The Capital Stack
We were fortunate enough to purchase the Suburban 36 portfolio with seller financing. In today’s debt market seller financing deals can be a home run and can benefit the buyer and the seller.
How A Seller Benefits from Seller Financing:
When an owner of a property thinks about selling, they often begin to consider the large amount of capital gains taxes they will incur after the sale. Capital gains tax can be as much as 20% of an owner’s profits. By seller financing owners can defer taxes by breaking up their earning over several years instead of receiving them as one lump sum. Seller financing allows owners to pocket money that would otherwise be lost to taxes.
A buyer can pay more for a property if the financing terms are in their favor. Money they would normally allocate toward bank debt can be added to the purchase price. Therefore, seller financing at more favorable terms can help the owner achieve a higher premium for their property.
How a buyer benefits from seller financing:
Seller financing saves the buyer time and effort. Securing a bank loan involves a 30 to 60 day underwriting period during which the bank will request countless documents from the buyer to determine if they are willing to finance the purchase. Seller financing is subject to less strenuous underwriting criteria and often is completed sooner allowing for a quicker close.
By seller financing buyers also avoid standard bank financing fees and appraisal fees. Financing fee can be anywhere from .5% to 2% of the loan amount. The cost of the appraisal can range between $4,000 to $10,000. Choosing to seller finance the Suburban 36 portfolio saved us ~$45,000 in fees alone.
With rates trending upwards the seller is able to offer the buyer the opportunity to finance at a lower rate then what banks could offer. Because rates are cyclical there’s a good chance after the seller financing term is expired rates will be lower. When purchasing the Suburban 36 portfolio we began negotiating with the seller in November 2021 when interest rates were around 4%. We ended up closing in July with rates around 5.5%. If we had chosen bank financing, we would have had to close with a 5.5% rate and the return for our investors would have suffered or in reality the price would have had to come down significantly to account for this difference. In this scenario, the competitive interest rate offered to us by the seller allowed us to save money that would otherwise be lost to the bank in interest.
Seller financing allows for extremely flexible rate, terms, and all others. I actually got an offer for one of our properties where the buyer wanted us to seller finance at 50 year term, 2% interest. Obviously I’d never do that, but the buyer was continually trying to convince me that this was a good thing to do. I told him that if he believes truly that it’s smart for a seller to take I would buy everything he owns with those terms. He quit responding after my offer further proving my point. However, this goes to show how flexible seller financing could be.
Major Market News
There’s a recent article by FirstTuesdayJournal entitled “Rising rates bring back seller financing”. The article shares our opinion and says, “The seller who offers a convenient and flexible financing package to prospective buyers makes their property more marketable and defers the tax bite on their profits.” The article continues by explaining that “Qualified buyers are willing to pay a higher price for real estate when attractive financing is available.” Check out the article for more information.
Tips and Tricks
Appraisal risk- The biggest risk we approach from an appraisal standpoint is our LTV when it comes to appraisals. Banks will lend on 75% LTV based on purchase price OR appraised value, whichever is LOWER. Here’s how this plays out with a low appraisal.
Purchase Price: $1,000,000
LTV: 75% – $750,000 loan amount, $250,000 down payment
Appraisal needed for everything to go smoothly is $1,000,000
Hypothetical $800,000 appraisal comes in.
Now the bank will lend 75% of $800,000. Purchase price stays at $1,000,000.
New loan amount $600,000
New down payment $400,000
Cash to close now increased $150k and this will have a large negative affect to cash on cash returns for the property.