© 2011 Cengage Learning created by Dr. Richard S. Savich. California Real Estate Finance Bond, McKenzie, Fesler & Boone Ninth Edition Chapter 14 Creative Financing Approaches

© 2011 Cengage Learning created by Dr. Richard S. Savich. Objectives After completing this chapter, you should be able to: Differentiate between traditional and creative financing techniques. Identify at least five ways in which real estate can be financed through ways other than the traditional methods. Contrast the all-inclusive trust deed to the installment Contract of Sale, citing at least three differences. Apply the formula to calculate blended interest rates. Name the instruments required to close a sale using the creative techniques presented in this chapter. List at least six items that must be disclosed under the Creative Financing Disclosure Act.

© 2011 Cengage Learning created by Dr. Richard S. Savich. Outline Secondary Financing Techniques All-Inclusive Trust Deed (AITD) Installment Sales Contract Lender Participations Sale-Leaseback Open-End Trust Deed Commercial Loan Stock Equity/Pledged Asset Loans Blended-Rate Loans Creative Financing Disclosure Act Imputed Interest

© 2011 Cengage Learning created by Dr. Richard S. Savich. Secondary Financing Techniques Second Trust Deeds carried by seller Referred to as “gap loans” Carried back by seller Helps buyer to purchase home Due in shorter time frame than first trust deed Buyer may renegotiate the second Secure a new loan to pay seller Refinance the entire loan In mid-2009 Fannie Mae and Freddie Mac eliminated seconds

© 2011 Cengage Learning created by Dr. Richard S. Savich. Collateralizing Junior Loans Use seller-carried note and second dead of trust as an asset They are pledged at collateral for a loan through Private parties Mortgage brokers Commercial banks At a discounted value Seller receives cash

© 2011 Cengage Learning created by Dr. Richard S. Savich. Seller Sells the Second Loan Instant cash Deep discount Who buys? Escrow companies Loan brokers Holders of maturing junior trust deed loans

© 2011 Cengage Learning created by Dr. Richard S. Savich. Broker Participation Broker becomes a lender for part of the equity Break note into two parts Assignment of seller’s note and trust dead for the portion of the broker’s interest In default, broker can foreclose

© 2011 Cengage Learning created by Dr. Richard S. Savich. Combination or “Split” Junior Liens Create second and third trust deeds Can sell a smaller second easier

© 2011 Cengage Learning created by Dr. Richard S. Savich. All-Inclusive Trust Deed (AITD) (aka wrap-around) Junior deed of trust to original loan Seller will pay off loans from monies received from buyer Used when In lieu of installment sales contract When existing loan cannot be paid off until later date Buyer wants income tax benefits Seller has overpriced property Low down payment Low interest existing loan Seller firm on price but not terms Buyer cannot qualify Heavy prepayment penalties When severe money crunch hits mortgage market Cannot be used to avoid due on sale clause

© 2011 Cengage Learning created by Dr. Richard S. Savich. Characteristics and Limitations to AITDs Can increase the seller’s rate of return It is a purchase money transaction, subject to encumbrances, to which it is subordinate The buyer become a trustor-grantee The seller becomes a beneficiary-grantor Subject to California’s antideficiency statutes so buyer-trustor is held harmless should foreclosure occur Legal title is conveyed by grant deed and is insurable by title insurance In event of default and foreclosure, the seller-beneficiary follows normal foreclosure procedures

© 2011 Cengage Learning created by Dr. Richard S. Savich. All-Inclusive Trust Deed Equity payoff Buyer takes over prior loans after seller’s equity has been paid off Full payoff Buyer continues to pay until entire balance is paid

© 2011 Cengage Learning created by Dr. Richard S. Savich. All-Inclusive Trust Deed Benefits to seller Only way to dispose when lock in clause Broader market because seller is willing to carry back No loan fees Higher sales price Defer recapture of equity Retain favorable terms of first Increase net yield No interest rate limitations Know immediately about default Trustee’s sale is speedier Income tax advantages Similar to installment sale

© 2011 Cengage Learning created by Dr. Richard S. Savich. All-Inclusive Trust Deed Benefits to buyer Get property not qualified for Larger property for same down payment Only one monthly payment Closing costs reduced Extra long terms can be negotiated No points No prepayment penalties Lower capital gain at resale Grant deed at beginning, not end

