Lease Option and “Subject To” - The Investor’s 1-2 Punch - Part 1 THE TECHNIQUES
In these pages we will discuss leases, options and taking title to real
property “subject to” existing financing. These techniques have been used by real
estate investors for decades. There has been renewed interest in recent years.
In the not to distant past mortgage loans were freely assumable when
buying a property. An assumable loan is one that the property owner put in place
when originally buying a property and subsequent buyers can take over the loan
(assume) with no qualifying.
Lenders created loans that could be assumed because interest rates were
generally very stable. There was little reason for them to require a loan be paid off
when the property was sold. That would merely require them to go through the
expense of finding another borrower to get the money working again.
In the 1980’s interest rates began trending up and lenders started
demanding that the remaining balance of mortgage loans be paid off when the
securing property was sold. There was some homeowner resistance to this, so
lenders lobbied congress and the Garn-St. Germain bill was passed into law.
DUE ON SALE
This law allows lenders to create mortgages with “due on sale” power. That
means that most all mortgages created in the last 20 years allow the lender to
demand that their loan be paid in full when a mortgaged home is sold.
Prior to the Garn-St. Germain law investors could find motivated home
sellers, have the seller carry back most of their equity in a promissory note
secured by a 2nd mortgage…. and assume the existing first mortgage loan. The
assumption process consisted of little more than notifying the lender of the name
of the new person responsible for the loan and its payments.
That is where the popular notion of “no money down” real estate investing
was born. It was much easier to profitably buy investment homes under those
conditions. When due-on-sale entered the picture new tactics were called for.
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“SUBJECT TO”
“Subject to” means taking title to a property and leaving the existing
mortgage loan(s) in place.
Example: The Browns buy a home. They pay $20,000 as a down payment
and arrange a mortgage loan of $100,000. Five years later they have an urgent
need to sell. The market value of the home is $135,000. The Browns now have
an equity of $40,000 in the home with a balance owing on their mortgage loan of
$95,000.
It’s a very slow real estate market. They have tried for over six months to
sell and have not found a buyer. Because of other circumstances they absolutely
must sell in the next 30 days.
Enter Mr. Pink, a real estate investor. He offers the Browns $5,000 cash
and will buy the home subject to the existing $95,000 mortgage loan.
Mr. Pink prepares a purchase agreement that carefully indicates that he is
buying the property “subject to” the loan that was arranged by the Browns. The
Browns sign the contract and they sign a deed transferring ownership to Mr. Pink.
Mr. Pink has now purchased $40,000 worth of equity for $5,000… AND he has the
leverage of a $95,000 loan that cost him no fees or points.
(If the Browns had been extremely motivated they might have agreed to
accept a $5,000 promissory note and payments from Mr. Pink. A no money down
deal.)
Wait a minute! Since the mortgage has due-on-sale power doesn’t Mr. Pink
have to come up with $95,000 to pay off the loan? Well, first of all neither the
Browns nor Mr. Pink are obligated to tell the lender about the transaction. There
apparently have been court cases that support that fact.
Secondly, even though the mortgage gives the lender the power to force a
pay off… it is the lender’s choice to use that power or not. While interest rates
are fairly stable lenders generally have no incentive to call loans due as long as
the monthly payments stay current.
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Investors considering buying property “subject to” existing loans should
understand that there is no law that requires them to pay off an existing loan when
they buy. There is no law that says the lender must be notified of a change of
ownership. And there is no law that says a lender MUST enforce a due-on-sale
clause. Responsibilities connected with due-on-sale are contractual and not
statutory (legal).
Generally lenders do not know when a property is sold. To have that
information they would have to monitor every deed recorded in every county in the
United States…. every day. Then they would have to match the names on those
deeds to the names of those who have received mortgage loans. At some point in
time technology may make that feasible, but not in the foreseeable future.
A situation that will cause lenders to be more attentive to changes in title will
be a substantial increase in interest rates. Good business practice would then
demand that corporate management serve the mortgage company’s shareholder’s
best interest by calling loans due and relending the money at higher rates.
Under normal conditions lenders are often very reluctant to call a loan due
that might result in a foreclosure. When a lender takes back a property either by
foreclosing or calling a note due, they are "punished" by the Federal government
for having a non-performing loan on the books.
A “called” loan is considered a bad debt. When this happens the
government will not allow the usual eight times the bad debt amount to be loaned
out by the institution. For example: Under our fractional banking system if a bank
has $100,000 of assets they can make loans totaling $800,000. A $100,000 non-
per-forming loan on the books will prevent the bank from loaning $800,000 and
earning the subsequent profit from fees and interest.
