Creative financing commercial real estate is an essential skill for today's investor. You're about to discover the top 5 creative techniques along with our 4 step process to purchase commercial property with creative financing. These techniques will allow you to do deals when traditional commercial real estate financing isn't an option as well as enhance the net cash flow and cash on cash returns, especially in a rising interest rate market:
4 Reasons Creative Financing Commercial Real Estate is Essential in Today’s Market
- Unqualified Buyer: Creative financing is a great way to purchase commercial real estate when you can't qualify for a traditional loan or don’t have all the money for the down payment.
- Rising Interest Rates: Creative financing is also a way to combat increases in interest rates. Due to recent interest rates hikes, some deals just don't cash flow anymore. It’s the same property, same seller, same NOI, but the higher interest rates have increased the debt service and therefore the net cash flow. What do you do? Apply creative financing techniques!
- Negotiating Tool: Structuring a deal with creative financing as a way of meeting a seller’s needs helps with negotiating a deal with a seller. For example, what if a seller wants to get out of the business, but they don’t want to pay capital gains taxes? And because they are cashing in, they don’t want to do a 1031 Exchange. What do you do? This is a common scenario in commercial real estate and as an investor you need to know how to negotiate the deal to meet the seller’s needs.
- Distressed Property: Creative financing techniques are essential when dealing with a distressed property. Here's another likely scenario that will become more common in today’s market. Let's say an owner has a 16 unit apartment building and eight of them are vacant because he has no money to fix the property. Or what if he has the money but doesn't want to deal with eight more tenants? If you take both situations to a lender, the lender will say no because there isn’t enough cash flow to support the loan. What do you do? You have a distressed property with tremendous cash flow potential but it’s 50% vacant. You need to use creative financing.
4 Steps to Win-Win Commercial Deals
When you are structuring your deals with creative financing techniques, it’s important that you use this 4 step process with the goal of creating a win-win deal for the seller and buyer. Whenever we apply a creative financing strategy with the seller, we are not looking to take advantage them. Our aim is to create win-win arrangement for the buyer and the seller.
Step 1: Seller Motivation - You must understand what the seller's motivation is first because when you understand the seller motivation, then you can design your deal structure around it.
Step 2: Creative Terms - Determine your creative terms using one of the 5 top creative financing techniques and pair the seller’s motivation with the technique that works best in the scenario.
Step 3: Write Up Offer - Once you finalized the structure, you need to know how to write up an offer using a letter of intent and a contract.
Step 4: Exit Strategy - Before you close, you should know how you are going to exit the deal. Are you going to just buy it, fix it up and sell it? Are you going to do a 1031 exchange or a cash out refinance because your seller financing structure is going to end? In many cases, your creative financing deal has a time limit of 5 years or so. So you need a five year plan on how you are going to pay off the seller or you may lose the property, your down payment and and all the equity. So, having an exit strategy is crucial to success.
5 Top Commercial Creative Financing Techniques
#1 – Master Lease Agreement
The master lease agreement is the most powerful technique for creative financing commercial real estate. We have used this technique on some of our best deals, with some of our most distressed sellers, and with some of the most unqualified buyers.
4 Ways to Write Up the Paperwork, 1 Technique
In commercial real estate, the term "Master Lease" refers to a creative financing arrangement that could technically be written up one of three ways in the paperwork; Lease with Option to Purchase, Subject To or Land Contract / Contract for Deed.
Lease with Option to Purchase: The property owner remains the title holder and the Buyer leases the property from the Seller while also acquiring the option to be able to purchase the property for a set price within a specified period of time. This is the most common version of how the paperwork of a Master Lease is drawn up.
Subject To: The property owner transfer title to the Buyer but the existing financing recorded against the property doesn't change. Most commercial loan documents have a due on sale clause (and commercial lenders are more willing to enforce that clause if title transfers than with residential loans) so how this is normally structured is that if the property is titled in an LLC, the Sellers sells the LLC to the Buyer to navigate around the due on sale clause. The terms of the sale of that LLC are similar to the terms of a Lease with Option to Purchase because the purchase price is set along with a specified period of time to pay off the existing loans.
