aspect, “What’s the interest rate on your note?” “It’s at 6%.” Most people that are buying owner finance notes want to see around 8% to 10% interest rate so you are going to have to take a haircut. What do you mean by a haircut? You’ve got to take a discount on the loan.
Owner Financing: If your goal is that you need to recoup that capital or you need to sell the property and make a profit, owner financing is not the strategy for you.
What do you mean by discount? I can’t offer you $100,000. I can offer you $80,000 or $70,000.” It all depends on the terms of the deal. A lot of people get upset, “Why do I take a haircut?” It’s because as a note buyer, I don’t want to be in something that’s 6% interest. I want something that’s a higher return on investment for me. One of the biggest things that we see is that their strategy was to sell the property. They need to recoup their money but they’ve got sold on terms of a note deal, the owner finance carryback, that doesn’t work in their favor and they end up taking a loss. It would have been better on the front end for them to sell the property, give some concessions to a buyer and make their $90,000, $95,000 and move on.
Seasoning Issues
The other thing that comes into play that a lot of note investors don’t realize is the seasoning issues. What do I mean by seasoning? Seasoning means the number of payments that have been made by the borrower. Usually, most note buyers want to see at least 6 to 12 months of seasoning on-time payments with the third-party servicer. They want to see that this borrower is paying some payments. It’s always nice if they put some downpayment and they have a decent credit score and stuff like that. If they have a decent credit score, great, they can offset that with a down payment.
That 6 to 12 months of seasoning often kills people, too because they get an idea with the owner financing. Lo and behold, in 3 to 6 months, they realize they’ve got to sell this property because they need the capital to go buy something else, to live off of or they needed that money. Their money or equity in that property is now tied up in an owner finance note deal that they can’t get out of. They can sell them out but they are going to take a haircut, take a discount or they’ve got to wait around for another six months for seasoning to kick in so they get the biggest bang for their buck. Those are the things that I get upset about.
Owner financing can be an amazing exit strategy if it’s the only one that will work for you. I don’t believe it should be your number one strategy. I know there are people out there who will argue with me and say, “It’s great for cashflow. You are going to make all this amount of money later on.” You can make it if it’s a $100,000 house. Over the 30 years, you can make $300,000. If you bought a house at $50,000, put some work into it, let’s say $20,000 and you owner finance it for $100,000, you tied up that $30,000, $40,000 of equity that you can’t touch. You can’t go out and do it alone against the property now. You can’t go and get a line of credit because you’ve got a mortgage on it to somebody who is in the first lien position. The big thing too, you have to realize what you can do with the property and evaluate your strategies that make them the biggest bang for your buck.
I’m constantly talking to investors and real estate people who are like, “I’m in owner finance.” I’m like, “What are you planning?” “I’m planning on selling the note.” If you are going to plan on selling the note because you need to realize your profit, don’t go about creating a note. Let the bank or somebody go out, get a traditional loan and let them carry the paper on it. You sell it. You worry about making the property as marketable as possible to get it sold and deal with that aspect of things.
Here’s another thing that drives me bonkers. I get this phone call often from my good network of real estate contacts investors who have been fixing and flipping property, they have been landlords and investors for years, and many of them are owning millions of dollars in real estate. I had this call with a guy from Houston and he was like, “Scott, we want to try to refinance out of our hard money loans.” I’m like, “What’s your hard money loan?” “Twelve percent interest for 6 to 12 months.” I go, “What do you want to do?” He goes, “We would rather have it as a lower interest rate for a 3 to 5-year period.”
I’m like, “Go to the bank.” “We were wanting to create a note.” I chuckled and I’m like, “What do you mean you want to create a note? You are at 65%, 70% of value now?” “We are at a good interest rate. We want to do a rate term and drop the interest rate down. We want to create a note.” I’m like, “Here’s what you don’t realize. You are the borrower or the property owner. You are not the bank. There’s another bank in front of you. If they are at a 12% interest rate, you can’t create a note at a 6% interest rate with a 30-year term with a 3-year to 5-year balloon on that real estate investment stuff and sell that note because somebody is going to want a big discount of almost 50% discount. You are still going to own the same amount, if not more because you still got to pay off that underlying loan.”
