I previously have written about considerations for heirs inheriting real estate in Florida who want to sell the property, such as in this blog article: https://www.legalteamusa.net/strategic-default-appropriate-decision/. Now, I’ll discuss issues related to how heirs can generate income through seller-financing an estate property.
Many heirs have a greater need for income than to cash in the home’s equity. Although you can take the cash and invest it to generate income, an opportunity for safe and immediate income can flow from the property itself through a seller-financed deal. An investor buyer may help you turn the inheritance into an income stream.
Real estate investors regularly seek ways to buy with other people’s money (OPM). A common OPM buying strategy is seller-financing. This is how it works. The buyer and seller sign a purchase and sale contract stating that all or part of the sale will be financed by the seller. The seller acts as the bank just like any other mortgage lender. Like bank-financed purchases, the buyer signs a promissory note agreeing to pay back the debt and the seller/lender takes a mortgage securing the note.
The promissory note is the legal contract promising to pay a debt. The mortgage secures that debt with the home as collateral. Should the buyer default on the loan, the seller/lender may take the home back through foreclosure.
The seller may agree to finance the entire deal, but it is usually better to have the buyer pay at least a portion of the purchase price in cash and finance the balance. Most sellers benefit from a cash infusion to pay some bills or for other reasons. Also, it protects the seller to make the buyer have some “skin in the game” through their own funds that would be lost in the event of default.
If you sell a home for $200,000, for example, the buyer might pay 20% cash ($40,000), and you could finance the balance of 80%, or $160,000. Interest-only financing is common in the private lending economy. If in the above example, your borrower pays 8% interest only, this would amount to $1,066.66 monthly income for the seller.
A common seller objection to “holding the note” is the fear of default. If the buyer fails to pay, the seller may have to foreclose. Filing a foreclosure would bring expenses, delay and stress. The lender would have to pay an attorney and court costs.
Foreclosure laws vary among the states. Florida is a “judicial” foreclosure state, as opposed to a “non-judicial” state. This means that to foreclose on a mortgage in Florida, the lender would have to file a lawsuit, serve the borrower with court papers and bring the matter to a judge to request a judgment, and hold a public court auction. The lender may recover all attorney’s fees and court costs through the judgment.
At the court sale, the lender could take back the title, or a third-party bidder, usually a real estate investor, may pay the amount owed to become the owner. The lender will walk away from the court sale with title to the property or cash from a third-party bidder.
In other states with non-judicial foreclosure laws, the process is quicker, simpler and less expensive. In Florida, a quick foreclosure may take at least about six months from default to court sale if it all goes right for the lender. In the worst cases, an aggressively defended foreclosure can go on for years if there are genuine legal issues in the case.
For most heirs unfamiliar with the legal system and private lending, the idea of a mortgage default followed by a foreclosure is stressful and intimidating. There are some precautions a potential seller-lender can take to reduce the chances of bad things happening.
First, understand and embrace the concept of a safe “loan-to-value” (LTV) ratio. The LTV is the percentage of the loan amount in relation to the property’s fair market value. In the example above, the loan would have 80% LTV ($200,000 value with a mortgage loan of $160,000). Your risk-tolerance and comfort level should govern your choices. Most private lenders would consider 80% too risky and would seek an LTV closer to 60%.
As a lender, your security is in the LTV. During the great real estate collapse and global recession that began in 2008, property values dropped greatly. In some extreme cases of over-valuation, they plummeted to below 50% of assessed values. Mortgage lenders were reckless during that time. They lent money, in many cases, at 100% of the already over-inflated values. When the foreclosure crisis resulted, mortgage lenders lost billions.
As a private lender, you will more likely prevent catastrophe by being conservative and disciplined in your evaluation of the deal. Following a standard such as not exceeding 60% LTV would mean the property value would have to fall by more than 40% to risk losing money by foreclosing on a home worth so much less than the value of your investment in the loan.
Next, the seller should consider lending only to investor buyers and bypassing owner-occupants. Although a “one-off” seller-financed deal to a homeowner can be structured to avoid legal compliance issues, consumer residential mortgage lending is very highly regulated by federal and state laws.
These laws are designed to protect consumers from lenders, who are required to follow strict legal requirements. Because consumer lending violations may result in heavy fines and attorneys’ fees awards for the borrowers, a safer policy is to work only with investors in a business-to-business model.
When the borrower is an investor who does not intend to live in the mortgaged home, the regulatory landscape is much different. The reasoning is that business people doing deals with each other don’t need as much protection from abuses including predatory lending and failure to properly disclose the terms of the deal.
In addition to avoiding owner-occupant borrowers, the seller should make sure to avert setting up the investor/buyer for failure. If you are only working with investor-buyers, they’ll very likely rent out the property to tenants. Returning to the example above, let’s say the monthly “market rent” in the community for a home like yours is only $1,500. To make this a safe investment for you both as the lender and the buyer (you are in it together), there should be a “cushion.”
Suppose the property taxes are $3,000 per year ($250 per month) and the yearly hazard insurance bill is $1,200 ($100 per month). If the buyer is paying you $1,066.66 in monthly mortgage payments, these additional obligations of $350 will bring the borrower’s total payment to $1,416.66. If they can only get $1,500 in rent, that leaves less than $100 in the buyer’s pocket each month, a razor-thin margin.
Any hiccups such as a tenant default, vacancies or increase in property taxes and/or insurance premiums could destroy that cushion. This is what being “set up for failure” looks like. If the numbers don’t work, then don’t do the deal. If you are in a safe lender position of 60% LTV, you could foreclose and take back the home if the shaky foundation of this deal collapses. It’s better, however, to avoid a problem than to solve it. If the numbers don’t create a scenario to generate safe income, then you probably should seek another option.
Seller-financing will likely seem a strange concept to many consumers, but it is worth understanding and considering when presented with the opportunity if the seller needs income. In the next installment, I will discuss considerations for heirs keeping the property as a long-term investment and becoming a landlord.
For anyone inheriting real estate, it is worth doing the research to understand whether to hold or sell the property, as well as all the options on how to sell. How to sell may include listing with a realtor, selling directly to an investor, working with an auction house or seller-financing the deal, as discussed in this article.
If you have questions about the information in this article or legal or investor issues related to inherited real estate in Florida, please contact me.
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