EP 653 - WARNING: Owner Financing Should Never Be Your Number One Exit Strategy

Good morning, good afternoon, good evening everybody. Welcome to this episode of the Note Closure show. As always, Scott Carson, excited to be here with the day. On today's episode, I want to share a little insight into what I believe is really one of the most overhyped exit strategies as a real estate investor. And that's create an owner finance note. Now I don't want to sound like a Debbie Downer out there for everybody, but I get phone calls all the time from investors that they've taken a one day class on owner financing or they watched a YouTube video or they got upset, sold into somebody's class just talking about, oh, how awesome owner financing is and how you can make so much money with owner financing and go from there. And as an active note investor, this is gonna sound a little bit, what's the word I'm looking for here? Being a hypocrite. Wanna talk about note investing? Don't get me wrong, I love note investing, but I love it when it works, right? And I get tons of phone calls, tons and tons and tons of phone calls from real estate investors who have a piece of property, they got sold on the idea of offering up owner financing and they offer up owner financing but they screw up the terms of the deal. And what do I mean by that? Well, the interest rate is too low. They over, you know, over calculate the value of the note. All right, and what do I mean by these two things? Because these are the two most important things really. When it comes down to one, they often hear people talk about, well, if you're the bank, you can set the value of the note higher since you're carrying financing. And that's a yes and no answer to that. Yes, you can set it higher. But what's your strategy for the goal? What's your strategy for the property? If your goal is that you need to recoup that capital or you need to sell the property and make profit on it, then owner financing is not the strategy for you. If the house is actually will appraise it, let's say 100 and you set the price of the home for 110 or 120. Because you're offered owner financing and you get somebody to agree to it, that doesn't mean you're really going to get the 110 or the 120. I often am talking with so many people who've offered owner financing, they've offered or had the loan be above the value of the actual as is value of the property and they get upset when I tell them that they have to take a discount because a, the Property's not worth 110 or 120, it's worth 195. And they get upset about that and they're like, okay, well then what can you tell me? And it goes to the second aspect. Well, what's the interest rate on your note? Well, it's at like 6%. I'm like, okay, most people that are buying on their finance notes are going to want to see around an 8% interest rate, 8 to 10% interest rate. So you're going to have to take a haircut. What do you mean by a haircut? You got to take a discount on the loan. What do you mean a discount? Well, I can't offer you 100. I can offer you 80 grand or 70 grand. It all depends on the terms of deal. And a lot of people get upset. Damn it all, why do I have to take a haircut? Because the fact, because me as a note buyer, I don't want to be into something that's 6% interest. I want something that's a higher return on investment for me. So that's one of the biggest things that we see is that people, oh, their strategy was to sell the property, they need to recoup their money. But they got sold on terms of a note deal of an owner, finance or carry back. That doesn't work in their favor and they up taking a loss when it would have been better on the front end for them just to sell the property, give some concessions to a buyer and make their 90, 95 grand and move on. The other thing that comes into play that a lot of note investors don't realize is the seasoning issues. Now what do I mean by seasoning? Seasoning means the number of payments that have been made by the borrower. And usually most note investors, note buyers want to see at least six to 12 months of seasoning on time payments with a third party servicer, that'd be another thing we get to. But they want to see this borrower's made some payments. Now it's always nice if they put some down payment down. They have a decent credit score, stuff like that, but they don't have a decent credit score. Great. They can offset that with a down payment. But that six to 12 months of seizing often kills people too. Because they're like, oh, you know, they get an idea with the owner financing and lo and behold, in three, six months, three to six months, they realize they've got to sell this property because they need the capital to Go buy something else or to live off of or they need to need that money now. Their money or that equity in that property is now tied up. Owner finance note deal that they can't get out of. Yes, they could sell the note, but they're going to take a haircut, take a discount, discount, or they got to wait around for another six months for seasoning to kick in so they get the biggest bang for their buck. And those are the things that I get upset about. Yes, I think under financing can be an amazing exit strategy. If it's the only one that will work for you, I don't believe it should be your number one strategy. Now I know there's people out there will argue with me, say, well, it's great for cash flow and you're gonna make all this money later on. Yeah, you can make if you it's a $100,000 house, yes, over the 30 year period you can make $300,000. But if you evaluate the time value of money, if you bought a house at 50, put some work into it, say 20 grand, it's worth 100 and you owner finance it for 100, well, you just tied up that 30, $40,000 in equity that you can't touch. You can't go out and do now a loan against the property, can't go get a line of credit because you've got a mortgage on it to