It doesn’t matter how many properties you own, how much money you make or even how well your current properties are doing; at some point you’re going to find it difficult to finance your real estate deals. For most real estate investors, finding good financing options for your rental property deals is always a challenge.
Even before my husband and I became full-time real estate investors, finding good cash flowing properties took a bit of work, and scraping together money for a down payment was definitely a hurdle, but financing our deals was the single biggest challenge we faced, so we looked at alternative financing.
And that was before the banks really clamped down on investors. These days you have to do three times the paperwork and be twice as qualified in order to buy rental properties using bank financing if you’re a full-time real estate investor. As a result, many investors look to joint venture partners or private money lenders to fund their deals.
A solution we used on several deals we did between 2002 and 2004 is a solution that is once again working for us, and that is vendor financing. If you’re struggling to find bank financing, you might resolve your financing challenge by simply asking this question of every seller: Will you carry financing? Not every seller is going to say yes; in fact most will say no. But you never know unless you ask!
During the heated market conditions of the mid-2000s, sellers willing to finance the deals were really tough to find because homes were selling so fast and for so much more money than most sellers expected. Today, with cooler housing conditions, lower prices than some sellers want to accept, and terribly low rates on GIC’s, we’re finding more sellers willing to entertain the option of financing some of the property to increase their return, speed up the sale and get a good price for their property.
What is Vendor Financing?
Owner financing, more commonly called a VTB mortgage or vendor take back mortgage (also known as vendor financing, owner financing or a seller take back mortgage) is simply where the seller (Vendor) of a property is willing to provide some (or all) of the mortgage financing on that property.
Owner financing can take several different forms. We’ve done deals where the seller provided the entire mortgage, which amounted to 80% of the property value. We paid her 6% interest amortized over 25 years for a three-year term with no prepayment penalties and an option to renew. She was able to sell her house in a slower market and made more money from it than she otherwise would have through three years of interest payments.
We also have used owner financing to top up traditional bank financing. In other words, we’ve had sellers provide us with a second mortgage (which simply means they are in second position behind the bank) to minimize the money we had to put into a deal. We’ve also used it to bring the financing on a property up to 80% of the loan to value when a bank would only loan 65%.
We’ve also used seller financing in the form of a promissory note. This is definitely riskier for a seller because a promissory note is not registered on title, but as an investor it’s a little easier to work with because secondary financing on a property can upset the bank that sits in first position (banks like you to have plenty of equity in the property and won’t fund your deal if you’ll be too highly leveraged with the additional financing).
A promissory note is simply a loan from the seller of the property with a contract stating that you (the buyer) promise to pay a specified amount of money to them (the seller) at a specified time in the future. It is not secured by the property but it is a binding contract whereby you agree to pay a certain amount to the seller. When we’ve used this form of a vendor take back mortgage in the past we typically make one balloon payment to the seller at a time in the future, but you can structure them like a mortgage with principal and interest payments, interest-only payments or annual blended payments.
Benefits of Vendor Financing for Sellers
A lot of people wonder why a seller would ever consider offering financing on a property. I alluded to a few benefits above including:
- faster sale of a property in a slower market
- a higher sale price because most investors are willing to pay a premium for a property they don’t have to finance using bank financing
- a higher overall return for the seller because even if the buyer doesn’t pay a higher price, there is a usually a good interest rate offered on the deal which essentially equates to a higher overall sale price. For example if the home would have sold for $300,000 but there is a two year 80% loan to value vendor take back mortgage at 6% interest, the seller is essentially getting $328,800 for the property ($240,000 mortgage times 6% interest times 2 years).
There are also potential tax savings if the home was not the primary residence of the seller whereby they can defer some of their capital gains to future years which can help to reduce the income tax bracket the gain ends up being charged in. (*Sellers should speak to their accountant to understand if this benefit applies to them and their situation). The biggest benefit for a seller is gaining a higher return on the proceeds of the sale of the property than if the funds sat in the bank.
Why earn 2% in a "high interest savings account" at your bank when you can earn 6%, 7% or more on your VTB mortgage? It’s a property the seller is familiar with, and the worst case scenario is that the buyer defaults on the payment and the seller gets the house back to resell again.
What kind of security does a seller have who puts their sale proceeds into mutual funds or stocks? None. Banks loan funds on mortgages because they are one of THE most secure forms of debt. We believe more sellers would consider this form of investment if they realized that the security of their investment is so much greater with a vendor take back mortgage than with so many other types of investments.
The lowest risk vendor take back mortgage for a seller to hold is in first position, but the challenge with that is the seller pretty much has to own the place free and clear from any current debt. Those sellers are out there – we even find them on MLS - but they are less common.
VTBs aren't the solution for every seller, but many folks are looking for ways to reduce their tax bill and still dispose of a property. Others want to bring in secured income every month. For some other sellers, it is just a way to sell an otherwise tough to unload property. Vendor take backs provide an excellent solution for these types of sellers.
How to Find Vendor Financing Opportunities
There is only one way we’ve ever found sellers willing to carry financing, and that is to ASK! Yes, it is occasionally mentioned in a listing and once in awhile an agent will mention it to us, but in all the cases where we’ve actually done a deal that used seller financing it’s been because we asked. And usually we’re more successful when real estate agents aren’t involved. There is no sure way to know a vendor take back mortgage is going to be an option until you ask, but some positive signs that one is a possibility include:
- A mention in the MLS listing that there are no financial encumbrances on the property
- A mention in the MLS listing that the seller is willing to carry financing
- Any indicators that it’s a rental property and that the property has been owned by the current investors for over 10 years
- Private sales where there is an indication that the sellers are willing to be creative with the deal
- Retirees downsizing into smaller condos or smaller homes who have paid off their home and don’t need their cash in a lump sum
- Quick price drops on a MLS listing. This can often indicate a strong motivation to sell. Why not offer a good price for the property in exchange for them carrying some or all of the financing?
In general, we find that the easiest place to find people willing to do a vendor take back mortgage is your local real estate investing club. Fellow real estate investors typically understand seller financing more than average home sellers and unless they have immediate plans for the cash many investors are happy to get a secured return on their money for awhile. Plus there are the tax benefits of being able to defer some of the capital gains on the property for a few years. There are many sellers who benefit from a VTB mortgage so all you need to do is simply ask!
Julie Broad is an active Canadian residential real estate investor and partner in Rev N You with Real Estate (www.revnyou.com)
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