© 2011 Cengage Learning created by Dr. Richard S. Savich. All-Inclusive Trust Deed Precautions for sellers What about impounds? Timing of AITD payments compared to first mortgage Limit another AITD upon resale by buyer (due-on- sale clause) Reserve right to have buyer refinance at later date Approve leases on income producing property Precautions for buyers What if seller defaults? Request notice of default and notice of sale Set up payments to cover any liens against seller

© 2011 Cengage Learning created by Dr. Richard S. Savich. Procedures in Setting Up AITD Examine existing trust deed clauses Due on sale Alienation Acceleration Ascertain outstanding balances, periodic payments and balloon provision Who collects and disburses payments Spell out default and foreclosure procedures Get title insurance Get insurance coverage

© 2011 Cengage Learning created by Dr. Richard S. Savich. Installment Sales Contract (aka conditional sales contract or land contract) Title remains with seller Until contract is complete Lawsuit is necessary for foreclosure Significant income tax benefit to seller Prorate capital gains over life of the note Can be used for any real estate including vacant land

© 2011 Cengage Learning created by Dr. Richard S. Savich. Lender Participations Participation in revenue of project Equity participation Charge one time fees or points Profit Participation Multiple lenders

© 2011 Cengage Learning created by Dr. Richard S. Savich. Sale-Leaseback (aka purchase and lease-back) Investor buys property Develops land Sells to major investor Leases back property Could be used for just land, just improvements, or both

© 2011 Cengage Learning created by Dr. Richard S. Savich. Advantages Seller Lease payments are tax deductible Rent is lower than loan payments Improvements may be tax deductible Frees up capital Long term leases not shown as long term liabilities Cash today, payments later Could buy back at later time Buyer Higher yield than loan Appreciation to lessor In default can go after other lessee assets Lease payments cover original investment and leave lessor with title Lessee could pay for repairs, maintenance, insurance, utilities, taxes and operating expenses. (triple net lease or net-net-net) Could do sale-leaseback with another party for same property

© 2011 Cengage Learning created by Dr. Richard S. Savich. Disadvantages Seller Long term contract No participation in appreciation Rent may exceed loan payments Expiration of lease could lead to problems Improvements may cost too much Buyer Lease payments are taxable income Rents could go below market If default, must operate property May not get depreciation deduction if only land lease Capital is tied up Only lessor, not creditor in case of seller insolvency Did lessee develop property for special purpose? Inflation Is repurchase option below market?

© 2011 Cengage Learning created by Dr. Richard S. Savich. Open-End Trust Deed Add on to principal Either until original loan amount Or until fair market value Not used too much due to seconds

© 2011 Cengage Learning created by Dr. Richard S. Savich. Commercial Loan Personal loan from bank Borrowers of substance Usually less than three years Purchase real estate Finance home improvements Purchase a foreclosure, when cash is required

© 2011 Cengage Learning created by Dr. Richard S. Savich. Stock Equity/Pledged Asset Loans Marketable securities are used as collateral

© 2011 Cengage Learning created by Dr. Richard S. Savich. Blended-Rate Loans Existing loan interest rate Market interest rate on new loan Somewhere in between (Existing rate X Existing loan balance) + (Market rate X Net new money) Blended yield = ________________________________ Total financing

© 2011 Cengage Learning created by Dr. Richard S. Savich. Benefits Buyers receive below market rate Borrower qualifies more easily Cash proceeds are greater Seller does not carry back as much paper Lender increases yield on old loans More creative Could be combo with lender and seller

© 2011 Cengage Learning created by Dr. Richard S. Savich. Creative Financing Disclosure Act Description of terms of loan Any other financing Warning about negative amortization When AITD, then who is responsible Terms of balloon payments Credit information about buyer Warnings about seller’s role in case of buyer’s default

© 2011 Cengage Learning created by Dr. Richard S. Savich. Imputed Interest If project >$4,217,500, then interest rate >9% or applicable federal rate (AFR), whichever is lower AFR is rate on federal securities with same maturity Does not apply to seller carry back loans when buyer uses property as principal residence Changes capital gain into ordinary income

© 2011 Cengage Learning created by Dr. Richard S. Savich. Questions and Comments?