somebody who's in the first lien position. And that's the big thing too is you have to realize what can you do the property. You have to evaluate your strategies that makes the biggest bang for your buck. And I'm constantly talking to investors in real estate, people who are, oh, I'm going to owner finance it. I'm like, well, no, what do you plan to do? Well, I'm planning on selling it out. Well, if you're going to on selling the note because you need to realize your profit, don't go about creating a note. Let the bank or somebody go out and get a traditional loan. Let them carry the paper on it. You sell it. You just worry about making the property, market the property as marketable as possible to get it sold and deal with that aspect of things. Now here's another thing that drives me bonkers and this happens. I get this phone call pretty often from my good network of real estate contacts, investors who have been fixing flipping property, they've been landlords, they've been, you know, investors for years, many of them owning millions and millions of dollars in real estate. But they don't Realize I had this call with a guy from Houston just the other day and he called me up, he's like, hey, Scott, we want to try to refinance out of our hard money loans. I'm like, okay, what's your hard money loans at? They're 12% interest for six months, six to 12 months. I'm like, okay, so what do you want to do? He goes, well, we'd rather have it as a lower interest rate for a three to five year period. I'm like, okay, then go to the bank. Well, we were wanting to create a note and I kind of chuckled. I'm like, okay, what do you mean you want to create a Note? You're at what, 65, 70% of value right now? Yeah, yeah, we're at a good interest rate. We just want to do a rate term and drop the interest rate down. We want to create a note. I'm like, okay, here's what you don't realize. All right? If you want to do that, you're the borrower on a situation. You're not the, you know, the borrower, the property owner. You're not the bank. There's another bank in front of you. If they're at 12% interest rate, you just can't create a note at 6% interest rate. You know, a 30, 30 year term with a 3 year to 5 year baloney on that real estate investment stuff. And just sell that note. Because a selling that note at 6%, somebody's going to want a big discount, almost a 50% discount. You're still going to own the same amount, if not more, because you still got to pay off that underlying loan. So let's say the property's worth 100. Let's say it's at 70 cents of the dollar. Hard money lender's at 70 grand on this deal. Well, to get the 70 grand by refinancing, you would need somebody come in and plunk down 70 grand. Well, if you wanted to do a note deal and create a note and then sell it off, that note you create would need to be more than the 70 grand you own. All right? For a note investor to come in and the deal. Now, the only situation would be otherwise. If you found somebody like at an IRA or private investor who's willing to take a 6 to 7% sub 12% interest rate on their money and tie it up for three to five years, that's okay. But the idea, I'm just going to create a note around my existing mortgage. I'm going to sell that to pay off my hard money. It doesn't work that way. Once again, in the case, it's like you need to go market the deal, go market to IRA investors, have somebody come in and cash you out that way, or reach it back out to the bank that's carrying the financing for this hard money lender and see if the they'd be willing to do a long term loan or a blanket loan because they were looking to do it over $3 million worth of property. But you got to understand, you just can't create a note. I mean, you could, but it doesn't mean that it's valuable. All right, so let's talk a little about here. Under financing should be, I believe, should be the only strategy if you can't sell the property. Traditionally, and we see this, we've had students that have bought portfolios, I've bought portfolios of loans and there's some stuff in parts of the country that are smaller markets and they can't get a retail buyer because it may be a lower value property sub 100,000. So it's hard to get a traditional bank loan that might make sense. And that's why contract for deeds are popular, were popular and are still popular in those areas because basically you're under financing, but you are more of a landlord. In a contract for deed, the borrower does not get the deed of the property until the property sold off, hence contract for deed. So you have the right as a property owner and the person carrying financing to evict. In most cases, depending on state by state, some states evaluate a contract for deed like a traditional mortgage. So you've got to foreclose compared to eviction. But that's why contract for deeds are so valuable on the $100,000 or less under financing. Look, unless you're going to get an 8% to 10% interest rate, you're going to get some sort of down payment. And the more down payment, the more valuable. That's the thing. If somebody's going to bring a big chunk down, they want me to carry financing, okay, I'll only do like a two year term. Why two year term versus a 30 year term? Because two years is enough time for anybody to be able to work on their credit, get their credit scores up 24 months, it does not take that long. If somebody's had a late pay or bankruptcy or foreclosure in the past, foreclosure is going to be tough to do it. But you should still have that borrower underwritten to see what's on the credit, you should pull the credit report. You should work with a mortgage loan originator, an mlo, even if it's only doing one a year. Yes, I understand that falls under Dodd Frank compliance. If you do one to four year, it's okay, you can do it yourself. But you should still evaluate the borrower, see what's for the credit to see if there's anything that's