It's really important that you know how to structure deals that no one else does to give you the upper hand. A typical real estate agent may or may not know how to be creative but for the most part, they're not interested because it may affect their commission. From my experience, nearly 95% of all property owners, the sellers, don't have a clue on how to safely structure creative deals.
Why Use a Second Carry Mortgage?
Have you ever heard of these terms or these phrases before when you're looking on LoopNet or online listings or getting things from brokers or even sellers? If you’ve heard this before: "seller may carry a small second to help get the deal done". How about "seller may hold a second" or "owner may carry some paper"? How about "owner may carry"? How about the emphasis "owner financing possible"? I'm sure some of you that are active in the market have seen these terms someplace somehow.
What does this all mean? This is actually code language telling you, "Here's an open door, an open window for you to explore creative financing." You just have to know what to do with it. Why seller carry second mortgages? Being creative allows you to close on more deals and make more money. That's the bottom line.
Seller Carry Strategies Assist You in Leveraging for Example:
- Lowering your down payment amount.
- Helps you increase your cash and cash return or ROI immediately and immensely,
- Makes your deals very attractive and unique.
- It allows you to take advantage of motivated sellers where loan assumptions are available.
- You'll be able to overcome financing obstacles that normally the average person would walk away from, but not you, after this training here.
Seller Carry Second Mortgage Example
Understanding seller carry second mortgages is an absolutely important tool to have in your arsenal of deal making tools. Let's do a quick example. Quick and easy, okay? I know you guys can't see the number but just try to follow me along in principle. Let's say the purchase price of an apartment building is $500,000, and the down payment is 25% or $125,000, but you only have $75,000 so you only have 15%. There's a 10% shortage.
Here's how seller carry mortgages can help. In order to satisfy the down payment requirement of the lender, which is 75%, the seller may agree to hold a second mortgage against the property for the remaining $50,000 or 10%. That's called a seller carry second mortgage. Now, if agrees to do that, everyone is happy. The seller gets to sell the property. You get to buy the property. Lastly, the lender's equity requirement, a 25% down payment is satisfied. In a nutshell, that's what a seller carry second mortgage is.
You're going to have two mortgages. You're going to have to pay the first mortgage and the second mortgage. You're going to have to evaluate this and figure your cash flow out by subtracting two mortgages from the NOI.
How does this affect cash in cash return if you don't do a seller carry second mortgage?
If you don't do a seller carry second mortgage in this case, you have to come up with the entire 25% or $125,000 instead of $75,000. You'll be only taking care of the first mortgage. You know, that can have a huge difference on your cash and cash return. Now, in the first case, you have a seller carry second mortgage. You have a certain cash in cash. In the second case, there's no seller carry. You're putting down the entire down payment. There's a certain cash in cash there. The difference is you putting 15% as opposed to 25%. That's over a 30% improvement on your cash in cash return.
If you can organize a small seller carry of 10%, your cash in cash return can potentially be over 30%. It can be a 30% difference there. For example, let's you're able to produce a 25% cash in cash return with the seller carry second mortgage. That's if you don't have a seller carry second mortgage. It can be 15-17%. You can go from 15-17% up to 25% with the seller carry second mortgage so that's huge.
Let me go over a second situation with you. Let's say we have the same apartment building at, $500,000 purchase price. The seller this time has 4 years remaining on a current loan in the amount of $300,000. The buyer must assume the loan because the seller has a large prepaid penalty if the loan is paid off, so he can't just sell it to you. You have to assume the loan, but there's a gap there right? He owes $300,000, but the purchase price is $500,000 so there's a $200,000 gap there to cover, but again you only have $75,000 so there's a $125,000 shortage. The question is what do you do? How do you buy this deal?
Here's what you do. Again, this is about seller carry second mortgage. You're going to take your $75,000 and you're going to apply to the gap of $200,000, and then the seller is going to carry a second mortgage for the remaining $125,000. Okay? You got it? You're going to put down your $75,000 to the bank. The seller's going to take out a second mortgage against the property for $125,000 so that gap is covered now. You become the owner of that property, but, guess what? You again have to take care of the first mortgage and you have to take care of the second mortgage. Basically, you're assuming the seller's loan with the current terms, and by the way, it's going to cost you about 1% a loan amount to assume it, plus closing costs. Again, you're assuming the seller's loan.
That's what a loan assumption is. When you hear the term "a loan assumption", this is exactly what it is. You're going to assume the seller's loan, the $300,000 so you're making payments on the $300,000 plus you need to service the $125,000 second mortgage. That is what we call a loan assumption with a seller carry second mortgage.
What would the cash in cash return be without assuming a loan and not taking a seller carry second mortgage?
