100% Financing with Seller Subordination

Frequently folks tell me, “I’ve tried to purchase properties the way you suggest, but my bank always says ‘No.’ What should I do now?” My answer is to keep on trying. If one particular technique doesn’t work, just hang on and don’t give up. There are lots of other ways that will work. Right now, however, let me tell you about a subordination technique that works particularly well, if you have a decent job and a good credit rating. Subordination means the owner/seller will allow the bank to make a new loan against the property in front of or senior to the seller carryback mortgage. This means that, if the property should ever be foreclosed, the seller could lose his or her equity or part of it because senior priority mort­gages would be paid off first from the foreclosure sale proceeds. However, without seller subordination, the bank could not fund the loan that’s required to make this particular type of sale work.

Seller Subordination: A No-Money Technique That Works

In case you’re wondering if this method really works, let me assure you I’ve made about a dozen of these deals. I’ve purchased $1.5 million worth of houses using a combination of subordination and owner financing. I call it my “30-30 plan.” Let me show you how it works.

First, you must find a seller who truly wants to sell—not just a luke­warm seller who has little or no motivation. I have found this method works best with sellers who have average, medium-grade rental properties. You don’t want trashed-out junkers and you don’t want pride-of-owner-ship properties. You want a property that can stand a few improvements, but not one that is seriously run down, because most lenders won’t loan money on junky-looking investment properties.

The typical lenders in my area are thrifts like Beneficial Finance, AVCO Thrift, Chrysler First, and Fireside Thrift. These are the old personal prop­erty (chattel) lenders with an add-on license to do real estate loans. Many folks call them “godfather loans,” because their interest rates are general­ly higher. However, unless you’ve done business with these lenders lately, you may not be aware of all the changes that have taken place over the past few years. Today these lenders make real estate equity loans combined with chattel mortgages. Their licensing allows them to write loans secur­ing both real estate and personal property. The extra personal property security allows them to be more liberal with borrowers than regular banks, so it’s generally easier to qualify for their loans.

Loan Terms Are More Important Than Interest Cost

It’s true, these thrifts do charge higher interest rates; however, not as high as you might think. More often than not, their equity loans have fixed interest rates and are generally amortized over a 15-year term. Another very important consideration with these lenders is that they’re seldom concerned about junior priority loans on the secured property—that is, loans that are recorded behind or after their own. Banks quite often pro­hibit additional loans on the secured property, even though the security is junior to their own loan.

Remember this about financing: it’s much more important for investors to borrow money from lenders that will give flexible terms than to borrow strictly on the basis of the lowest interest rate—within reason, of course. Flexible terms will add value to your properties when it’s time to sell, because you can pass along the good terms to your buyer.

The Attraction of the Southside Property

My Southside property consisted of four rental houses located on a large city lot. The property was in average condition. The sellers had owned the houses for many years and had done extensive upgrading, like blacktop-ping the driveways and building privacy fences. They had also added car­ports and installed several new roofs. Generally speaking, the property looked in pretty good condition when I bought it. On a scale of one to 10, I’d call it about a seven. It’s important to remember that lenders like prop­erties that look good.

The sellers’ motivation was a strong desire to retire. The owners had operated a small travel agency for many years and now wanted to close shop and travel themselves. Like most owners who decide to sell their average-looking properties with a large amount of equity, they wanted a rather substantial cash down payment from the buyer. At least 20% to 25% was the amount they would take, according to their real estate agent.

The property looked good and, of course, the competition is always much keener when a property shows well. Looking back now, I must admit that the good looks impressed me, too. I paid a bit too much for the looks, so Southside turned out to be less profitable than most of my other deals—but that’s another story. We’re talking financing now. We’ll look at bigger profits another time.

An Ideal Candidate for My 30-30 Seller Subordination Plan

The Southside property was an ideal candidate for my no-money-down 30-30 subordination plan. First the seller must agree to finance (carry back) at least 30% of the purchase price. Second, the existing financing on the property should not exceed much more than 30% of the total purchase price. It must also be assumable.
Here’s how the numbers looked when I made the offer to purchase Southside:
Asking price = $115,000 (reasonable for rental income and condition of
the property.)

$105,000: My offer to purchase (accepted)
$ 34,650: Existing mortgage (assumable)
$ 70,350: Sellers’ equity
The sellers agreed to accept my offer of $105,000 and allowed me to place a new second mortgage (loan) on the property for $37,500. The loan funds were disbursed as follows: $32,500 went to the seller, $1,500 went to pay escrow closing costs, and $3,500 came back to me at closing. I not only accomplished a no-cash down purchase, but also got money back on the deal.

