Sellers Lending to Buyers and Selling the Note

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I am seeking to sell my properties to my tenants. I want to create a mortgage and then sell the mortgages. Properties are undervalued in this area as they have been historically fixer-uppers. Ours are in very good condition due to major renovations. This would interfere with a regular mortgage, but temporarily holding one might eliminate this problem. Is there a way to do this or is this not possible?

The first question one would ask is why you would want to do this. The answer, easily enough, is that this way you aren't chained to lender requirements as far as the appraisal goes. When you've got a property above the neighborhood in quality, it's very hard to get an appraisal for as much as you might be able to get at top dollar. Why? Because there's nothing else in the area as good. This phenomenon has a name: Misplaced improvements. I've spotlighted a few of these. They are not good investments, but they are an excellent way to get a significantly better home for not much more in the way of purchase price. If you've got a beautiful 5 bedroom home with 3000 square feet and all the amenities, and nothing else in the neighborhood is over 1500 square feet, and kind of run down at that, they are still your comparables (comps). If I understand the rules correctly, the appraisal can only be a maximum of 25% over the comps. So if everything else in the neighborhood is selling for a maximum of $400,000, this one can't appraise for more than $500,000, even if it might be worth $800,000 in a neighborhood of like properties. Best property in a neighborhood: Bad investment (relative to other properties), but a good way to find a great home for your family to live in at a bargain price.

So this person wants to get around that, and has an idea as to how. Forget lender standards, he'll just make the loan himself. Well, he is permitted to do this. Willing buyer and a willing seller agree upon the price, and since a regulated lender isn't involved to force the evaluation into a LCM, or "lesser of cost or market" format, the appraisal becomes irrelevant. Buyer and seller agree upon a price, and part of the transaction is that the seller carries the note.

Now the first issue is the "due on sale" clause of most mortgages. So if you sell the property in this manner, any mortgages you have become due when you sell the property. No problem if you own it free and clear, or if you've got the cash to pay it off somewhere. A large problem if you don't. It is possible that some lenders may allow the loan to be assumed, and to put the loan you are actually holding behind their mortgage as a second trust deed. You then have justification for charging a higher rate of interest on the portion you actually hold. Cool, from the seller's point of view. Not so hot from the buyer's point of view. Remember, they've got to actually make those payments. Some lenders may also agree to modify their trust deeds so that you're still holding them, but they become "pass-through" type investments. Expect the lender to require a modification that raises the interest rate in this instance.

Now, let's ask the next question: Why would the tenant want to pay more than the area is worth? Well, I wouldn't, but it does happen. There are "Rent to Own" appliance stores everywhere, and PT Barnum underestimated by several orders of magnitude. Many people think that for some unguessable reason that they are not qualified to buy a property, or that they are less qualified than they are, and many loan officers and real estate sharks prey upon this sort of buyer. It is for this reason among many others that I counsel everybody to shop their loan around and find a good buyer's agent, who should inform you as to the issues involved and represent your interests, so that if you end up doing it, you walk in forewarned and forearmed, and have someone with a fiduciary responsibility to you and only to you that you can and should sue if they don't. Because buying under these conditions is not likely to be in the buyer's best interests in the kind of situation envisioned by this seller. The buyer ends up owning more than the property is worth according to a lender, making it difficult to refinance, even if general values have increased. I would certainly want some major concessions in price or interest rate in order to consummate the loan. Note that it isn't wrong of the seller to do this as long as you do not misrepresent the situation; everyone wants the best possible bargain and both sides are entitled to pursue that best possible bargain, and sometimes, one side does a much better job than the other.

Now, let's assume that all of the above has been done. Willing buyer, willing seller, price agreed, exchange made and now we are going forward to the seller wanting to sell the note. Can they expect to be able to sell?

The answer is that yes, the holders of the notes can sell, but in my estimation they would be better off not doing so, other factors being equal. You see, all of the other lenders out there selling their notes have a track record. Even lenders just starting out can document their underwriting standards. Furthermore, CMOs and MBSs are normally sold in lots of $50 million or more - in other words, pretty good risk diversification, as that is at least 100 different loans from 100 different borrowers in 100 different areas at a whack, and the chance of that lender taking a net loss is far less than if there are only ten or twelve. Furthermore, as most lenders can document their risk management practices, and the ones who have been at it for a while have a track record of thus and such a foreclosure rate, and thus and such a loss write-off rate, they get a price for their notes that is commensurate with the value. In most cases, pretty darned good, netting three or four percent over value after paying the security brokerages who act as go-betweens. Do this six or ten times per year, you make some pretty decent money even after paying for everything it takes to do those loans.

In the case under consideration, however, those security brokerages are going to charge about the same amount as they charge on much larger issues. After all, they have to do basically the same work, so they want the same pay. Furthermore, you're going to have some real trouble convincing prospective buyers that your risk management underwriting is acceptable, as you are missing at least one of the most basic protections for lenders that there is: the assurance that if everything goes south, they will be able to market the properties for something approximating their investment. Chances are, they are going to require that you perform an appraisal in order to sell the loan to them, and since the appraisal will come back with the same value that you were trying to ignore in the first place, and the price they will offer for the loan will reflect that, and they will offer far less for those notes than you have at risk. All of them are in the same area, and all of them have the same issues. A lot less diversification of risk than what they normally see, and with other issues as opposed to loans underwritten by regulated lenders, as well.

Now if you can sell enough in one area, the comparables will start to reflect these values, for which neighboring properties will certainly thank you, but the real point is that after a few of these sales, both in the MLS and publicly recorded in a short period of time, your appraiser can start to get value, at which point regular lenders start being willing to bite off on them, if you've got a good appraiser who can justify choosing the comparables that they did. If you're selling out a sixteen unit conversion, well, most of them should be "model matches," but if they are all single family residences of varying floor plan and not particularly close to one another, there are likely to be persistently difficult issues with appraisals.

The upshot is that in most cases, when you go to sell the note, you are going to take the same "loss" (of value), if not more, than you otherwise would have "suffered" by simply putting the property up for sale at prices that the neighborhood comparables would support, and letting the lender's chips fall where they may. Don't get me wrong; if you're in a position to hold the notes yourself it could be a great way to make some money, although you've got to watch out for foreclosure issues. But if you're planning to sell the notes, you're going to have to go through the same rigmarole that the regulated lenders do, and come out much the worse for the fact that you did not go through the same process that they would. Now just to note, this has a lot in common with a couple of scams I've read about, and Wall Street is certainly a lot sharper than I am on that score. Just because you're being honest does not mean that the flinty-eyed people who invest other people's money for a living are going to believe you're honest, especially when what you're doing looks like a known scam to them. Oh, you'll be able to sell the notes, of that I have no doubt. But I sincerely doubt that you'll be able to sell them at face value or anything like it.

Caveat Emptor


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About this Entry

This page contains a single entry by Dan Melson published on April 27, 2008 7:00 AM.

Contingent Sales in a Buyer's Market was the previous entry in this blog.

April 2008: Why Loan Rates Are Cheap is the next entry in this blog.

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