Real Estate Paper: Your Most Valuable Tool

As a real estate agent and broker for 20 years, I’ve found my knowledge and use of notes to be my most valuable tool. I did the tenants and toilets game for what seems like 100 years. I sort of backed my way into paper investment. I learned to use real estate notes in my investing, and mortgage buyers became a valuable resource.

I work with Realtors daily and teach continuing education for the State of Utah. Here are five techniques I teach to Realtors. I hope they work for you as well as they have for me.

1. Create a second and third; sell the second

Sometimes you’ll find a buyer is willing to pay a good price for a property, but does not have the cash to assume the existing financing or the ability to refinance with a large down payment. Many times the seller needs a particular amount of cash and might consider a discounted price in exchange for the cash.

Using private financing and your knowledge of seller financing, here is a technique that works very well:

Let’s say the buyer is short of the cash the seller requires, but the seller is willing to discount his property a little in exchange for the cash (or the buyer is willing to pay a little over market value). When the seller has equity that he will take back in paper and is willing to discount, there is a way to put this deal together.

The seller wants $17,000 cash, but the buyer only has $10,000. To get the extra cash, the seller would be willing to discount a few thousand off the market price. The buyer is willing to pay full price, but needs a lower down. The value of the property is $50,000. Here are the terms:

The way to put this deal together is to take the seller’s discount and use it to generate the cash. Instead of creating one $25,000 second to the seller, create a $10,000 second note and a $15,000 third note. The $10,000 second is sold in the marketplace for $7,000 cash, and the third is given to the seller. The seller now has his terms and cash, and the buyer has his terms.

The buyer pays $50,000 with $10,000 down, assumes the $15,000 second, and pays the seller on a $10,000 private second and a $15,000 private third. The seller gets $10,000 cash down, assumption of the $15,000 first, $7,000 from the sale of the second to a paper investor and receives payments on a $25,000 seller carry back. His total is $47,000. Both buyer and seller have had their needs met.

2. Prioritized commission notes

Many deals don’t close when there is just a small distance between the needs of the seller and buyer. Often, the amount of cash to the seller is the issue, and the agent could close a deal if he were to take his commission on paper.

Agents and their brokers tend to shy away from this because they feel they need immediate cash and see no alternative with a note other than collecting payments. If structured properly, the note could be structured to be salable immediately with very little discount, and the deal could be saved. You can double your sales if you don’t walk from commission notes so quickly.

Those agents that do take their commissions as a note usually create one that is not salable. Even that would be better than a deal that doesn’t close, but there is a better way.

Paper that is secured by real estate with a safe loan to value ratio (LTV), usually 80% or less, is readily salable. Let’s look at two scenarios. The first is the way most agents would approach the transaction. The second includes a simple change that makes a major difference.

$100,000 Sale price
$ 60,000 Existing first loan (assumable)
$ 10,000 Down payment from buyer
$ 23,000 Second to seller (private seller financing)
$  7,000 Third trust deed to broker for commission

Many brokers wouldn’t even insist on a trust deed note to secure their commission, yet this third may not be very salable. The LTV ratio is 90%, and most note buyers would not buy a third with only 10% equity above them. Now for one simple change.

$100,000 Sale price
$ 60,000 Existing first loan (assumable)
$ 10,000 Down payment from buyer
$  7,000 Second trust deed to broker for commission
$ 23,000 Third to seller (private seller financing)

The broker takes his commission in a second position, and the seller subordinates his note to a third position. When the seller requests you take your commission on a note, it is not out of place to insist that your note is safe and salable. Usually this will be a small note and will be paid off soon.

When the second is paid off, the seller’s note, which is currently in a third position, will drop down into the second position. You can also structure this transaction so that all of the payments on the seller financing go to your second trust deed note until it is paid.

3. Lower the rate; raise the balance

This is a tremendous negotiation technique to help bring buyers and sellers in disagreement together about the price to be paid.

Let’s say that a buyer has offered $85,000 for a property and will assume a $40,000 first loan. The down payment will be $15,000 and the seller would receive a $30,000 second loan at 13% payable $331.86 per month.

The seller wants $11,000 more for the property. The buyer thinks a price of $96,000 is ridiculous, but wants the property. What do you do? Would you walk away? Beat on the buyer and seller trying to get them to agree on price?

In cases where the seller is hung up on price, he may not be as hung up on terms. Do you know you can please both the buyer and seller at the same time? If the buyer offered a $41,244.16 note at 9%, the payments would be $331.86 per month for the same period of time as the first note.

Does the buyer pay any more? No! Does the seller receive his price? Yes! (Even a little more.) Both notes, if discounted, are worth exactly the same amount. The real difference is how it looks. You just have the negotiating advantage of understanding the correlation between interest rate and price.

A small change in the interest rate can make a large difference. The buyer will pay the same amount and the seller will receive the same amount. The difference is in the packaging. Here are the original terms of the $30,000 note and the terms of the new note:

The strategy is to look at an interest rate adjustment when the seller and buyer disagree on price. A few percent difference in the interest rate can mean a difference of thousands of dollars in the long run.

4. Graduated payment balloon alternative

Balloon payments are like time bombs sometimes–foreclosure in embryo, a potential problem and lawsuit. There are better alternatives than balloon payments that will accomplish the same goals without the risks.

A common situation that is created is where the buyer has a 30-year amortization on his or her note and a 5-year balloon payment. A $30,000 note might look like the following:

The balloon payment in five years would be almost $29,000. Where is the buyer going to get the cash? Can he refinance? What are the rates? Is the buyer still financeable? These are some important risks.

If the buyer began with the same payment of $263.27 per month, but raised it by $50 each year, the loan would pay off in less than one third the time of the original. Instead of a nasty, potentially hazardous balloon payment in 60 months, the loan would fully amortize in 106 months.

The sellers achieve their goal of getting their money out quickly with less risk of taking the property back. The buyer has a far more palatable scenario of a gradual increase in payments. If the payments become a burden, the buyer can refinance at a time that makes sense (60 months may not).

5. Balloon payment rollover provision

Another alternative to a balloon payment is an extension provision that will give the buyer some time to raise funds or workable financing. This provision may allow for a one-year extension of the balloon payment upon the payment of 10% of the outstanding principle balance.

In the previous example, the balloon payment of $28,972 could be extended for a year upon payment of $2,897 in principle on the note. This can be structured as a one time or continuous provision. That means that the next year the same provision could apply if financing were tight.

The clause can also be qualified as to available financing and interest rates. This is just a sample of some of the ways agents can use paper to improve their profits.