Where Does All the Money End Up?
Ideally, an existing mortgage on the property you’re buying should be approximately $30,000 to $35,000 (30%). The seller must agree to subor­dinate to a new loan (mortgage) for about the same amount (30%). And finally, the seller must agree to carry back a third mortgage for the balance (30% to 35% range).
The obvious question you are probably asking yourself is “Why on earth would a seller surrender his or her equity by allowing a new loan to be recorded on the property ahead of his or her interest?” The answer becomes clearer when you follow where the money goes—and understand the benefits to the seller.

The seller gets the money, at least most of it. That’s what makes this deal work. Some investors try to play games with this type of financing, by attempting to pocket a large share of the new loan proceeds. This tactic is very poor business, because it grossly over-finances the property. It also increases the monthly debt service, which in turn adds far greater risk to all lenders involved. A buyer can be quickly overcome by negative cash flow, caused by high payments to service too much mortgage debt.

I have found this financing arrangement works best when you give all the borrowed money, except expenses, to the seller. Here’s an example, using a $100,000 deal. Let’s say you can assume a $30,000 existing mort­gage. The seller has agreed to carry back a $35,000 third mortgage and will subordinate to a new bank loan for the balance. Obviously, an appraisal must substantiate the property value; however, most lenders would be willing to loan up to 70% of the appraisal. In this example, a 70% loan means the lender would be willing to loan $70,000 on this property. Since there is an existing first mortgage for $30,000 against the property, it means any additional borrowing cannot exceed $40,000 ($30,000 plus $40,000 = $70,000).

In this example, I’ve tried to use very reasonable numbers. In other words, my ratios and loan percentages are well within limits for most lenders. With a decent job and good credit rating, an applicant could rea­sonably expect to receive loan approval without too much difficulty. Obviously, you’ll need an appraisal and, of course, the standard financial information all lenders require from investors.

How Does a Seller Benefit?

The big advantage for a seller with this arrangement is he or she gets $35,000 cash up front. That’s an extra-large down payment for rental houses. Typically, sellers are accustomed to receiving only 10% to 20% cash down payments for average rental properties. As you can plainly see, this plan will net the seller far more cash at the closing table.

There’s also another big benefit for sellers who have owned their rental properties for a long time and have large equities or profits build up. (By the way, this 30-30 plan is more or less geared for long-term owners, because the numbers work better.) Quite often, the extra-large down pay­ment (30% to 35%) will allow the seller to get all or nearly all of his or her original cash investment back. In other words, the large down payment will totally cash the seller out of the property, leaving none of his or her own money in the deal.

It’s a bit easier to finance or carry back a mortgage for the apprecia­tion or growth because you’re only financing the profits you’ve earned. It’s always riskier for sellers when their own money is still left in the deal. Most investors are reluctant to carry a mortgage without first getting all of their hard dollars back out of the property. If they can do that, they’re general­ly a lot more agreeable to seller financing for the balance of the sale.

I personally don’t object to financing my profits, because I like the additional interest income it earns. It’s a marvelous recipe for making bonus profits. On the other hand, I need my down payment dollars back when I sell, so I’ll have the funds for my next investment.
Advantages to the Buyer
The major advantage is that you can acquire real estate with no money down—that is, none of your personal money! What this means is that lack of cash doesn’t need to stop you from buying income properties. However, as I told you earlier, you must have a decent job and a good credit rating to qualify with commercial lenders. If you do, then my 30-30 plan can work very well to help you acquire investment properties that you might otherwise have to pass up.

To avoid negative cash flow problems with this plan, you must be very careful not to take on mortgage payments in excess of what the property can support! This is where my income property analysis form (Chapter 5) can be an extremely helpful tool. Basically, you’ll need to carefully calcu­late all the expenses necessary to operate the property, then subtract them from the gross income. The remainder is what you’ll have left to pay the combined mortgage payments.

The most serious problem with no-money-down deals is that the total purchase price must be financed—unless, of course, other trading is also involved. You must carefully negotiate the mortgage payments so they don’t exceed whatever amount of income the property is capable of earn­ing. Effective use of the 30-30 plan requires special planning and skillful negotiating to avoid negative cash flow.

Lenders Want Clean, Sweet-Smelling Properties

Lenders are like 98% of the population: whatever they do is generally based on how things look! They will gladly lend money if your project looks good, but they don’t want anything to do with the “ugly duckling” properties. Believe me, looks count for everything—loans included! It will serve you well if you understand this basic human characteristic, because it’s exactly how lenders think! If your property is reasonably clean with no visible signs of a problem, chances are quite good that most mortgage lenders will finance up to 70% or more of the purchase price or the appraised value, whichever is less.

