What is Seller-Financing?
If you’ve ever been to a traditional real estate investing seminar, then you’ve heard that you can buy real estate without using your own money. One of the ways to do this is through a strategy called “seller financing.”
While this has been a fantastic way to acquire property for both investors and homebuyers, it holds some huge pitfalls for the uninformed. And now, Fannie Mae is getting involved to try to protect the buyers in these deals.
Seller financing is pretty simple, and has been around for a long time. Basically, it means the seller provides the financing to the buyer. Instead of the buyer obtaining a note and mortgage from a conventional bank, the home-seller creates the note based on an agreed-upon interest rate and length of time. This has some big advantages for both parties.
Advantages of Seller-Financing
- The seller can sell his or her home quickly to a willing buyer
- The purchase price may be at market value or even higher – within reason
- The seller receives payment for the sale of the home in monthly income payments vs all at once
- The buyer gets to purchase a house with “creative” terms that a bank might not allow. For example, the down payment may be lower or in some cases, even nonexistent, and debt levels and credit standards may also be lower
- The buyer does not have to get an appraisal to get the loan, but pays what he or she thinks the property is worth
- The buyer owns the home – either right away or once the note is paid – depending on how the note is set up.
- It’s important to note that seller financing is completely legal when done correctly. The seller is simply choosing to make a private loan to a buyer so that they can purchase a property, using that property as collateral just as a bank would. Because of that word, “private,” the seller can use whatever terms he or she pleases to determine whether the buyer is creditworthy and, within the bounds of reason and law, can set the interest rate wherever the buyer and seller find mutually acceptable – again, as long as it is within reason and is legal.
Advocates for seller financing also point out that it eliminates many landlord-related headaches for the seller (now the note-holder), such as property taxes and maintenance, because they have sold the property – and, therefore any issues that come up belong to the new owner, not the note-holder – just like a bank.
That responsibility, however, is where the uncertainty in a seller-financing transaction comes into play. And it’s where certain companies are taking ruthless advantage of buyers, be they investors or owner occupants.
And by ruthless, I mean this. An investor buys a house in need of repair, and then turns around and “flips” it to a homeowner or investor for much more than he or she paid. In some cases, I’ve seen investors sell the unfixed property for twice what they paid, and sometimes even double market value.
Now who would agree to such a deal?
It works like this. The investors calculates what a buyer would be paying if they rented the house, or they determine what payments the buyer could afford. And then they create a note based on that ability to pay – with that note lasting as long as 40 years. Unsuspecting buyers may be so excited to finally have the chance to own a home, they never realize they’ve paid far too much. They also don’t realize that if they had just rented, they wouldn’t be on the hook for all the maintenance, taxes and insurance. If the buyer find he or she ultimately can’t meet all these demands and defaults, the investor simply forecloses or in some cases, they simply evict the person if the “buyer” was never put on title. Meanwhile that tenant-buyer may have sunk a lot of money into fixing up the property when they were hoping it would be theirs forever.
In late May, Fannie Mae announced that it would no longer sell its foreclosed homes to one of the biggest seller-financing firms in the business, Vision Property Management. According to the company website, Vision’s goal is to “turn renters into future homeowners via our lease-to-own program [which] shifts specific responsibilities to the contract holder for the potential future opportunity of homeownership.”
Vision requires its “contract holders” to take possession of the home in “as-is” condition, assume responsibility for taxes, liens, and home repairs as well as ongoing maintenance, provide their own insurance. They also state, “As long as you bring at least three times the monthly payment (including operating costs such as taxes and insurance) you will not be denied even if you have little to no credit.”
So why am I telling you all this? Because while Vision is calling itself something slightly more user-friendly than a seller-financing firm, that is, in fact, what it’s doing. It’s buying properties at a discount (often from sources like Fannie Mae’s REO portfolio) and then seller-financing them to buyers.
And it appears to have made some pretty major missteps along the way, such as allegedly selling properties that were contaminated with lead to people who were not aware of the issue and could not afford to remediate it and allegedly selling to people who did not understand the issues with the properties they purchased or who accepted the “as-is” clause without being able to follow through on maintenance, repairs, taxes, and debts. The New York Times has been tracking Vision for over a year and pointing out all sorts of alleged misconduct.
But the point is not whether or not Vision is a good company. The point is what Fannie Mae is stepping in to do about it.
Fannie Mae sells a LOT of foreclosed properties to investors, and they used to sell a lot to Vision. Now, however, not only will they not sell to Vision, any investor who buys more than 25 properties a year from Fannie Mae will be held accountable for the use of those properties down the road. Basically, the government is taking the threat of seller-financing to uninformed buyers very seriously.
This is where you, as an investor, come in. Of course, if you’re buying in bulk from Fannie Mae, get ready for some increased supervision and accountability. But most investors are not doing this. It’s more likely that you are going to come in on the buyers’ side of things.
There are a lot of people in the real estate industry currently offering opportunities to buy homes using seller-financing strategies. These strategies are appealing for all the reasons we already discussed. But, they also hold the same pitfalls for we already discussed. But, they also hold the same pitfalls for you that they do for any other buyer.
Seller-Financing Pitfalls To Avoid
You must be sure that you understand exactly what you are getting into when you get involved in this kind of private financing.
Do you know what environmental issues you should look for? Maybe mold or lead, maybe something more unusual.
Are you aware of all the terms of the deal? Many sellers require a balloon payment before you can refinance or extend your loan with the seller. What is your strategy for making monthly payments and associated “extras?”
Can you meet your commitments? Many sellers are not particularly careful about vetting their buyers because they feel that the ability to foreclose on the property gives them an extra level of safety if the buyer cannot meet their monthly payment commitment. The burden will fall entirely on you to make sure that you are not overextended, and remember that as the owner of the home, you will probably not be protected by your state’s renters’ rights legislation, if it exists, even if you are working with a rent-to-own program.
Peter Bakel, a Fannie Mae spokesman, explained in a public statement that Fannie Mae opted to stop selling REO properties to vision after an “extensive review” in order to keep with its mission of “providing liquidity, stability, and affordability to the U.S. housing and mortgage markets.”
Mel Watt, the director of the Federal Housing Finance Agency (FHFA) has also raised questions about seller financing in the past and was questioned about Fannie and Freddie sales to investment firms who use this strategy in a recent Congressional hearing.
Seller financing can be a huge opportunity for a real estate investor to build a portfolio of properties quickly, but the lack of oversight of this type of private financing can present pitfalls if you are not careful.
And if you’re an investor, do the right thing. Selling a property for far more than it’s worth is not right, and will come back to bite.