How To Profit In Land Contracts - Part 1 HOW TO BE A SUCCESSFUL REAL ESTATE INVESTOR
In this manual we will be talking about the tools that can help you make money in real estate. These are powerful tools and you must take the time to learn how to use them effectively. Please don't feel they are beyond your capacity to learn. They only seem complex at first. Once you understand the techniques you just do the same profitable transaction over and over again.
Understand that these techniques only work with truly motivated sellers. There are plenty of those. If you have been watching you know that zero to 5% down payment loans are easy to get. Some lenders offer to refinance homes for up to 125% of value.
Tens of thousands of people fall for these easy money traps and end up being unable to make the monthly payments on those high balance loans. There's your market!
You can help these home owners get out from under those unmanageable debts by using land trust and land contracts. You can even make money by buying property that has no equity.
No equity properties can be a real gold mine for you, because most other investors just don't know how to make profitable deals out of them. Read on and you'll learn how to do it.
Mortgages and Due On Sale
Almost all home mortgages that have been created in the last twenty or so years contain a "due on sale" clause. This means that if the mortgaged property is sold the mortgage contract requires that the existing loan must be paid in full at the time of the sale. This can present a single family home investor with a challenge.
Years ago just about every home loan could be "assumed" by a buyer for a small fee and no qualifying. "Assume" means that the investor could simply take over any existing financing on the property. This was a very profitable time for the small real estate investor. There were no qualifying requirements, points or loan fees and often the loan’s interest rate would be lower than available new financing. It was easy for the knowledgeable investor to buy profitable rental homes.
It was during this time that the concept of "no money down" became popular. A buyer could find a motivated seller, convince her to carry-back her equity in the form of a second mortgage and then take over the existing first mortgage. Shazam – no money down!
The key was to structure the deal so that the total of the payments on the first mortgage and the owner carry-back second loan would be less than the investor could collect in rent. If the investor failed to do that he was said to have bought an "alligator". An alligator is a property that would eat money out of his pocket. During this period that nasty reptile devoured more than one enthusiastic, but only partially educated investor.
Many mortgages now being placed can be assumed when the property is sold, but the buyer must qualify and pay fees just as if she were getting new financing. This is not an acceptable situation for the serious investor.
The wise investor targets single family homes as the instrument that will bring him financial independence. You must accumulate a portfolio of three to fifteen rental homes to reach your objective. To do that you must be able to buy homes without the expense of new financing and, even more importantly, without having to qualify for loans.
Does the investor have an alternative? Yes, because there are rules and there is practice. The due on sale rule says loans must be paid when property is sold, but in practice lenders very seldom enforce the rule! That is your opportunity alert.
The due on sale clause was included in real estate notes to protect the lender from wild swings in interest rates. If they had originally lent the money at 6% and rates were now at 12%, for example, they wanted a pay-off so they could reinvest the money at the higher rate.
During periods when there is little change in interest rates it is rare that a lender will call a loan due when the property is sold. There are probably two reasons for this. First, it is cheaper to leave the loan in place rather then demand payment and find a new borrower for the money.
Second, most loans are managed by loan servicing companies. Lenders have learned that is cheaper to pay a company that specializes in nothing but managing the collection and accounting of loan payments than to do it them selves.
Loan servicing companies are basically just buildings full of computers and clerks. As long as the loan payments come in on time no alarms are set off and no one seems to have any interest in who is making the loan payments. Why should they? The whole idea is to service the loans as economically as possible and doing more than just watching for late payments would surely add to the expensive of the operation.
If there were a substantial increase in interest rates lenders would more closely scrutinize their existing loans. They would watch for things like changes in insurance beneficiaries. That could signal them the lender that someone other than the original borrower was making payments on the loan. Until there is a meaningful raise in interest rates lenders don’t seem very interested in calling loans due.
The aggressive investor is aware of the situation and is willing to buy property "subject to" the existing financing. "Subject to" are the words used in a purchase offer to inform the home seller of the buyer’s intention to continue making payments on the existing loan(s) after taking title.
The buyer does not plan on getting new financing and paying off those loans. Yes, the buyer knows there is a chance the lender will learn of the sale and insist that he pay off the loan. The buyer/investor is willing to take that risk in order to build his portfolio of rental properties.
Nationally syndicated real estate columnist Robert Bruss mentioned in one of his columns that he often buys single family investment homes subject to the existing financing. It is a common practice among experienced investors.
If the lender did for some reason call the loan due you, as the buyer, might negotiate with the lender and pay a fee to keep the loan in place. Or you could get new financing and pay off the loan. This would be sensible if you had held the property for a few years and had built some equity. Or you could stall the lender and sell the property.
When you buy a property subject to existing financing the seller’s responsibility for the loan continues until it is paid off. If the lender called the loan due and you just walked away the lender would look to the seller for satisfaction. No ethical investor would ever do that. Anyone who buys property "subject to" must be prepared to be responsible for that financing, because it is the right and moral thing to do.