In our hypothetical case, the seller is willing to carry back a $35,000 mortgage and will subordinate to a second mortgage to be placed on the property. The buyer agrees to assume the first mortgage that exists on the property at the time of purchase. Right about now is where we (the buyer) must ask the seller to cut us a little extra slack. It should be obvious by now that three loans on this property will cost more than the property can afford to pay back under normal circumstances. To illustrate what I mean, let’s review the numbers once again in our hypothetical transaction.

The scheduled income for this property is $350 per unit, or $1,400 per month in gross rents. For the purpose of planning, let’s assume it will cost 40% of the income each month for expenses to operate the proper­ty. That’s $560 per month. The debt service (two mortgage payments) will cost $662.72. The total cost for expenses and mortgage payments is $1,222.72 per month. Obviously, there’s little money available to pay another monthly payment on the seller’s carryback mortgage. Therefore, I propose asking the seller for some special consideration for the payback of his note. I would tell him that $175 to $200 is all the property can afford to pay him.

Paying Back the Sellers’ Note

Back to my Southside houses …. They presented a similar problem for me at the time. Here’s how I explained things to the sellers.
Look, Mr. and Ms. Seller, I’m more than willing to place a new loan on the property in my name. No risk to you because the loan won’t be in your name. Also, I’ll give you all money from the new loan except closing costs and the $3,500 for repairs that you’ve already agreed to do. It’s much easier for you to deduct the repairs from loan funds than spend your own cash out of pocket.

I’m sure you realize that my 35% down payment is more cash than most investors are willing to pay. Also, most buyers would certainly want you to finance (carry back) a much larger share of the sale. I’m more than happy to use my good credit to get you the most money, but I do need a favor from you.
I’m willing to work at the property and do the repairs and manage the tenants, without taking any money from the proper­ty for myself. However, as you can see from the income and expense information (income property analysis form), I’m not going to have enough rent money coming in at first to pay you the monthly mortgage payments. I need you to give me a little extra time ’til I can raise the income a bit.

Special Terms Required: Deferred Payments

I told the sellers I’d pay 10% interest on their note in five annual pay­ments. That’s $250 per month (10% of $30,000 is $3,000, divided by 12 months equals $250). That way I’d have the first 12 months without any mortgage payments. It would give me breathing room and some time to get the rents up a little.
Also, I’d have the opportunity to gain one full year’s worth of tax deductions. Assuming an 80% improvement ratio and $12,000 worth of depreciable personal property, an investor in the 31% tax bracket would realize a $1,600 annual savings. That makes up more than half the $250 deficit. A $30 rent increase would take care of the difference.
In addition, don’t forget when I figured out the expenses (40% in this case), approximately $110 per month was allocated for maintenance, repairs, and management—that’s my job! Obviously, owners can’t pay themselves, but saving those expenses amounts to the same thing as get­ting paid for it. It’s still my money, because it’s my property.

Getting a Stake in the Game

Right about now you might be thinking to yourself, “Have I missed some­thing here? I can’t possibly see how I’m going to get very rich with this deal! This program is tighter than a banjo string. If I lose one month’s rent or a toilet breaks down, I’ll end up paying money out of my pocket. There’s no safety margin!”
Let’s be realistic here. I’m not telling you how to get rich. I’m telling you how to get a free stake in the game. If you agree with me that owning income-producing real estate is the right way to go and, further, that rental properties continue to become more valuable, year after year, I would ask, “How can you go wrong?”
You’ve got a winning hand. First, your name is on the deed: you are the owner and that’s good for you! Second, as almost everyone agrees, income real estate appreciates: rents continually go up, therefore, so does the value of the property producing them. Third, your return on a no-down investment can be phenomenal: everything you take out of the deal is pure profit! That’s because you have nothing in the property to begin with. You could lose the property, but never any money! In terms of risk, I’m sure you would agree, the odds will never get better.

I might just mention that Southside was purchased for $105,000, with none of my own money down. Today it’s worth $205,000 and rents are $2,300 per month. Counting appreciation and rents, I’ve earned a profit of $9,400 for every year of my ownership. It also shoots down the theory that it takes money to make money. In the case of Southside, good credit and a decent job was all I needed.

