It is no secret to anyone who has been in the real estate business or financial market for more than a decade; that the Real Estate Market is cyclical. When the market suffers from a downturn due to any cause including increase in interest rates and/or inflation, the willingness of the institutional lender to provide highly leveraged loans declines. Unfortunately, at the same time the ability of buyers to pay significant down payments also declines.
As you know, one of the benefits of investing in real estate is the ability to leverage your investment that is. Although you control the entire asset, you only are required to pay a portion of the purchase price down; the balance can be financed over time. During the present cycle, interest rates are low and inexpensive institutional financing is plentiful. However, when the economic conditions tighten – and history declares they will – sellers who want or need to sell will once again be faced with carrying back a note secured by either a first or second Trust Deed on the property – or waiting out the cycle.
There is a Proverb that declares: “a wise man sees the problems ahead and prepares for them”, as a Cash Flow Specialist or Investor involved in the purchase, flipping or sale of promissory notes secured by real estate, it seems that right now you would be wise to get ahead of the curve and learn all you can about how seller carry back financing is structured, bone up on the variables, be able to recognize nuances in the note and be in a position to analyze the effect of specific clauses affecting the value or transferability of the note.
The new Cash Flow Consultant may not be aware of the many variations in the type of notes and variations in the payment schedules. So, here is a little run down not intended to be absolutely all-inclusive.
To begin with, there are installment notes, which usually have a constant, periodic repayment in any amount that is negotiated. Some notes may have interest included or interest added. There are also notes with a moratorium on the payment for a specifically negotiated period, after which regular periodic payments begin. Then there are cases when the buyer splits their down payment which could result in a note payable as “principal only” for a period until the balance of the down payment is paid. Then the periodic payment of principal and interest commences in.
Interest rates on seller carry back notes can be a typical “fixed rate” or an “adjustable rate” (ARM), or may be structured with provision for graduated payments (GPM). Then there are: All-inclusive notes where sellers’ carry back referred to as an AITD which “wraps around” underlying senior notes.
It would be prudent for Cash Flow Consultants to also be aware of certain “clauses” and provisions contained in the note and/or trust deed, which can significantly affect the value of the note either, up or down. Some basic clauses and provisions often found in notes are: prepayment penalty, late payment and grace periods, due on sale, agreement to subordinate and release clauses, exculpatory clause, right to extend, lock-in clauses and the right of first refusal on the note, due date extensions; balloon payment provision and a payment guarantee.
In future articles regarding seller carry back financing and private financing, I will be addressing the notices available to the seller holding a second trust deed to protect their equity position and mitigate potential loss. In the meantime you should be aware that the clauses and provisions mentioned in this article could have a bearing on the value and transferability of the note. Therefore, a working knowledge of these provisions can often “save your bacon” as an investor and keep the note professional from getting egg on his face.
The cash flow consultant who is at least familiar with the clauses and/or provisions will be light years ahead of the competition, save time and increase their success rate and bottom line. Interest rates have already begun to inch up and in many areas (not California), builders have exceeded market absorption with supply exceeding demand. Check out our glossary page on this web site for the definitions of the clauses and provisions mentioned in this article.