Let’s say the property is worth $100,000 and it’s $0.70 on the dollar. Hard money lender is at $70,000 on this deal. To get the $70,000 by refinancing, you would need somebody to come in and plunk down $70,000. If you wanted to do a note deal and sell it off, that note you create would need to be more than the $70,000 you own for a note investor to come in and fund the deal. Otherwise, the only situation would be if we found something like an IRA or a private investor who is willing to take a 6%, 7% or sub 12% interest rate on their money and tie it up for 3 to 5 years. That’s okay.
The idea, “I’m going to create a note around my existing mortgage. I’m going to sell that to pay off my hard money lender.” It doesn’t work that way. In this case, you need to go market the deal to IRA investors and have somebody come in and cash you out or reach back out to the bank that’s carrying the financing for this hard money lender. See if they would be willing to do a long-term loan or a blanket loan because they were looking to do it over $3 million for the property. You’ve got to understand that you can’t create a note. You could but it doesn’t mean it’s valuable.
When To Use Owner Financing
Let’s talk a little bit about it here. Owner financing should be the only strategy if you can’t sell the property traditionally. We have seen this. We have had students that have bought portfolios. I bought portfolios, loans and stuff in parts of the country that are smaller markets. They can’t get a retail buyer because it may be a lower value property. It’s a sub $100,000 so it’s hard to get a traditional bank loan. That might make sense and that’s why the Contract for Deeds was popular and are still popular in those areas because you are owner financing but you aren’t more of a landlord in the Contract for Deed. The borrower does not get the deed of the property that’s sold off, hence, the Contract for Deed.
You have the right as a property owner and the person carrying financing to evict in most cases, depending on the state by state. Some states evaluate a contract for a deed like a traditional mortgage. You’ve got to foreclose compared to eviction. That’s why the Contract for Deed is valuable on the $100,000 or less. Unless you are going to get an 8% to 10% interest rate, you are going to get some downpayment. The more downpayment, the more valuable it is. As soon as they bring a big chunk down and they want me to carry financing, I will only do a two-year term. Why a two-year term versus a 30-year term? Two years is enough time for anybody to be able to work on their credit and get their credit scores up. It’s 24 months. It does not take that long.
If someone had late pay, bankruptcy, or foreclosure in the past, foreclosures can be tough to do but you should still always have that borrower underwritten to see what’s on their credit. You should pull their credit report. You should work with a Mortgage Loan Originator MLO, even if it’s only doing one a year. I understand that falls under Dodd-Frank compliance. If you do want it to four years, it’s okay. You can do it yourself but you should still evaluate the borrowers. Look at their credit to see if they do their part and clean up the credit, late pay, reducing their debt to income, credit cards and stuff like that if there’s anything that’s going to stop them from being able to get a traditional loan in 12 or 24 months.
Always look at the property if it needs a lot of work. If you don’t want to do the work and you want to carry financing, that’s okay. Do it for 6 to 12 months. Many people step into it like, “I’m going to offer this for the cashflow side.” They never run the numbers. What’s more valuable, having a $90,000 on $100,000 property in your hand now or owner financing it and getting $7,000 annually in payments at 7% interest and $100,000?
The nice thing about owner financing is it’s like a deferred sales trust. It can lay out the tax consequences of a long-term capital gain versus a short-term capital gain. Who knows what’s going to happen over the next few years? That’s why I’m a big fan of non-owner financing. It’s not tying up the investment there. It’s best to take that property, sell it as-is, brand in, turn around and double down. Take that profit in and then go buy 2 or 3 assets versus tying up the majority of your profits and something that you can’t touch for 12, 18, or 24 months.