No Limit to Creativity in Real Estate
Subordination by the seller, as we’re discussing here, is not a new idea. Folks who sell empty building lots do it all the time. They sell the lot with an agreement that they will record their mortgage (seller financing) behind a new first mortgage on the property to serve as collateral for the bank’s construction loan. That’s how a new building gets financed.
Ray Kroc, founder of McDonald’s, was moving along at a snail’s pace trying to franchise his hamburger chain until he met up with Harry Sonneborn, a real estate wizard who understood the power of subordina­tion. Prior to meeting Sonneborn, Kroc’s expansion dream was bogged down for a lack of construction funds. Sonneborn did the same thing for Kroc as I’m telling you about here. He asked lot sellers to subordinate to McDonald’s lenders in order to get construction loans to build hamburg­er stands. Obviously, it worked quite well.

Variable Rate Mortgages Offer Another Option

Another transaction, similar to Southside, came to me several years back. The seller insisted on receiving monthly payments. However, he agreed to my variable payment plan. This allowed me to start with reduced pay­ments and gave me some extra time to build up my rental income as the mortgage payments went up. The owner carryback mortgage loan was $42,000, payable in 9% interest-only payments, and all due in 13 years. Interest-only payments at 9% amounted to $315 per month. However, we structured the note to start with payments of $210 per month (6% inter­est) and ended up in the 12th year at $420 per month (12%).
This arrangement worked for both of us. The seller got a 9% average interest rate and I had low payments—$210 at first, which was about all I could manage when I took over the property.
I’ve had other transactions where I’ve secured the seller’s carryback note to other properties I own. Obviously, you must have multiple assets to make this arrangement work.
As I said in another chapter, you won’t need 100 ways to buy real estate. Half a dozen good techniques will most likely do the trick. I also told you that good credit will be one of the most valuable tools in your investor kit. Naturally, all banks and commercial lenders will approve or deny credit based on the kind of records you develop. If you’ve paid your bills in a timely fashion over the years, no doubt you have a good track record established. If not, you‘ll need to begin the necessary repairs to get it fixed. Fortunately, that can be accomplished over time.
Success Requires Borrowed Money
Stated another way, investors who cannot borrow money for financing and fix-up with a little left over for groceries will quickly find their investment plan won’t get very far. Borrowing money is the only way most of us can ever achieve our financial goals in a reasonable time.
Money borrowing rules are changing almost daily. It doesn’t take a rocket scientist to understand that finding money to do ugly fix-up proj­ects can be difficult, especially for investors who are just starting out and plan to do most of the work themselves. Still, it can be done. So keep on reading—you’ll see.

Making Yourself a Better Borrower

There are several self-help measures to ease borrowing difficulties. The first, obviously, is to protect your credit rating if you have a good one. If you don’t, I’ll show you a few things you can do to make it better.

You’ll also need to keep your personal financial and accounting records up to date and on-line. You should do this at least annually, so you develop a good history. Sometimes more often is better and will generally be required if you are an active buyer/borrower. I will discuss the financial records (tools) you need for every lender, both private and institutional. Having good financial tools is just as important for the do-it-yourself investor as having good plumbing tools and a sharp saw.

Bankers Like Homeowners with Steady Jobs
When I worked at the telephone company years ago, I had an excellent credit rating. Banks were willing to loan me money even when I didn’t need it. The first two questions bankers would always ask me were “Where do you work?” and “For how long?” When I answered, “At the telephone company” and “20 years,” the loan manager relaxed into his easy chair and said, “How much do you want and when do you need the check?”

I began buying rundown houses long before I quit my telephone job. The first time my banker drove out to see my fixer houses, I thought he was going to throw up.

Still, he remained impressed with my 20 years of telephone employment. But he also gave me some personal advice about buying any more junky properties. He even hinted about not making any more loans. Soon afterwards, Beneficial Finance became my fix-up property lender. They didn’t mind junky houses quite so much, as long as I was still employed at the phone company. Quite a number of these early 18% to 20% inter­est loans got paid back over the years, which made the folks at Beneficial smile from ear to ear.

Banker Enemy Number One: An Unemployed Loan Applicant

If there’s anything a loan officer hates worse than an unemployed deadbeat, it’s an unemployed house fixer who wants to borrow money. The news that I had quit my telephone company job turned every lender against me. If I had been playing monopoly with my banker, he’d have sent me directly to jail without passing go. One thing you need to understand is that bankers don’t like loan applicants who can’t produce a copy of a W-2 form. It’s their only evidence that someone else thinks you’re worth spending money on. I never realized how important a regular job is to bankers. Before I quit my job at the telephone company, my Beneficial mortgage payments alone were about three times more than my monthly paycheck. Still, Beneficial seemed totally unconcerned—until the day I quit the phone company. My 20-year, squeaky-clean credit record didn’t mean anything toward getting additional loans with them. When the paycheck stops, it’s like starting all over again. We must somehow prove to lenders that we still have the ability to pay them back. Bankers can visualize only two kinds of customers—low-risk employed folks and unemployed deadbeats.
How to Build Your Financial Integrity

Borrowing money is much easier when you can show lenders good finan­cial records for yourself and your real estate business. It’s very important to demonstrate that you know exactly where you stand financially. Lenders admire organized applicants. They don’t like borrowers who show up ask­ing for money, but can’t explain exactly how much they need and, even worse, how they’ll pay it back. These problems can be partially overcome with good sound financial records.

