With interest rates on conventional commercial real estate loans soaring above 5%, investors are turning to creative financing to fund their deals. Creative financing in real estate involves unconventional methods of funding real estate purchases, which include:
Seller Financing or Seller Carry-Back: The seller acts as the lender, allowing the buyer to make payments directly to the seller over time rather than securing a mortgage from a traditional lender. This type of financing typically involves a Secured Promissory Note and Deed of Trust recorded on the property to secure repayment of the seller financed loan. The Secured Promissory Note and Deed of Trust should be prepared by a real estate attorney for investment properties to ensure the transaction is completed and recorded correctly.
The seller can finance a part of or the entire purchase price. If a traditional lender finances a portion of the purchase price, the traditional lender will have a first position Deed of Trust on the property and the seller will have a second position Deed of Trust.
Subject-To Financing: The buyer acquires the property “subject to” an existing mortgage on the property. In this type of transaction, the buyer pays the seller its equity in the property whether in cash or per a promissory note. While the deed is transferred into the buyer’s name, the existing mortgage is not transferred but remains in place under the name of the seller. The buyer will take over the existing mortgage payments and insure the property. This type of financing structure can be advantageous to the buyer if the existing mortgage interest rate is lower than interest rates currently offered by traditional lenders. The risk involved in this type of transaction is that the existing mortgage lender has a “due on sale” clause in its mortgage documents which grants the lender a right to accelerate the mortgage when a transfer of the property occurs without the lender’s consent.
Assumption of Mortgage: The buyer assumes responsibility for the existing mortgage on the property. This type of transaction requires the lender’s approval and can be advantageous to the buyer if the interest rate on the existing mortgage is lower than current mortgage rates. Not all mortgages are assumable. Whether a mortgage is assumable will depend on the type of mortgage. A careful review of the mortgage documents by an experienced real estate attorney is needed to determine whether a mortgage is assumable.
Hard Money Loans: Short-term, high-interest loans from private lenders, are typically used for fix-and-flip projects. Under this type of loan, the repayment period can vary from 3 to 36 months, with interest rates ranging between 10% and 18%. The repayment terms can include interest only payments with a balloon payment and prepayment penalties. While these loans can be funded more quickly than conventional loans, the loan servicing fees, origination fees, short repayment period and high interest payments are likely to cost investors more than conventional loans. Hard money loans are secured by a Deed of Trust on the property so a failure of the borrower to repay the loan can result in the lender foreclosing on the property.
Limited Partnerships: Investors can pool resources in a limited partnership to purchase real estate and share the costs, risks, and profits. A general partner manages the partnership and the real estate while the limited partners serve as passive investors. The general partner has unlimited liability with regard to the partnership while the liability of the limited partners is limited to the amount of their investment or capital contributions in the limited partnership. Limited partners, however, have little to no involvement in the management of the limited partnership or the real estate. Investors should consult with an experienced business and real estate attorney on structuring a limited partnership for the purpose of purchasing real estate investment property.
General Partnerships: When 2 or more individuals come together to pool resources and conduct business for a profit, this forms a general partnership. Unless otherwise specified in a partnership agreement, the profits and losses of a general partnership are shared equally among all partners. A disadvantage of a partnership is that every partner is “jointly and severally liable” for the general partnership’s debt and liabilities. This means that the actions of one partner binds the partnership and creates personal liability for all other partners. Investors should consult with an experienced business and real estate attorney on structuring a general partnership for the purpose of purchasing real estate investment property.
Use of Retirement Accounts: Individuals can use funds from retirement accounts, such as a Traditional IRA, Roth IRA, or individual 401(k), to invest in real estate. Investors should consult with their financial advisor and tax professional on the tax advantages and rules and regulations related to the use of retirement accounts to fund real estate purchases.
Lease Option (Rent-to-Own): The buyer leases the property with the option to purchase the property at a later time. A portion of the lease payments may be credited towards the purchase price. This allows a buyer to live on the property while building up their credit or saving for a down payment. A purchase option agreement may include an option fee that can apply to the purchase price. A purchase option agreement should be entered into separate from the lease agreement and it is recommended that a memorandum of the purchase option is recorded on the property in order to provide notice of the purchase option to others. A purchase option should be prepared by a real estate attorney for property transactions.
Creative financing involves several methods that can be used individually or in combination, depending on the circumstances of the buyer, seller, and the real property involved. The benefits, risks, and tax advantages and disadvantages of these methods should be carefully assessed by investors and their tax and financial advisors with regard to their overall tax planning strategies. Real estate attorneys specializing in investment properties should be consulted to advise on the legal risks of these methods and prepare the appropriate transaction documents.
Contact an experienced real estate attorney in Vancouver, Washington and Portland, Oregon.
