One of the biggest problems real estate investors face when structuring transactions involving seller financing is the seller’s concern for security and assurance that they will be repaid. Let’s take a look at a typical example:
You find a potential rental home that you want to purchase from a motivated seller with an attractive long-term, fixed-rate existing first mortgage already in place with a balance of $100,000. You plan to buy the home, rent it out, and hold it for long-term appreciation. The home is worth around $150,000, and the seller is eager to sell for the discounted price of $120,000.
You offer to put down $5,000 in cash and to get a deed from the seller by taking title “subject to” their existing first mortgage balance of $100,000, and then have the seller agree to take back a second lien mortgage note for the remaining $15,000.
The eager seller is okay with the sales price; okay with your proposed down payment; and okay in allowing you to make the payments on their first lien mortgage for them. But the seller is reluctant because you are not assuming their existing loan.
They recognize that the existing $100,000 bank loan is still in their names and that their credit is still at risk on that loan, and they realize that the $15,000 second lien they would take back seems risky to them if for some reason you don’t perform.
Create peace of mind for the seller with a “wrap”
You recall hearing about a financing instrument called a “wrap.” Wraps (wraparound mortgages) are security instruments in which the seller who agrees to finance the sale of their property will encircle their existing financing by “wrapping” around the existing debt they owe with their own financing provided to the buyer.
You go back to the reluctant seller and “tweak” your offer as follows:
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$120,000 purchase price
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$5,000 cash down payment
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$115,000 to be held by seller as a wraparound mortgage
You explain to the seller that you will make them monthly installment payments on a $115,000 promissory note secured by a purchase money wraparound mortgage that will encircle their existing $100,000 bank first lien mortgage.
The seller will collect the payments from you on the $115,000 wraparound note and then in turn make the payments they are still obligated to pay on their existing $100,000 bank debt while retaining the difference. With this new proposal the sellers realize that they are in far better control of the financing and in protecting their equity.
If you do not make the payments on this wraparound mortgage, they will know instantly that you are in default to them while continuing to protect their credit and obligation on the underlying bank first lien mortgage.
Another reason to use a wrap–when selling
Recently a customer we dealt with sold a restaurant property for $225,000 to a buyer who put down $60,000 in cash. The buyer formally assumed an existing 8% private loan with payments of $825 per month on a $115,000 first lien mortgage balance. The sellers agreed to finance the $50,000 still due by holding a purchase money second lien mortgage and note.
The way they structured this sale and financing could have been “tweaked” for the benefit of the seller using a wrap around mortgage. To illustrate what they did:
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Sales price $225,000
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Cash down payment $60,000
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Private first mortgage assumed $115,000
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Seller financed second lien mortgage $50,000
These second lien mortgage note holders came to us seeking to sell and convert their $50,000 second lien mortgage and note into a cash lump sum. Unfortunately, because of the type of collateral that was involved (a high turnover type restaurant business and property), and the second lien position of the mortgage note, the discounted cash value of their second lien was greatly affected.
A better way to structure the sale
It would have been far better for them to have sold the commercial restaurant property and financed it using a wraparound mortgage (or similar instrument) as follows:
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Sales price $225,000
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Down payment $60,000
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Balance finance $165,000 financed at 10% with wraparound mortgage
By financing the sale using a wraparound mortgage there are several profitable “spreads” the sellers could have created while producing a far more marketable and saleable note in the event they ever wished to sell their paper.
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The $50,000 equity spread that exists within the wraparound mortgage note owed of $165,000 that encircles the existing $115,000 in debt still outstanding on the underlying private first lien mortgage note
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The 2% interest rate spread between the 10% that would be owed to the property sellers on the $165,000 wraparound mortgage note they will collect and the 8% still owed on the underlying private mortgage note.
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The monthly positive payment spread on the installment payments that would come in on the $165,000 wraparound mortgage note and the payments still to be made out on the underlying $115,000 private mortgage note
While it’s technically true in this example that a wraparound mortgage is a second lien mortgage subordinate to the underlying first lien mortgage debt. The structure allows the paper holder greater flexibility.
In the event these sellers ever wished to convert their paper (that is the $165,000 wraparound mortgage note they hold) into a cash sum, the investor who would purchase such a note would be in a position to fund the sellers a lump cash sum for the purchase of their wraparound mortgage note.
Then, from those proceeds advanced, simply pay off the $115,000 underlying first lien mortgage, thereby extinguishing that debt against the property. When the transaction is completed, this process called “unwrapping a wrap” would mean that the former $165,000 wraparound mortgage note would now become a far more desirable first lien mortgage note against the property.
Wraparound notes and mortgages can solve many problems once you become familiar with the concept.