Jay’s Five Basic Financial Documents for Borrowing
Financial records are the same whether you own one property or 50. Obviously, if you start while your investments are few, you’ll need less paper. However, the documents themselves will always remain the same. I think every investor should prepare his or her own records and keep them updated annually—more often, if necessary, for loan activity.

I will briefly describe each of the five financial documents and, I hope, give you enough information so you can develop your own records. Remember: nothing is magic or sacred about these forms. You can simply draw them up yourself on plain white paper or obtain financial statement forms from a bank or the local stationery store.

Another important benefit you get from preparing these forms is it gives you an excellent financial picture of yourself. Many investors don’t have the slightest idea about their net worth. Some are afraid to find out.
Following is a description of the basic financial tools I suggest you pre­pare and start using. I promise they’ll help you a great deal next time you’re ready to borrow money from the bank or you need evidence to show a seller who is contemplating a carryback mortgage for you.

1. Schedule of Real Estate Owned (Form Setup)

This form should be typed up on plain white paper with headings as follows:

Almost every conventional loan application form requires this infor­mation, in the same order. Therefore, when you keep this form updated, it can simply be made part of any loan application package you plan to sub­mit. Standard 8½ x 14 paper (horizontal) is best to use because it match­es the size of most bank application forms.

2. Schedule of Real Estate and Notes Owned (Form Setup)
This form is very similar to the previous one. However, it contains some additional information. I have found it very helpful, especially when pri­vate lenders (sellers who agree to carry back financing) ask for financial data to consider financing a sale to me. This form also contains the infor­mation you will need to fill out the asset/liability section of any financial statement you prepare. The following headings are used to prepare this document. It should be typed horizontally on plain white, 8½ x 11 paper.

3. A Personal Financial Statement (Blank Forms
Available)
This form can be standard stationery store copy or a form obtained from your local banker. Often, the various lending institutions have their own special forms with their names printed on them. Sometimes their forms have special or unusual questions that they want answered—for example, “How do you plan to make your payments in case you die?”
All financial statements are pretty much the same. You list all your assets on one side and liabilities on the other. The difference equals your personal net wealth. You might be surprised when you find out what you’re really worth.

4. Profit and Loss Statement (Form Setup)
This form should show your total income at the top. Then you will list all operating expenses. After that, list mortgage payments and depreciation. The bottom line will show a profit or loss for the period.
I always prepare a profit and loss statement annually. However, you may need to do so more often if you are aggressively shopping for loans. You can type this information on plain white 8½ x 11 paper.

Income should include all sources, such as rents, deposits (if you mix them with rents), coin laundries, notes receivable, and management fees (if applicable). Expenses are all your operating costs, which generally include payroll, licenses, insurance, maintenance, repairs, supplies, utili­ties, advertising, telephone, taxes, legal fees, and accounting. Remember: owner draws are not to be mixed in with employee payroll. Draws can be a separate item if you choose.

Net operating income is what’s left over after you subtract the operat­ing costs from total gross income. Mortgage payments should then be subtracted from the net operating income to determine positive or negative cash flow (profit or loss). Depreciation can also be shown as an expense item. However, I like to keep it separate from my regular expenses, because it’s really only a paper expense. (You don’t write a check to pay it.) Lenders will often ask what your profit or loss is before depreciation. You’ll really impress them when you know the difference and have the correct numbers. Good impressions, along with good records, will often make the differ­ence between loan approval and loan denial.

5. Business Financial Statement (Form Setup)
A financial statement about your real estate business is almost exactly like a personal financial statement about yourself. If you’re just starting out in business, chances are your personal statement is all you need. However, if you have several properties already, or perhaps a real estate partnership interest, I would suggest you prepare a business statement to better demonstrate your financial capacity.
In my real estate business, the management division—One Stop Home Rental Company—owns trucks, special tools, and furniture, which are not included on my personal financial statement. As you expand your real estate activity, you may find it’s better to have several separate busi­ness entities. Each should have its own financial statement.

Fixer-Uppers part 19

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