One of the disclosures on an FHA-insured loan requires that the lender
contact HUD for permission to foreclose a mortgage on a property that was
transferred without paying off the loan (subject to). There have been few such
cases reported as this is written.
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HOWEVER!
Every investor who buys “subject to” an existing loan must be prepared for
the lender to call that loan due -even if the odds say the lender will not. If the
lender called a loan due the investor’s first action might be to negotiate with that
lender. She might be able to formally assume the loan at the current interest rate
by paying an assumption fee of some amount. This could be an economically
sound move for the lender. The money would stay in place earning a market
interest rate and they would not have the cost of placing the loan with a new
borrower.
Or the investor could explain that they planned on selling the property within
the next month or two and would the lender hold any foreclosure action if they
kept the payments current. In other words, contact the lender’s loan mitigation
department and work out the best deal possible.
Another choice for the investor would be to find another lender. Every
experienced investor should have spent time developing a list of private lenders.
Someone on his list could be a source of short-term funds to pay off the existing
loan and give the investor time to find a retail buyer or a new conventional loan for
the property.
A last resort would be to allow the lender to begin a foreclosure action,
which usually takes about three months – depending on the law of the state.
During that time the investor could find a buyer, flip to another investor or arrange
new financing. A notice of default usually will not affect the original homeowner’s
credit score if no actual foreclosure sale takes place. It goes without saying that
the investor must always find a solution and not allow the home to be lost through
foreclosure.
Hope for the best, but plan for the worst and you will never be disappointed.
When the investor buys a property “subject to” existing financing the name
of the original borrower stays on the loan. That person is still responsible for the
loan. If the investor fails to make timely monthly payments the lender can
foreclose on the property and that foreclosure will appear on the original owner’s
credit history.
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At the time of purchase, the investor must not only carefully explain this to
the home seller, but must require the home seller to sign a document attesting to
the fact that the seller has been told and understands they remain liable for the
mortgage loan. This document will be essential in case a dispute should arise.
In explaining the use of “subject to” techniques many teachers stress that
the investor has the benefit of acquiring financing without any cost or responsibility
to pay back the mortgage loan. That’s true, but the investor has a very real moral
obligation to the home seller to make timely payments and pay off the loan as
soon as practical. If the payments are late or stop, it is the home seller’s financial
records that will suffer.
In buying “subject to” you make a promise to the home seller to keep the
payments current. That’s a promise you must make in your purchase contract to
persuade a homeowner to sell “subject to”. If you don’t keep that promise and the
home seller speaks to an attorney, things could become very uncomfortable for
you. Even though you protect yourself as much as possible with disclosure and
good documentation, courts will probably favor the home seller in any legal action
against you.
In this age of “instant wealth” promises from TV real estate gurus, it is very
likely that many partially educated investors will carelessly use “subject to” and
financially damage enough home sellers that at some point restrictive legislation
may be enacted. Don’t do “subject to” deals unless you are confident that you can
handle the mortgage payments… even if you can’t rent or sell the property as
quickly as you plan to. Have a backup plan!
Another consideration is that since the mortgage loan will continue to appear
as an obligation on the seller’s credit report it can make it difficult for the seller to
qualify for a new mortgage loan if they attempt to buy another home. You must
explain this to the home seller when you buy.
So the question is "Can the seller get another loan?" The short answer is
"yes". This assumes the seller could typically qualify if they were not going to
leave their loan behind. Here’s how you can explain the situation to a seller:
Ordinary Rental -If the seller doesn't sell the house and plans to move, the
seller will be forced to either lose the property or lease the property.
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If the seller finds a renter to occupy the property, the seller's loan will still be
in place just like in a “subject to” deal.
Most lenders will look at rental income from a lease and give the seller a
75% income credit toward their debt ratios in the new loan qualifying process.
For an example, assume the seller has a payment of $750 on his existing
mortgage loan (the one you are taking “subject to”). His tenant is paying a $1,000
monthly lease payment.
The lender will include 75% of that $1,000 rental payment, or $750, as part
of the seller’s qualifying income, which will help offset the underlying debt payment
of $750.
Even if the rent were only $750, the 75% rental income credit would equate
to $562.50, against the monthly payment of $750. The $187.50 difference is
usually not enough to disqualify the seller from getting the new loan.
