When property sellers need to
receive as much cash as possible immediately for the down payment on their next
house, it is critical to anticipate this need in order to use seller financing
to their advantage.
Getting top dollar for a note
In a typical seller-financed closing, the seller
only receives cash from the down payment at the time of sale. This amount could
be used to pay the real estate agent and put the remainder toward their own
down payment on another house, but in many cases, the amount received is not
enough. In addition, sellers who uses private financing to close the sale will
not get the full amount financed when the note is sold.
Most sellers need as much money as possible when
they "cash out" their newly created note, so their objective is to
sell the note at the lowest discount possible. And to do this, they will need
to create a secured cash flow that is attractive to note buyers.
Note pricing factors
The size of the discount - i.e., the difference
between the purchase price and the remaining balance - depends largely on
factors such as the specifics about the payer, the property/price, and the note
terms. If the note is created without these important criteria in mind, the
seller may have a difficult time finding a buyer to pay the amount that the
homeowner needs.
The Payer
Clearly, there isn't much the seller can do about
the "quality" of the payer because most people interested in
accepting seller financing are higher-risk borrowers. Still, if there is more
than one party interested in buying their property, sellers offering financing
can still discriminate based on credit history or the amount of the down
payment offered.
The Property/Price
Similarly, the seller can't change the basic facts
about their property - where it's located, the type of structure, or its age or
condition. But, the seller can control the price they set for their property.
Most sellers have a specific amount in mind that
they need to get out of a sale. In traditional real estate sales, getting that
money usually is determined by the property's price. But with seller financing,
there is another step that is taken before the seller ends up with the total
amount of money they were looking for - the note must be sold.
Since private notes are typically sold at a
discount, the seller must set their price higher than the amount they were
looking for to compensate for the drop that will come with the buyer's offer.
By setting the price slightly higher than market value, the seller can create a
note that sells with a minimal discount. Individuals that don't qualify for
conventional funding are motivated to buy real estate, even if the price is
somewhat higher than market value.
Increasing the sales price and the implied value of
the property will not actually affect the buyer's discount, but the adjustment
could lead to more money in the seller's pocket.
A higher sale price means a note with a larger
unpaid balance, which could still bring the seller the desired net amount after
discounting. Keep in mind that higher sale prices can also lead to larger down
payments (as a set percentage of the price), resulting in more money in the
seller's pocket.
The Note Terms
The most important thing for sellers to do is to
structure their note so that the buyers won.t be forced to incorporate a deep
discount into their offers. From the buyer.s point of view, higher interest
rates and shorter terms are preferred. The actual offer made is based on the
yield the buyer is looking for; in general, higher yields are associated with
riskier notes. The discount is directly related to the difference between the
interest rate on the note and the buyer.s desired yield.
While sellers can.t know exactly what a buyer.s
required yield will be, the seller can certainly create a note that could
minimize the expected discount. Generally, buyers will want to receive a yield
anywhere between 12% and 20% on a note. While yield parameters will fluctuate
with the market, a 10% yield is typically the lowest they will accept for new
notes.
A note creation example
Because buyers usually want to earn a yield above
12%, creating a note with an interest rate under 10% would automatically mean a
steep discount when the note is sold.
For example, creating a cash flow with a 3% interest
rate doesn.t make any sense if the seller needs to get top dollar for their
note, because there is already a seven-point difference between the interest
rate and the buyer's desired yield. In addition, most buyers will create a gap
in their favor by yielding at least one point more than the interest rate.
Sellers can also avoid unnecessary discounts by
reducing the terms of their notes. Another part of a buyer's discount is based
on the time-value of money principle, meaning that notes that take longer to be
paid off will usually be discounted accordingly. An ideal term for a private
secured note is between five to ten years (60 to 120 months).
Conversely, it isn't a good idea to shorten the
term down to two years or less because a foreclosure situation will be created
- the monthly payment will likely be too steep for the payer to keep up with
for long.
By keeping the eventual note buyer's criteria in
mind when creating a private note, property sellers can ensure that their real
estate note deal works out the best for them. and that they net the highest
amount possible when a cash settlement is reached.