Wrap Around: Similar to a Subject To, with a Wrap Around, the existing liens remain on the title and but then a new lien is originated with its own financing terms and wraps around the existing financing. Title is transferred to the Buyer.
Land Contract / Contract for Deed: This is an agreement whereby the title transfers to the Buyer once the entire sales price has been paid. This way of writing up the deal is very helpful when establishing an installment sale for IRS tax purposes. Once again, the terms of this are similar to the other two, whereby the Buyer has a specified time to pay it off and a pre-arranged purchase price.
Therefore, since all four of these versions of a Master Lease are essentially the same in the end, I will teach the principles of the Master Lease as all four being one creative financing technique.
Master Lease Components
- No banks are involved; there is no requirement for an appraisal nor a loan application, credit check and certainly no origination fees.
- The Buyer agrees to pay the mortgage payments, insurance, taxes and any other ongoing expenses; or one lease payment that covers all of those monthly expenses. Think of this like a Triple Net Lease in principal because the Buyer is taking over all property expenses.
- The Buyer is also assuming all of the responsibility for the operations of the property.
- The Seller typically gets a down payment, aka an option payment and then waits for the Buyer to pay off the rest of their equity within usually 5 years or so.
- Since the Purchase Price is established at the time the Master Lease is originating, any forced appreciation from improving the NOI benefits the Buyer so long as the Buyer can perform on paying off the Seller before the Master Lease ends. So, if your master lease purchase price is $1MM, and by year 5, the property value has increased to $2 million, then the $1 million profit benefits the Buyer so long as they finish the deal.
- Depending on if the paperwork is written as a Lease with Option to Purchase, Subject To or Land Contract will determine if the Buyer gets legal title or equitable title and that determines whether the Buyer or the Seller gets to take depreciation on the property.
Master Lease Example
Our Protégé Dean purchased a large self storage facility using the Master Lease commercial creative financing technique. His deal is a good example of how to implement the Master Lease using the 4-step process.
Seller Motivation: We focused on determining what the Seller’s real motivation since the Seller tried to keep it close to his vest. We narrowed it down to two things; Either (1) the seller wanted out of the business but he didn’t want to pay capital gains right away, or (2) he didn't want to work with an agent. With our seller's motivation hunches in mind, we knew early on that we would need to use a creative financing technique.
Creative Terms: Dean negotiated a 3 year master lease agreement with a $2.5 Million Option Price for a 3 year term with a option/down payment of 10% (considerably less than the 25 or 30% a bank would require) of $250,000 and a monthly lease payment of $9,375 (the amount was determined based on a 5% interest only payment on the $2,250,000 balance).
Write Up Offer: Dean submitted his offer using our Master Lease Agreement contract that we give those in our Protégé Program. The win-win deal arrangement provided the Seller with $250,000 upfront along with $9,375 per month for the next three years, while still claim depreciation for their taxes and not have to deal with the property anymore. Meanwhile, Dean gets to increase the NOI by raising rents and making improvements, collect the increase in cash flow and benefit from the forced appreciation.
Exit Strategy: Dean can either cash out refinance within 3 years to get his original $250,000 down payment back along with paying off the $2,250,000 while still cash flowing; or Dean can capture capture the forced appreciation by selling at the end of 3 years.
Forced Appreciation: Recall that the value of a commercial property is determined based on the Net Operating Income (NOI). Forced Appreciation is accomplished by increasing the NOI. NOI is increased by reducing expenses and increasing the income. The day that Dean closed, the NOI was $73,603 a year, which is actually less than the $112,500 in payments due to the seller. However, Dean immediately raised rents where he could as well as reduced expenses so that he could at least break even with debt coverage within a few months. Then, he systematically increased NOI well above the debt coverage and by year three, the net operating income is estimated to be $285,542 per year.
To calculate the amount of Forced Appreciation, start with $2,500,000 as his original purchase price. Then, divide Dean’s 3 year ProForma NOI by the market cap rate of 7%.