I have had some smart people call me, “I got owner finance note.” I’m like, “What’s the interest rate at?” “It’s 5%.” That might seem high now compared to the 2% or 3% interest rates out there. If somebody has got decent credit, let them go get the credit. Don’t you drop it down below 8% or 7% because you are offering them the service of carrying the paper? If you are going to carry the paper, you want to be damn sure that vehicle or that note is saleable and is popular to sell on the backend if it’s 12 or 24 months versus doing somebody a solid favor.
If somebody can’t go get 5% of their own, don’t give them 5%. If somebody can’t go get a 3%, don’t give them 3%. Make them go do that. If they can’t do it, that makes what you are offering valuable. Of course, if you have a rough property or it’s got a weird layout and banks don’t like it, they don’t want to carry financing on that type of dock, you may need to carry financing on that stuff. That’s why I’m a big believer that most investors should stick to their bread and butter or vanilla property classes.
Anytime I have gone outside my property class, whether it’s a higher value house or a different type of asset class, I end up easily getting my snakebit because the values are different so I had to put more rehab into it. The days on the market were longer. A higher percentage of my profit gets eaten up because of money carrying costs. That’s the important thing. Especially if you’ve got underlying financing a property, you can’t do an owner finance rap. It won’t always will but it can stipulate the due-on-sale clause. That’s another thing. Banks are looking for things. They may not want to take it back. We have only had this happen a few times but people get all bent out of shape about the due-on-sale clause.
As long as the bank is getting paid, they don’t care until there’s something that goes wrong. Taxes don’t get paid or payments get missed. The biggest thing you have to realize is what’s your underlying financing. What are your underlying profit margins? Where does that go from there? What does it mean for you? How soon are you looking to tap into this? Unfortunately, most people that are owner-financing are like, “We are going to do a 30-year in a 5-year balloon.” You tied up that property for five years unless the property values have accelerated dramatically, which is a good thing and then your LTV can drop down compared to value or the borrower brings a big chunk of money to the table.
In that case, it might be willing to carry it for some time but you still always have to stipulate in the agreement like, “This is a two-year term. The borrower is agreeing to work on the credit.” You may want to have them get signed up with GetFundable.com, formerly CreditSense or some sort of credit optimization company. You may want to get requirements that they are working through that to boost their credit score so that in 12 or 24 months, they can go get a traditional loan, refinance you out and you won’t take a bigger loss.
Why You Shouldn’t Owner Finance At A Too Low Interest Rate
The thing we see are a lot of people owner-finance it at a too low interest rate. They tie up their money for a longer period and then something happens in life that they have to tap into that equity. Now they’ve got to take a discount and they can sell the loan. It’s not a loss but there’s a substantial price being chewed out of it to capture that equity and profit to go do something else with it. If you are going to do carry financing, I’m a big believer in making sure you take whatever type of downpayment they are getting and then split the remaining balance between a 1st and 2nd lien. If someone is bringing 10% as a down payment, that’s great. Don’t do a 90% first lien. Do an 80% or a 75% first lien and a 10% to 15% second lien. Make them the same interest rate if you need to.
The reason you want to structure that way is if you do end up having to sell the note, you can retain that second for cashflow and sell the 75% or even 80% first-lien off to somebody and take a less discount. Carry that small second for cashflow and still be able to recoup a big chunk of your profit and still retain the cashflow. It makes that note a lot more marketable. If you do 100%, 90%, 95% financing, you are probably only going to get $0.80 if you sell the note. Instead of taking that 10% to 15% discount, cut it up into a 1st and a 2nd, and keep that second for cashflow or mailbox money. Sell off the first, recoup a big chunk of your cash, keep a small part from the mailbox money and go from there. That makes that note more desirable to a note buyer if it’s cut up in the 1st and 2nd.
Owner Financing: Owner financing should be the only strategy if you can’t sell the property traditionally.
One of my buddies out of South Florida years ago, when everything was happening in Florida, they did a loan mod for a borrower. What they did is they structured and turned it into a 1st and a 2nd. The first was for the value of the property. The second was the amount that was either being forgiven or the negative equity. They structured the terms on that second with favorable low-interest rates but it turned into mailbox money because they have already bought the loans at a big discount.