going to keep them if they do their part and clean up their credit, their late pays, reducing the debt to income, credit card stuff like that. Is there anything that's going to stop them from being able to get a traditional loan in say 12 or 24 months? I always look at what the property is as well too. If it needs a lot of work, okay, you don't want to do the work and you want to carry financing, okay, that's okay, do it for six to 12 months. But so many people step into it like, oh, I'm going to offer this for the cash flow side. And they never run the numbers. What's more valuable, having a 90 to $90,000 on $100,000 property in your hand now or owner financing it and getting a $7,000, you know, $7,000 annually in payments if you do 7% interest at 100 grand. Now the nice thing about owner financing, you know, it's like a deferred sales trust, kind of like that. It can delay out the tax consequences to a long term capital gains versus short term capital gains and who knows what's going to happen over the next few years. So that's why I'm a big fan of not owner financing, not tying up the investment there. It's best to take that property, sell it as is, bring it in and then turn around and double down. Take that profit in and then go buy two assets or three assets versus tying up majority of your profit and something that you can't touch for 12, 18 or 24 months. And I've had some really smart people call me up, hey, I got to own their finance note. I'm like, what's the interest rate at 5%? I'm like, 5%? I mean, that might seem high now compared to the 2 or 3% interest rates out there. But if somebody's got decent credit, let them go get the credit. Don't you drop it down below 8% or 7% because you are offering them a service of carrying the paper. If you're going to carry the paper, you want to damn sure, damn sure that that vehicle, that note is as saleable and as popular to sell on the back if it's 12 or 24 months versus just doing somebody a solid favor. If somebody can't go get 5% of their own, don't give them 5%. If somebody can't go get a 3%, don't give them 3%, make them go do that. If they can't do it, then guess what, that makes what you're offered valuable. Now of course if you have a rough property or it's got a weird layout and banks don't like it, they don't want to carry the financing on that type of document. Yeah, you may need to carry financing on that stuff. But that's why I'm a big believer that most investors should stick to their bread and butter, their vanilla property classes. Anytime I've gone outside my property class, whether it's a higher valued house or a different type of asset class, I end up usually getting snake bit because a, the values were different. So I had to put more rehab into it. Days on market with longer hence more money. Higher percentage of my profit got eaten up because of money carrying costs. That's the important thing. Especially if you've got underlying financing a property, you can't really do an owner finance wrap because that can. It won't always will, but it can stipulate the due on sale clause. And that's another thing. Banks are looking for things now they may not want to take it back. We've only had this happen a few times but people get all bent out of shape about the due on sale clause. I'm like as long as the bank's getting paid, they don't really care until there's something that goes wrong. Taxes don't get paid or payments get missed or that's the biggest thing you have to realize, ladies and gentlemen is what's your underlying financing, what's your underlying profit margins and where does that go from there? What does it mean for you? How soon are you looking to tap into this? And unfortunately most people that are owner financing, they tie stuff. Oh, we're going to do a 30 year and a five year balloon. Okay, You've basically tied up that property for five years. Unless a, the property values have accelerated dramatically, which is a good thing, then your LTV can drop down compared to value or the borrower brings a big chunk of money to the table. In that case it might be willing to carry for a period of time but you still always have to stipulate in the agreement that hey, this is a two year term. The borrower's agreeing to work on the credit. You may want to have them get signed up with like getfundable.com, formerly Credit Sands or some sort of credit optimization company. You may want to make that a requirement. So they're working through that to boost their credit score so that a in 12 or 24 months they can go get a traditional loan and refinance you out and taking too big a loss. But that's the thing we see is a lot of people, they owner finance it at too low an interest rate. They tie up their money for a longer period of time and then something happens life that they have to tap into that equity. Now they've got to take a discount. Now they got to sell the loan at not a loss but a substantial price. Being chewed out of it to capture that equity now that profit to go do something else with it. If you are going to do and carry financing, it's always important. I am a big believer in making sure you take whatever type of down payment they're getting and then split the remaining balance up between a first and a second. Like if somebody's bringing 10% as a down payment, that's great. Don't do a 90% first lien, do an 80 or a 75% first lien and a 10 to 15% second lien. Make them the same interest rate if you need to. But the reason you want it kind of structured that way is if you do or you do end up having a sell the note. You can retain that second for cash flow, sell the 70% first lien or 75 or even 80 off to somebody, take a less discount, carry that small second for cash flow and still be able to recoup a big chunk of your profit and still retain the cash flow. It makes that note a lot more marketable. If you do 100% financing or 90% financing or 95% financing, you're probably