$285,542 / 7% = $4 million
$4MM - $2.5MM = $1.5MM Forced Appreciation
The Power of the Master Lease Agreement
Dean acquired a commercial property for only 10% down that he will create $1.5 million in equity in 3 years, or roughly $500,000 per year; all thanks to the Master Lease creative financing technique. Not only would this porperty not have qualified for traditional financing, even if it did, his cash on cash returns would have been much lower if he had to put 25% - 30% down.
More on Master Leases
For further study on the Master Lease Agreement, go here: https://www.commercialpropertyadvisors.com/master-lease-agreement/
Check out Dean’s video on how he purchased this large self-storage property using creative financing:
Real World Commercial Deal Without a Bank Loan
#2 - Seller Carry 1st
This creative financing technique is when the seller becomes your bank by originating a mortgage whereby the seller is the lender and you are the borrower. Another way to say this is the seller is holding the paper, hence the name "Seller Carry". You may have also heard this called owner financing or seller financing. Why would a seller agree to be the bank and lend you the money to purchase their property? Here’s an example of what that might look like with a Seller Carry 1st technique.
Example: You meet with the seller, and he tells you he has no mortgage. This seller wants to sell, but he wants to maintain some of the income. So how do you do that? How do you create a win-win deal around the seller motivation? You use the Seller Carry 1st technique. Here’s a break down of an example deal.
- The purchase price is $500,000.
- You give the seller $50,000 as a down payment.
- The seller will give you a mortgage for remaining $450,000 in first position.
- Structure the mortgage using the 10-5-5 principle which is 10% down, 5% interest only payments for 5 years.
This technique is ideal for a seller with no mortgage, but the property is distressed. It could be a property in a great location with a lot of potential but because it is distressed, a lender will see it as too risky. And it is also a great technique to combat high interest rates. If you can negotiate a 5% interest rate today, it's a win for you. And lastly, it is ideal for a distressed seller, who needs someone to take over the property for personal reasons. With this technique, they can be the lender for you to get the deal done quickly and efficiently.
#3 - Seller Carry 2nd
The Seller Carry 2nd mortgage is similar to Seller Carry 1st, only the seller holds a mortgage in the second position. This technique is useful when you don’t have all the down payment and is great to have in your toolbox of creative strategies. Most banks require you to have 25% down. If you don’t have the full 25%, the seller can loan the remaining amount to you as a second mortgage.
Example: You have found a life changing deal: great locations, lots of cashflow and a motivated seller. There's one problem though, you don’t have enough money for the down payment.
- The purchase price is $500,000
- The down payment will be 25% or $125,000, but you only have $75,000, leaving shortfall of $50,000
- The seller will loan you the $50,000 as a second mortgage. The bank will give you a loan in first position, and then the seller will give you another loan in second position.
- The ideal terms for a Seller Carry 2nd would be 4 to 5% interest only payments.
#4 – Sale Leaseback
Sale Leaseback is a commonly used creative financing commercial real estate technique. It's an old technique with terrific benefits. This technique is used when you purchase a property from a professional, for example a dentist, and their practice is in the building. They sell the building to you, but remain the tenant and you lease it back to them. That's why it's called, sale lease back. The benefit for the dentist is it frees up their equity. They can use the cash to expand their practice or buy new equipment. With all their cash freed up, they can focus on their business. As the buyer you inherit an automatic and established tenant with a fixed rent, which will get you the best terms with a lender.
#5 – Seller Equity Participation
Seller equity participation is when the seller sells the property to you but some of the profits from the sale go to your down payment. So, at the close of escrow, the seller gets the profits but 25% of the purchase price will go back as the down payment into the property. This technique is ideal for sellers with a lot of equity.
There are two main benefits of this technique. First, as the buyer you have no down payment. Second, the seller who puts in the down payment becomes a limited partner with you. The seller gets the majority of the sale price plus a certain rate of interest on her money. Alternatively, she could get a certain interest in the property for as long as you own the property. This technique is a great way for a seller to maintain income and stay in the real estate game, even though she just sold everything to you.
That's Creative Financing Commercial Real Estate. They are a must for today's commercial real estate investor.