On the front end, they restructured it 100% LTV first and a 10% to 15% second lien and they carried it for cashflow. They waited for the values in Florida to rebound back. Now, there was some equity and those second liens were encumbered. There was value to make and they could sell them off. Along the way, they received cashflow and they receive payments on the second. It was a win-win. It’s one of the brilliant strategies by our buddy Todd Billings of Debt Ventures back in the day.
That’s the biggest thing. I don’t want to sound like a Debbie Downer, as I said before. I’m not a fan of owner financing as your primary strategy. I’m a note investor. I have helped originate a lot of first-lien owner financing back in the day but with the market being where it’s at, if you don’t know how to structure it properly and how to evaluate your borrower properly, owner financing can be the worst exit strategy for you. It can be something you tie up profit. If you took a discount, you’ve got most of your property to backend. We are all going to pay closing costs and realtor commission, CCC. It’s expected to be 10% roughly. That’s what we look at our numbers when we figure in we are going to sell a property later on. What’s the strategy? Let’s figure 10% for closing costs, 6% commission and roughly 4% closing costs. Usually, it’s less than the higher the value of the property but that’s where it makes the most amount of sense.
I would not get into owner financing unless you are buying a lot of properties that are sub $100,000. If you are buying at a $100,000 to $200,000 range, sell it traditionally. You might want as well go to some traditional loan from the bank or wait around and keep marketing the property. Offer some concessions. List it to at 80%, 85% of the value and put it into a multiple offer situation to bid up so you are taking less of a haircut on a traditional sale.
Don’t Collect The Payment Yourself
Don’t tie up your loan. Another thing that a lot of people try to drip on, depending on what state it’s in, it’s like, “We are going to collect the payments ourselves.” I’m like, “No. Don’t do that.” That’s not a good thing. That’s a great way to end up losing value on that note in the long run. Why? If you are self-servicing, that means you are collecting the payments. You don’t have a third-party servicer like Madison Management or Note Servicing Center. There’s somebody else who can collect your performing loan for you at $15 to $20 a month. You devaluate the asset you are trying to collect.
Nobody wants to get, “Here are the copies of checks.” We want to see a third-party servicer who can do a quick download, press a couple of buttons, download a spreadsheet, show payments and how they got situated. That third-party servicer keeps you honest and it’s well worth $20 a month. If you are offering a deal, “It cuts too much into my profit and my note,” then you shouldn’t be owner financing. If your monthly payment is going to be less than $250 a month, you probably shouldn’t be doing owner financing that property. You should adjust the term so it’s more than $200 to $250 or sells it outright and be done with it. Recoup the profit, turn around and get the velocity of capital rocking and rolling again.
If you don’t know what the velocity of capital means, that means how often are you flipping your funds. If you have tied up profit on a property, a rehab, a fix and flip, or something else, in a mortgage for five years, the velocity capital isn’t moving fast. If you are making 8%, that’s great. That’s all you are making that money. Whereas if you are taking the money back, invest it in something and making 12% on a flip twice a year or 20% return for you there, you are missing out on a ton of capital and profit. As I say, the double down mentality, “Take the profit from one property and turn it into 2, 3, 5.”
Let me give you an example. Let’s say you bought a property for $50,000 and it’s worth $100,000. You borrowed the $50,000 and you go out and do traditional stuff. You sell it and you make a $50,000 profit. You could go out and buy one more property if you want or you can leverage it. If you are able to get financing, put 10% down across 5 or 10 other properties. Now, you have leveraged that capital. If you have owner financed it, that money is stuck inside of that property.
I have had people come back and say, “Scott, I’m going to take my rehab and I’m going to go refinance it first before I offer a wraparound or before I turn it into a rental.” It still means you have to hold that property for roughly 90 days to seize it for the new value. If the bank comes across you listing it for sale, they are not going to finance the property because they are going to take a loss on it. You may have a two-year prepayment penalty.
