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Tips on Creating a Real Estate Note

Over the past few years of low interest rates in real estate, there was not a lot of news about owner financing. Banks and credit unions have scrambled to find more customers by lowering their lending criteria and competing on rates, so that nearly anyone could find a loan for their house or business somewhere. That is still somewhat the case today, though it will become less so as interest rates continue to rise and foreclosures climb.

Even in these times, there are still a lot of sellers offering owner financing on properties. The reasons for offering owner financing vary, but include:

  • Seller wanting to defer taxes on gains.
  • Saving the high bank closing costs and fees.
  • Creating more flexible terms and payment schedules.
  • Weak buyer credit.
  • Sales between family members, or divorce agreements.

Owner financing notes can vary, but always include an agreed upon term, interest rate, payment amount, and payment date on which the buyer of the property must pay the seller. The conditions are formally written in a note, sometimes also called a promissory note or installment note.

Usually, the seller would have preferred to have received all of the cash upfront. Even if that wasn't the case at the beginning, circumstances may have changed or new investment opportunities have appeared that cause the seller to need cash quickly.

There are investors, both institutions and private, who will buy these notes. They will generally discount the note (pay the seller an amount below the note's current balance) to offset their risk and meet certain yield requirements. The amount of discount varies across notes, but the two biggest factors in determining the discount (besides the type of property) are the amount of equity in the property (cash down payment plus principal payments received) and the credit of the buyer. The more equity and the better the buyer credit, the more that the note is worth.

So, if you're creating a note, here are some tips to maximize the amount that you would receive if you later need to sell it, as well as help protect yourself if you don't:

  • Obtain a good down payment. This means at least 10% for a standard house, and 20-30% for commercial properties, land, and mobile homes. These numbers cannot always be reached, so try to get as much as you can without putting the buyer into a financially precarious position.
  • If you can, sell to a buyer with decent credit. A FICO (credit score) of at least 650 is preferable, though 625 is usually adequate. You'll often still be able to sell the note even if the buyer's credit is below 600, but be prepared to take a larger discount. Also, recognize that the FICO score does not always represent the buyer's ability and propensity to make timely payments, as they may have a low score due to having a lot of open credit but still be current on all payments.
  • Ensure that the interest rate being charged is at least as high as comparable bank rates.
  • Keep the term of the note as short as possible. Everything else being equal, a 10-year or 15-year note is worth more than a 30-year note.

Other items that we consider to be positive when deciding whether to buy a note and how much to pay include:

  • Property is owner-occupied (for houses and mobile homes).
  • Access to power, water, and roads (for land).
  • In regard to commercial notes, multi-unit apartments or general purpose office buildings are easier to place than specialty businesses like restaurants. A note on a property that was previously a gas station or anything that could have adverse environmental consequences will be much harder to sell due to the potential liability.
  • The property and surrounding area being in good condition.

You'll also want to be sure that the sales price is not far above the market value (if you might someday sell the note) and that the title to the property is clean. If you have questions about structuring your note, feel free to contact us anytime.

Click here for more information on selling a real estate note, mortgage note or business note.

Article written by Alan Noblitt. Published with permission from Alan Noblitt, Seascape Capital Inc.