This is even a more drastic change. In this case, Let's say there's no assumption so you're going to cover the $200,000 difference just out of your pocket. Boom. Down payment, $200,000. Your cash in cash is going to be X-ed. Now, let's say that in case B, you only have $75,000 so you're going to apply the $75,000 and he's going to do a seller carry of $125,000. There's a huge difference there in the cash in cash return. Guess how much? 50%, over 50% in this case, in the difference in the cash in cash return. If your cash in cash return, without the assumption, you plop down $200,000 as 10%, for example, your cash in cash return with the assumption can be over 25% so that's over 50% there.
We saw the huge problem. The huge problem was the seller wanted to sell. He has a loan assumption with a large prepay penalty. You don't have all the equity so the solution is a seller carry second mortgage.
Basic Rules on Seller Carry Second Mortgages For Commercial Deals.
Some of you are going to be thinking, "Peter, how do I calculate what my interest rate should be on my seller carry second mortgage?" Here's the answer:
- Always start of with 5% interest only payments if you don't know where to start. Always plug in 5% interest only on the second mortgage.
- Try to negotiate no interest payments for the first six months. This allows you to have higher cash flow before having to take on the second mortgage payment.
- Never over-leverage or over-debt a property. Try to maintain, at the minimum, 10% equity in a property.
- My last tip here is not all lenders will allow second mortgages, and I found that here's the reason why:The lender's figure you’re going to pay the second mortgage before spending the money on maintaining the property. The lender is concerned about the property looking well and being taken care of. You're more concerned about paying the second mortgage so you don't go into default. That's the reason why not all lenders will allow seller carry second mortgages.
When Seller Carry Second Mortgages are Good to Use:
Number 1: It's good to use when you want to be creative and seller motivations are evident.
Number 2: They're good to use when you have enough time and a good plan to increase the property value through appreciation, forced appreciation, or principle pay downs. You need to give yourself enough time to pay off the loan.
Number 3: Seller carry second mortgages are good to use when you need or want to leverage your down payment or the amount of money that you have.
Number 4: Seller carry second mortgages are good to use when a seller has to pay a large prepay penalty if he pays off his loan too early.
Number 5: Seller carry second mortgage when you're assuming loans.
For those of you that are active, over time, you will run into one of these situations. Believe me. You will. Now you know how to handle it
When is Not a Good Time to Use Seller Carry Second Mortgages?
Number 1: When it creates a situation where there's too much debt on the property. For example, negative cash flow. If you were to evaluate a deal where you have the two mortgages an there's negative cash flow, this is not a good time to use that.
Number 2: When your debt coverage ratio equals 1.0. By the way, debt coverage ratio is basically your NOI divided by your annual mortgage payments. When that formula equals 1.0, that means you're breaking even, it's not a good time to use seller carry second mortgage.
Number 3: Seller carry second mortgages are not good to use if the seller's current mortgage matures soon, within the year, it matures. It's probably not a good time to use seller carry second mortgages because you need time to fix up the property, get the NOI up, get the value up so you can pay it off.
Number 4: If you don't have a clear plan or extra strategy to pay off the seller carry second mortgage when it's due, it's not a good time to use this strategy.
Number 5: If you don't have enough time to allow the property value to increase, to pay off the second mortgage, it is not a good time to use seller carry second mortgages.
Some Technical Things About the Seller Carry Second Mortgages.
Second mortgages, by definition, must be recorded after the first mortgage. You are pretty much the seller that gives you the second mortgage will be in second position. The first mortgage from the bank will be in first position and then you will, the seller will be in second position. Second this is, first mortgage be paid off during the term the second mortgage, the second mortgage becomes the first mortgage. All right. Just going to switch positions once that first is paid off. Standard real estate law does not differentiate between the first and second mortgages. From a legal perspective, recording a second mortgage follows the same procedure as a first mortgage. For those of you wondering, how do you record a second mortgage, It's the same as the first mortgage. We won't go into detail so you're going to have to know that.
Lastly, this is important. If you default on a second mortgage, the lender can start foreclosure just as you would on the first mortgage. The lender's interest is second to the first mortgage. The first lender must be paid off completely before a second mortgage lender receives any money. If you default on your second mortgage, they can foreclose on you, but the person in first position is still in first position, so in order for a second mortgage holder to get any money, the first mortgage has to be paid off.
All of you now know how to evaluate a deal with or without a second mortgage. You also know how to calculate and include both mortgages properly. You all know now when it is ideal to use as well when it's ideal to not use. You know what the benefits are of using a seller carry second mortgage and how to be creative there. You now know what the risks are and lastly, now you're able to create more deals from deals you may have walked away from.