“Scott, that’s why I’m going to do the loan for at least two years.” “Great.” Now you’ve got to wait 90 days or 120 days to reseize the property to get a better value for it because that’s what’s going to happen with the banks, they are not going to give it to you full value if it’s a foreclosure flip. If it’s an investment property, the max they are probably going to give you let’s say is $0.70 on the dollar. You might as well sell it traditionally. Move on and then double down or 1031 exchange it from that one property to another one to avoid your capital gains taxes.
I’m not trying to bash owner financing. I know it sounds like I’m not a fan of it. I like it in specific situations. Unfortunately, people are not being taught. They are only being shown the true terms of it in rose-colored glasses, “Doesn’t this number look great over here while we tie things up here?” I’m not a fan of it. Can owner financing be a great thing for you if you know how to structure it? Yeah. I’ve got a buddy, Chris McClatchy, that for years has been getting people to owner finance properties to him. He has been gaining people selling properties. He’s offering full price or above offering prices to get them to carry the paper at 0% interest in a lot of cases where every dollar he’s spending or paying into the mortgage goes towards the principal.
Through amortization, he’s paying down the value of that property where he ends up with a lot of free and clear property that he can then refinance, pull the equity out and go from there. He’s able to tie up real estate because people don’t realize, “You are going to offer me full value and nobody else is. You are going to offer me the above value.” I get excited about the turns but then they once again realize, “This is not such a great strategy for me if it’s at a low-interest rate and I have tied up that property now. I’ve got to sell it either through normal terms of business, loss of loved ones, death or whatever it might be.” You’ve got to know when to hold them and when to fold them.
Owner financing would be a great thing if you understand it for yourself and if you are going to use that tool to go and get a property but I don’t believe it’s the best strategy for you as an exit strategy when selling your property. The best number one turn is always going to be to sell the property traditionally, especially if it’s over $100,000. If it’s below $100,000, you are going to have a hard time getting a traditional loan from a bank. If you are getting a traditional loan, you may want to look at a contract for deed or lease options.
The minute you tie it up into a mortgage, your one way to get out of that if the bar doesn’t pay is to foreclose and you are dealing with that. If you need to sell the note off, you are going to sell it at a discount if it’s not properly structured. Don’t take a one-day class, a webinar or watch a YouTube on owner financing. You will get bogged down. You have to understand the pros and cons of both sides of the strategies. Owner financing has its pros but it also has its cons. People consider arguing back and forth but numbers don’t lie. Your financial calculator doesn’t lie if you know what to do.
If you have bought a property and you are one strategy doesn’t sell traditionally and you have to owner finance it, you probably didn’t do a good enough job on the front end of buying that property. Some of our students had bought some cheap property. They offer up terms with the idea that if they sold the note at a big discount, they didn’t care that they were coming out ahead anyway. I can’t fault them for that. If you are buying a property and you’ve got to sell it, don’t offer owner financing. Sell it traditionally. Offer some terms. Market the property a little bit below the value to get multiple offer situations. Make the buyers bid against each other to drive that value up. You are going to take a big discount on that.
At some point, if you owner financing and then you need to set one up before it’s due, before twelve months of seasoning, without servicing or at a low-interest rate because you didn’t know what was going on in the market, you are going to take a haircut and you are not going to feel good about it. Go out and take some action, everybody. I would highly recommend that before you ever sell a note, somebody wants to structure a note or somebody approaches you and ask you to carry the note, always find out and get a third-party opinion on evaluation.
You can always email me, Scott@WeCloseNotes.com. You can always go to First National Acceptance Corporation. If you give them the terms of the note and what your borrower or buyer is looking for, they can tell you the value of it. They can tell you roughly what to expect on the resell of it whether it’s at twelve months or a brand-new loan. A brand-new loan doesn’t have a lot of value, especially in the world nowaday’s with the craziness of COVID and everybody being delayed or laid off and stuff like that. I would be looking more so to stick and get it sold traditionally. Let somebody else go out and jump through hoops to get financing. Take your money to the bank. Go out and take some action. I hope this was helpful. I love having you guys on here. Share and subscribe to it. We look forward to seeing you.
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