The most effective and successful commercial real estate investors know how to leverage and master credit. Property owners must be disciplined in managing their financial obligations unless they want debt to engulf them. Since securing finance is almost always essential to acquiring commercial real estate, that discipline begins with where financing comes from. Sources of finance are many and varied and include traditional banks, credit unions, finance companies, and private lenders. Often, another viable option is owner financing from the seller of the building. What is owner financing? How does it work for commercial deals as opposed to home purchases?
When Is Owner Financing a Good Idea?
Owner financing is when the seller serves as the mortgagor. It is an alternative arrangement whereby the prospective owner/buyer makes monthly payments to the owner/seller, building equity without actually assuming legal possession of the property. Once a certain level of equity is attained, the buyer then purchases the property outright. The numbers and timeframe differ for each transaction. However, certain features of this type of arrangement make owner-financed properties the best avenue for some real estate entrepreneurs. They can use these features as criteria to determine whether this type of financing works for them.
The Buyer is Low on Capital
Newer would-be landlords often lack the funds to make a down payment on a commercial building with promising revenue projections. It goes without saying that commercial properties carry hefty price tags, and down payments can be similarly daunting. Eager investors without sufficient funds must be creative or give up. One way to secure a commercial property is through owner financing. In brief, the buyer makes the down payment in installments, month by month. In this manner, new investors get the proverbial foot in the door with affordable remittances.
The Buyer Lacks Established Credit and Experience
A hallmark of traditional banking institutions is that they are averse to risk. Their singular goal is to get their loaned money back promptly and then some. People who are brand new to investing are often younger. Not only do they lack a solid history of profitable real estate successes, but they also lack a record of paying any debt in a timely fashion. Typical lenders will cast a critical eye on such applicants, knowing the results of an approved loan hinge on the borrower’s acumen and wisdom. Young investors may be ripe for commercial real estate owner financing.
The Owner Is Motivated to Sell Quickly
Of course, buyers cannot simply decide to owner-finance a commercial property. The decision rests with the owner, and some owners may not be interested in owner financing. There are several reasons why a landlord may want to offload a building. They may be selling off assets for retirement, gathering funds to purchase a preferable property, seeking to eliminate existing debt, or they may be dissatisfied with a commercial site’s financial performance. The list goes on. The key for the buyer is the intensity of the motivation. The greater the urgency, the more likely a seller will agree to a proposal for owner financing.
How Does Owner Financing Work?
What does owner financing mean when the rubber hits the road? What are the financial and legal instruments involved? The answers to these questions depend on the nature of the transaction and what state laws apply. Ordinarily, the seller has the purchaser agree to a mortgage loan that lasts five or so years, after which the buyer can obtain financing from an external source to pay off the remainder of the purchase price. Yet there are many particulars peculiar to commercial buildings as opposed to residential buildings. A few different arrangements are described below.
No, this term does not refer to raw, vacant land. Actually, it is the simplest scheme whereby the buyer makes regular payments to the seller according to an agreed timetable. When the last payment is made, the seller transfers the deed to the buyer without further responsibility. This spares both parties the time and money spent on lender approval, processing, and underwriting. However, some states permit sellers to foreclose after one missed payment, so buyers beware of the disadvantages of owner financing.
Lease to Purchase
This also forms an uncomplicated relationship. The prospective buyer rents the building from the seller for a mutually acceptable period, after which the buyer has the option to purchase the property. This often obliges the seller but leaves the buyer free to walk away. Nevertheless, the owner keeps the rent, while the renter gains no equity. In addition, lease-purchase contracts stipulate conditions that must be met for the purchaser to exercise the option, such as deposit, secure financing, and clear title.
Some finance sources permit wraparound mortgages. Suppose the owner is carrying an existing mortgage. In that case, the lender may approve an arrangement where, for a fixed period, the buyer, after a modest down payment, makes monthly payments to the owner, who, in turn, forwards those remittances to the lender. The buyer may pay a higher rate to the seller than the latter pays to the bank. Another disadvantage of owner financing with wraparounds is that if the owner defaults, the buyer loses the opportunity to purchase the property and any equity gained.
What About Rental Income and Taxes?
This all begs the original question, what is owner financing? Commercial properties involve tenants, rent rolls, leases, and, of course, income. How do parties to owner financing approach the collection of rents? Moreover, who pays property taxes on owner financing? These issues are best spelled out clearly in the land contract, lease-purchase agreement, or mortgage document. A buyer with limited means will want to begin earning revenues immediately, but the owner/seller may want to hold some back, given the risks. Taxes are legally the burden of the owner, but the property inputs are also negotiable.
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Christy McFerrenOwner Financing for Commercial Property