only going to get 80 cents if you sell the note. So instead of taking that 10 to 15% discount, just cut it up into a first and a second and keep that second for cash flow mailbox money, sell off the first, recoup a big chunk of your cash, keep a small part for mailbox money and go from there. But that makes that property, that makes that note more desirable to a note buyer if it's cut up in first and a second. One of my buddies out of South Florida years ago, when everything was happening in Florida, one of the things that they did is they structured. If they did a loan mod For a bar. What they did is they structured and turned into a first and a second. The first was basically for the value of the property. The second was either what the amount was that was either being forgiven or the negative equity. And they basically just structured the terms on that second. Very favorable low interest rates. But it just basically turned into mailbox money because they already bought the loans at a big discount on the front end. They restructured it technically 100% LTV first and a 10 to 15% second lien they just carried for cash flow waited for the values in Florida to rebound back. Now there was some equity. Now those second liens were encumbered. Now there was value to them, they could sell them off. But along the way they received cash flow, they received payments on these seconds and it was a win win. One of the brilliant strategies by our buddy Todd Todd Billings from US Debt Ventures back in the day that's the biggest thing. I don't want to sound like a Debbie down. As I said before I'm just not a fan of owner financing as your primary strategy. Yes, I'm a note investor. Yes I've helped originate a lot of first lien the owner financing back in the day. But with the market being where it's at, if you don't know how to structure it properly and you don't know how to evaluate your borrower properly, owner financing can be the worst exit strategy for you. It can be something you tie up profit when if you just took a discount got most of your profit back end. We're all going to pay closing costs and Realtor Commission CCC. It's expected to be 10% roughly. That's what we look at our numbers when we figure in we're going to sell a property later on. What's the strategy is a let's just figure 10% for closing costs and commissions, 6% commissions and roughly 4% closing costs. Usually it's less than that the higher the value of the property is but that's where it makes the most amount of sense. I would not get into under financing unless you are really buying a lot of properties that are sub $100,000. If you're buying at 100 to $200,000 range just sell it traditionally makes me go get a traditional loan from and or wait around and just keep marketing the property. Offer comes to Sessions offer listed at 80 85% of value and like put into a multiple offer situation to bid up. So you're taking less of a haircut on the traditional sale. But don't tie up your loan. Another thing that a lot of people try to jump on depending on what state it's in, is like, oh, we're going to collect the payments ourselves. And I'm like, no, don't do that. Okay, that's not a good thing. It's a great way to end up losing value on that note in the long run. Why? Because if you're self servicing, that means you're collecting the payments. You don't have party servicer like Madison Management or Note Servicing center somebody else who can collect your performing loan for you at 15 to 20 bucks a month. You devaluated the asset trying to collect. Nobody wants to get, oh, here's copies of checks. We want to see a third party servicer who can do a quick download, press a couple of buttons, download a spreadsheet, show payments in how they got it situated. That third party servicer keeps you honest and it's well worth the 20 bucks a month. If you're offering a deal that oh, it cuts too much into my profit on my note, then you shouldn't be under financing. All right? If your monthly payment is going less than 250amonth, you probably shouldn't be owner financing that property. You should or you should adjust the term so it's more than 200 to 250. Or just sell it outright and be done with it. Recoup the profit and turn around and get the velocity of capital rocking and rolling again. That's one thing. You don't know what the velocity of capital means. That means how often are you flipping your funds? If you've tied up profit on a property or rehab, a fix and flip or something else, and you've tied it up in a mortgage for five years, the velocity capital isn't moving very fast. If you're making 8%, that's great. That's all you're making in that money. Whereas if you're taking the money back, investing in something, making just say 12% on a flip twice a year or 10%, I mean that's technically a 20% return for you there. You're missing out on a ton of capital. You're missing out on a ton of profit and being able to really, as I say, the double down mentality, take the profit from one property, turn it into two, turn it into three, turn it into five. Or let's give you an example, let's say you bought a property, 50 grand, it's worth 100. You borrow the 50 and you go out and do traditional stuff. Okay, You Sell it, you make 50 grand profit. Well, yeah, you could go out and buy one more property if you want, or you can leverage it if you are able to get financing, put 10% down across 5 or 10 of the properties. Now you've leveraged that capital, but if you own or finance it, guess what? That money is stuck inside of that property. Now I've had people come back say, well Scott, I'm going to take my rehab and I'm just going to go, I'm going to go refinance it first before I offer up a wraparound or before I turn a rental. I'm like, okay, you know that. Okay. It still means you have to hold that property for roughly 90 days to seize it for the new value. And if it's listed for sale, if the bank comes