So, regardless of whether you plan on acquiring the property “subject to”,
with a lease option or some other form of creative financing where the existing
loan stays in place (lease/option), the worst case scenario should be that the new
lender treats the property as if it's a rental.
“Subject to” deals are not familiar to many in the real estate industry. Many
of these deals don’t have a "traditional" type of document that clearly ratifies the
purchase. Depending on the language in the purchase agreement, this may or
may not be a problem.
If your purchase agreement states clearly that you (buyer/investor) have
agreed to make the payments on the existing loan, your seller can submit that
agreement to a new lender. That may be all that is needed to satisfy the lender
and get the new loan application approved.
If the lender wants more evidence of a proper sale fill out a HUD-1
Settlement Statement. Even though you do that yourself it does give evidence
that a sale took place. If your deal is being closed through an escrow company
they will have completed the HUD-1 form. Check the “resource” page at
ThePowerLetter.com for a service that offers easy creation of HUD-1 forms.
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The truth is that there is almost always some lender who will make the loan.
But it may not be the first two or three lenders contacted. You should impress
upon the seller that they must find a loan broker who will spend the time looking
for an agreeable lender. A good loan broker will do that to earn their commission.
Example: The authors found a financially distressed homeowner who was
behind with mortgage payments, but a foreclosure notice had not yet been filed on
his home. He did not have enough cash to make up the back payments, but did
have enough money to move to another state and to pay us $1,000 to buy his
home. (There was little equity in the home, so we required the $1,000 payment to
make the deal feasible.)
We carefully explained and documented that we were buying ‘subject to’ his
existing mortgage loan. We laid out all the details – that his name would remain
on the loan and that his credit history would suffer if we failed to keep payments
current. We added that he might have to expend extra effort to get a new
mortgage loan if he were to try and buy a new home. This is all just good investor
disclosure.
When we buy “subject to” our plan is to quickly sell to a retail buyer through
a lease-option with a term of one to three years. When the renter/buyer exercises
the option she would buy the home with new financing and that would clear the old
loan from the original home seller’s credit history. We explain this to all sellers.
This family sold us their home in Arizona and moved to Minnesota. A few
months later we received a call from a Minnesota real estate agent explaining he
was the home seller’s uncle. He said he was representing the sellers and they
now wanted to buy a home and what had we done to them, because they were
refused a mortgage loan? He had never heard of “subject to” and was sure it was
some illegal scam.
We patiently explained exactly what had transpired. That we had saved the
family from foreclosure and had completely disclosed all the benefits and
shortcomings of the transaction… and we had the signed documents to prove it.
We told the agent to start calling every loan broker in the phone book and the
chances were good he would contact one who was willing to spend the time to
find a lender. He said he was recommending that his relative talk to an attorney.
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A few days later we received a call from the home seller. We always strive
to build a good relationship with everyone we deal with and this case was no
exception. The family was desperate when we found them and grateful when we
solved their problem.
The seller said that he was aware of his situation and had no intention of
seeing an attorney. He went on to say that he had called every loan broker he
could find and no one wanted to work with him… did we have any suggestions?
After hanging up the phone we visited two of the real estate forums easily
found on the Internet and asked if anyone knew of a broker or lender who could
help our seller. Within an hour we had a response from a loan broker who said
she could find him mortgage money as long as there were no other serious credit
problems in his financial history. We put the seller in touch with the loan broker
and the deal was done.
(Postscript: We later learned that this family filed for bankruptcy shortly after we
helped them find a loan. It’s a shame, but leopards don’t change their spots.)
“SUBJECT TO” DETAILS
Yes, “subject to” is a powerful tool for real estate investors, but it must be
used carefully to protect all parties.
In the purchase contract be sure there is a clause that reads something like:
Buyer is purchasing property SUBJECT TO the existing mortgage loan(s). Buyer
agrees to make all loan payments beginning on _________ and there after until
and unless loan is paid in full. Seller acknowledges that the existing mortgage
loan will not be replaced with new financing by the buyer and that seller’s name
will remain on the existing mortgage loan and any default in the terms of payment
of that loan will likely appear on and effect the seller’s credit history and the seller
could be held responsible for the loan. This document and accompanying materials are designed to provide authoritative information in regard to the subject matter covered in it. It is for illustration purposes only and presented with the understanding that the author and publisher are not engaged in rendering legal, accounting or other professional opinions. If legal advice or other expert assistance is required, the services of a competent professional should be sought. |
