Multifamily Financing and The Seller Carryback

Seller carryback financing.  So simple, so eloquent.  So screwed up so often.   This article will discuss seller carryback from the sell-side perspective and present the risk the seller is assuming. Most buyers think that obtaining a seller carryback is a good thing.  It very much can be under certain parameters.

Most sellers are confused about the matter of how to use seller carryback financing; thus, they refrain from its' consideration because  a confused mind always says no- to everything.  As a seller, carrying a note, or mortgage, represents one more tool to get a property sold.  It's is not the be-all-best-all option but represents an opportunity to assist you in selling an asset when traditional methods are falling short.

Nothing beats an all-cash sale.  But a deal that includes a seller carryback, if it helps to meet your goals and objectives, is worth a look.  From Nolo:

In seller financing, the seller takes on the role of the lender. Instead of giving cash to the buyer, the seller extends enough credit to the buyer for the purchase price of the home, minus any down payment. The buyer and seller sign a promissory note (which contains the terms of the loan).

In a world split in two politically, economically, on policy and premise for societal advancement - why talk about the simple things, like seller carryback financing?  Because seller-financing is a temptation than even a cash buyer may bite on.

Real estate investors learn early and often that OPM (other people's money) is there to assist them in building their fortune. These "fortune builders" recognize they can  buy more with leverage.  This house of cards has no end in sight until it does.  Like musical chairs, when the music stops, it stops for everyone playing the game.  This is why you, the seller, must understand the level of risks associated with carrying back a mortgage.

Carryback Financing

Seller carryback financing is referred to as "creative financing." It's not so much creative but non-conforming from a lender's perspective.  Most people are aware that if a seller carryback is involved in a sale, the likely reason is that conventional financing alone would not get the deal done.

The seller carryback is there to help you, the seller, get the deal done.  If it doesn't help you, don't do it.  Seller carry back by its very nature is high risk and intended to be transactional, meaning to assist in getting the deal closed.  It is not intended to be long-term financing.

Often, the objective is to help the buyer to get to the next re-financing event or sale re-sale of the asset.  As the seller, any term beyond five years is further increasing your risk. From The Truth About Mortgage:

Seller carryback financing is basically when a seller acts as the bank or lender and carries a second mortgage on the subject property, which the buyer pays down each month along with their first mortgage. It may also be referred to as owner financing or seller financing.

I recently drove by a national burger chain advertising their latest fare: a Turkey Jalapeno Burger.  Now that's creative! Not very appealing in my book, but creative.  No doubt, this offering is the product of hundreds of hours of market research and taste tests.  It was probably first offered in just a few stores.  If it has legs, the store expansion will continue.

Good ideas get tested, then expanded across a market.  Yet every good design doesn't work everywhere, right?  West coast people eat strawberries; east coast people eat cherries.  Switching this around would confuse many.

Mortgage loan products are developed similarly; different mortgage products are intended to allow deals to proceed under varied circumstances.

If you recall, CMBS (Commercial Mortgage-Backed Securities)  is a relatively new mortgage product.  The first tranche was not a billion-dollar portfolio, more likely one hundred million, then tinkered with until deemed viable to sell to institutional investors.

How old is seller carryback financing?  Likely close behind ancient man's creation of language when the first farmer sold a developed field to another in exchange for a percentage of crops (for some time- of course).  More likely, after the invention of the abacus when bean-counting transformed from hobby to profession.

The current day problem with seller carry back financing is that most lending institutions are opposed to secondary funding.  Most financial institutions are reluctant to allow non-institutional secondary funding. More succinctly, they don't allow it and state this explicitly in their loan documents.

Mezzanine financing is an excellent strategy for buyers of commercial deals to maximize leverage where the first lien holder is involved in all layers wrapped into the mortgage.  In commercial deals, there are often multiple loans "layered" and serviced by the same primary lender. Each has a different risk profile and interest rate that reflects this risk.

The common thread, or theme, with mezzanine debt is that the same lender or servicer is overseeing the the loan in its entirety. This operational oversight is why and how "mezzanine" debt survives and flourishes in commercial real estate; the lender is getting paid with every layer increased debt and is underwriting the risk accordingly.

seller carryback money stacks of money

A Seller Carryback That Works

A seller carry back that works for the seller is when the equity in the deal equates to at least twenty percent (20%), and the amount carried back by the seller does not exceed one-third  (33%) of the senior mortgage financing.

Example:  Deal strike price is $1,000,000.  Cash down payment is $200,000, first mortgage is 600,000 with a seller carry-back of $200,000.

Why is this a reasonable seller carryback deal structure? Because it is at least a defensible position.  There is equity behind the seller carryback and a manageable first mortgage in front of the seller carryback.  If the seller had to foreclose this position, the mortgage financing in place at origination equates to a sixty percent (60%) loan-to-value (LTV) of the originating purchase price.

Consider this recommendation as a max-leverage point and only for income-producing rental property.  If the seller were to foreclose, there is now an existing mortgage to address.  If there was no debt prior, the seller - now owner - must manage this debt regardless of current rental income.

A Seller Carry back That Doesn't Work

A seller carryback that does not work for the seller, using the same dollar amount as in the prior transaction:

Bad Example: Deal strike price is $1,000,000.  Cash down payment is $100,000, first mortgage is 800,000 with a seller carry back of $100,000.

In this example, the seller's carry back mortgage is in a precarious position.  The likelihood of foreclosing on this position is improbable as even a successful foreclosure leaves the originating seller saddled with a property financed at 80% of the sales price.

When considering a seller carryback, presume that you, the seller, will have to foreclose on the senior financing.  How many sellers have the mental stamina to take back this same deal highly levered having sold the asset?  Very few.  Thus, the carryback goes up in smoke.

For a seasoned real estate investor doing so could be "just another deal" in the course of business.  For the non-seasoned, having to proceed with foreclosure to protect a secondary piece of financing deemed (by them) to be a valuable asset, this could be a life event.  If so, avoid seller carryback financing.  For the seasoned, full steam ahead, and please consider the rule of thumb presented here.

Another "trap" for sellers is when the only cause for using the carryback is to overcome credit risk raised about the buyer.  Here is where the scale of justice is in your hands.  However, being a judge does not excuse you from being burned in the transaction.  Becoming "the bank" brings with it all the rights and privileges of having to collect. Weigh carefully.

Seller Carryback and Land

The only way a seller carryback works well for the seller of land is with cash equity paid to the seller at closing and when the only mortgage in place, post-closing, is held by the seller.

With considerable equity capital offered by the buyer (i.e., a 50% cash down payment), you may wish to consider allowing the buyer to obtain a mortgage with a small seller carry back. Even then, your note is just a piece of paper with nominal value in the event of foreclosure.

Using my example of a $1,000,000 sale, if the seller is carrying a  $100,000-second mortgage behind a $500,000 first mortgage on a property with no income (land), there is little incentive to proceed with foreclosure.  In the event of a default, the seller, if successful, must address the debt and debt service with no corresponding income from the property.

Know that seller carryback's have their place.  They should not be the leading transaction type of choice, but they can help a seller salvage a deal that would otherwise be a loser and/or create equity that would otherwise disappear altogether.  Recognize the risk.  Don't chase recovery unnecessarily in the case of default.  Know when to fold and move on.

John Wilhoit is the author of the best selling book on rent roll analysis: How to Read and Rent Roll. See also the companion guide to measuring the quality of rental income: Rent Roll Triangle.  Find JW's Podcast here.

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