across you listing it for sale, they're not going to finance the property because they're going to take a loss on it. You may have a two year prepayment penalty. Well, Scott, that's why I'm going to do the loan for at least two years. Okay, great. But now you've got to wait 90 days or 120 days to re season the property to get a better value for it because that's what's going to happen with the banks. They're not going to give it to you full value if it's a foreclosure or flip. And then if it's an investment property, the max are probably going to give you, let's say 70 cents on the dollar. You might as well sell it traditionally, move on and then double down or 1031, exchange it from that one property to another one to avoid your capital gains taxes. So look, I'm not trying to bash in our financing. I know it sounds like I'm not the fan of it. I like it in specific situations. Unfortunately, people are not being taught, they're only being shown the true terms of it in rose colored glasses. Oh, doesn't this number look great over here while we tie things up here, here and not a fan of it now. Yes. Can owner financing be a great thing for you if you know how to structure it? Oh yeah, I got a buddy. Chris McClatchy for years has been getting people to owner finance properties to him. I love this term. We may have to have him on here. It's been a while since we've had him, but he's been getting people selling properties he's offered full price or above offering prices to get them to carry the paper at 0% interest in a Lot of cases where every dollar he's spending or paying into the mortgage or towards principal so he, he's through amortization really paying down the value of that property, where he ends up with a lot of free and clear property that then he can then refinance and pull the equity out and go from there. But he's able to tie up real estate just because people don't realize, oh yeah, sure, oh, you're going to offer me full value and nobody else is, or you're going to offer me above value. Ooh, I get excited about the turns. But then they once again realize, hey, this is not such a great strategy for me if it's at very low interest rate and I've tied up that property now and I have to sell it either through normal terms of business or loss of loved ones or death or whatever it might be. You got to know when to hold them and when to full. Okay. Owner financing would be a great thing if you understand it for yourself, if you're going to use that tool to go and get property. But I don't believe it's the best strategy for you as an exit strategy when selling your property. I think the best number one term is always going to be to sell the property traditionally, especially if it's over 100,000. If it's not, if it's below 100,000, you're going to have a hard time getting a traditional loan from a bank or your borrower getting a traditional loan. And then you may want to look at a contract for deed or lease options. But the minute you tie it up into a mortgage, guess what, ladies and gentlemen, then your one way to get out of that the borrower doesn't pay is to foreclose and you're dealing with that. Or if you need to sell the note off, you're going to sell it at a discount if it's not properly structured. So don't just take a one day class or a webinar owner financing or watch a YouTube and owner financing and just get so bogged down that you have to understand the pros and cons of both sides of strategies. And owner financing has its pros, but it also has a con. All right, Some great thing out there and people consider arguing back and forth, but numbers don't lie. Your financial calculator doesn't lie if you know what to do. Now if you've bought a property and your one strategy doesn't sell traditionally and you have to owner finance it, then you probably didn't do a good enough job on the front end of buying that property. Now if you bought it cheap, we've got some of our students that bought some really cheap property and they offered up terms with the idea that if they sold the note at a big discount, they didn't care. They were coming out ahead anyway and I can't fault them for that. But if you're buying a property, you've got to sell it. Don't offer under financing, sell it. Traditionally offer some terms. Market the property a little bit of a low value at a multiple offer situation. Make the borrower or the buyers bid against each other to drive that value up. Or you're not taking a big discount on it because at some point drop down or financing and then you need to settle note before it's due, before 12 months of seasoning or without servicing or at a low interest rate because you didn't know what was going on in the market. You're going to take a haircut and you're not going to feel very good about it. So go out, take some action everybody. I would highly recommend before you ever sell a note before, if somebody wants to structure a note, somebody approaches you and asks you to carry the note, always find out and get a third party opinion on the value of them. You can always email me scottclosenotes.com or you can always go to like First National Acceptance Corporation. If you give them the terms of the note, what your borrower or buyer is looking for, they can tell you the value of it. They can tell you roughly what to expect on a resale of it, whether it's at 12 months or a brand new loan. The brand new loan doesn't have a lot of value, especially in today's world with the craziness of COVID and everybody being delayed or laid off, stuff like that. So I would be looking more so just to stick and get it sold. Traditionally let somebody go off, somebody else go out and jump through hoops to get financing and you take your money to the bank, ladies and gentlemen. So go out, take some action everybody. Hope this was helpful and love having you guys on here. Share it, subscribe and we look forward to seeing you on top everybody. Bye.