Okay, more posts on the value of owning real estate as a way to fund retirement. In this post, I want to share important info on how real property is traditionally bought and sold to facilitate the transfer of legal title (ownership). Each has its own positives and negatives. Research some of these ideas for yourself to see what works best for you.
- All cash
- Cash down payment and traditional (conventional) mortgage
- Borrowed down payment and traditional mortgage
- Buyer assumes existing debt and seller holds note
- Institutional financing
- Seller finances the purchase price
- Wrap existing debt and seller holds the note
- Combination of any of the above
This is the most simple and direct way to purchase real estate, for obvious reasons. Of course, for most people it is also cost prohibitive. Most professional investors have built up a large enough cash reserve where they can afford to buy using “all cash” should they so choose. An important question to ask is:
“Should I spend all my own capital to buy one property or split it up and use it as a down payment to buy multiple properties?”
This is not always an easy question to answer. The answer should be based on your individual and business goals as a real estate investor, your risk tolerance, your family’s needs, your current stage in life, and your social needs. The “all cash” option has benefits for some and can be a problem for others. Following are some of the pros and cons to consider:
- Simplified purchasing and operation
- More secure return on investment
- In the early years of the investment, the cash flow is sheltered from taxes
- There is no risk of mortgage default
- Operational risk is greatly reduced
- Generally yields a lower percentage on return
- Limited market penetration
- Lack of diversification
- Ties up cash, making it less available for other acquisitions or to cover other expenses that may come up.
Cash Down and Traditional Mortgage
The most common way to finance a real estate deal is through a cash down payment and obtaining a traditional mortgage. Obviously the residential owner-occupied market uses this method of financing the most, and it therefore mirrors the commercial marketplace in terms of financing options. This method is generally the most flexible form of financing.
Borrowed Down & Traditional Mortgage
Also called a “No Money Down” mortgage, this type of loan can be problematic. If you borrow money and claim the debt on your loan application for the new property, it may cause the application to fail. And if the money you borrow is through a credit card, for example, it’s going to cost big in terms of interest expense. When the payment on the down payment loan is added to the payment on the traditional mortgage usually the amount will become so large that it can’t be covered by the operations of the property and can often lead to foreclosure. Sometimes it is just more profitable for you to join forces with a partner or two to get the down payment, thereby avoiding higher payments. This is not a method for acquiring real estate that I can really endorse.
Buyer Assumes Existing Debt & Seller Holds
This is another “No Money Down” purchasing technique. To determine if this is a financing method appropriate for you, consider the following:
- The liability you will assume with the existing debt
- The quality of the underlying debt
- Seller motivation
- Your relationship with the seller
- The legal validity of the seller documentation
- Seller junior liens
- Availability of title insurance
- Terms and conditions of the seller’s financing
100 Percent Institutional Financing
One of the “No Money Down” options, this technique carries certain risks. One critical issue is the quality of the underlying title of the property. You have to ask yourself why the seller would be willing to sell under these conditions. Possible answers include that he/she couldn’t sell any other way. Maybe they are charging a high interest rate to produce revenue for themselves. Perhaps they know that no one else will make the loan. They may know that the title isn’t clean. If you are wise, whatever the reason, you will research the status of the title and make sure legal documents are in order.
If you choose to use this form of financing, ensure the following:
- The price is fair
- The interest rate is reasonable (compare with market rates)
- The title is clean
- You understand the terms and conditions of the debt
- You are willing to deal with the risk of high leverage
- You can buy title insurance for the property
- Documents are legally sound
- Legal filings are done to notice your transaction
Wrap Existing Debt & Seller Holds the Note
This is another “No Money Down” option that wraps the existing debt of the property into a new loan. The buyer pays on the new loan with a portion of the payment going towards the original loan’s payments.
If you choose this form of financing, ensure the following:
- A clean title
- Record your interest in the property
- Use an escrow company to receive the payments from you so they can pay the original debt payment then distribute the difference to the seller
- Draw up sound legal documents that ensure the seller will make their debt payments
Note: Watch for a “due-on-sale” clause in the seller’s debt documents. (If such a clause exists, the seller’s lender may call the loan due and payable when the sale to you occurs; this may cause you serious problems if a lender should enforce the clause and the seller is unable to make payment in full). The rules that govern whether you will be held personally responsible for paying off the property or whether the proeprty itself can be relied upon to satisfy real estate debt vary from state to state. Be sure you know your state’s laws regarding this issue.