Understand that there is no law that says you cannot buy property subject to the existing financing. It is NOT a criminal act. Congress did create a law that says lenders have the right to call the loan due if they choose to! The truth is that you will be hard pressed to find a situation where a loan was called due when all the payments were current.
No special paperwork is necessary when buying subject to. It is just written into the purchase agreement that the buyer will buy the property subject to the existing mortgage loan. The bottom line is that the due on sale clause is not an insurmountable barrier to the aggressive investor. There’s more.
You can be very successful investing in real estate by using land contracts and land trusts when purchasing property subject to current financing. Plus, you can not only actually buy property with no down payment, but you can even profit from property that has little or no equity - property that most other investors won't even consider. No equity properties can provide you with a very lucrative income.
Land Contracts
Land Contracts, Contract for Sale, Contract for Deed, Installment Contract, Conditional Sales Contracts, Agreements of Sale, Installment Land Contracts; it’s called by different names, but it is the same thing. It is a binding agreement between a person who is selling a property (Seller or Vendor) and the person who is buying the property (Purchaser or Vendee).
Under a Land Contact a property is sold much like a conventional sale, but the seller is financing the sale and holds the deed until the buyer has paid for the property. This is usually done with monthly payments. Holding the deed gives the seller more control than he would have with a conventional sale.
Land contracts are often used to sell either a problem property or to sell to a buyer with bad credit and a poor financial history. Using the land contract strategy provides a quick and inexpensive way to sell a property without the rigid guidelines, hassles, expenses and delays associated with conventional financing. The contract provides the Seller with monthly (usually) income and a better than average rate of interest and the Buyer with a property she could not otherwise obtain.
Land Contracts can be a sensible way to sell property and are valid in all states. In essence the Seller is financing the Buyer's purchase.
Although Land Contracts are relatively simple documents each state has its own laws and intricacies. You must have the help of a real estate attorney in creating the contract, at least for the first time.
Not all contracts will follow the same order, but general they contain:
Parties to the Contract
Legal Description of Property
Price and Terms of Payment,
Purchaser’s Obligations
Taxes and Insurance
Seller’ Right to Mortgage
Seller’s Obligations
Assignment of the Contract
Miscellaneous Provisions
Notarized (optional) Signatures.
The contract begins with the parties who are entering into the contract. The Seller is often listed first and then the name of the Buyer. The date of the contract appears near the top and that is important because that is the date that interest will begin to accrue. Consequently, when the first payment is due, one month's interest is usually already owed, since it is paid in arrears.
The Seller agrees to convey to the Buyer a carefully described parcel of land. This description must be exact. When the purchase is completed and paid off, this should match the description on the deed. The city, village or township of the property is noted, together with the county and state.
Along with the actual land sold, the Seller also conveys such things as any buildings, easements, tenements, improvements and appurtenances. In other words, everything that is attached to the property just as in a more conventional sale.
The contract must exhibit in detail the total purchase price, down payment, beginning balance of the amount due (purchase price less down payment), the interest rate, date of any balloon payment and date that the first payment is due.
Properties sold on a Land Contract often sell for more than comparable properties, because the Seller provides the financing to a Buyer who may not be able to qualify for conventional financing.
The down payment can be any amount but usually falls between 5% and 20% of the purchase price. From the standpoint of the Seller, the bigger the down payment the better. It represents money that does not have to be collected in the uncertain future and it also represents the Buyer's commitment to the property. The more the buyer has invested in the property the less likely he will default.
The monthly payment can be any amount based on amortization of the Buyer's financial obligation over any period of years, although 30 years is normal.
The contract may include an acceleration clause (balloon payment) that reads "The remaining balance due must be fully paid within five years from the date hereof." If the Buyer fails to make that payment he is in default.
A Seller might use the acceleration clause to give the Buyer a few years to get his credit cleaned up. Buyer then would be able to qualify for financing to pay off the Seller and receive the deed. This would allow the Seller to take his profit and find another investment.
Remember the Seller must continue to make payments on any loans that were against the property when he bought it "subject to". The payments made by the Buyer under the Land Contract must cover those payments and should provide some positive cash flow to the Seller.
A grace period in the contract permits the Buyer to be a few days late with a payment and not be in default. A contract should call for a penalty if the payment is received after that period.
The interest on Land Contract financing is usually stated in annual terms (11%). The Land Contract financing is amortized just like a conventional loan with a portion of each payment going towards principal and interest.
The person responsible for making tax and insurance payments can vary depending on the terms of the Land Contract.
The three most common ways to handle the payments of taxes and insurance are:
1. The Buyer pays taxes and insurance.
2. The Seller pays taxes and insurance, but then adds the amount he pays back to the balance on the contract.
3. The Buyer makes monthly contributions to an escrow account held by the Seller (or a neutral party) and the Seller (or neutral party) makes those payments.
NUMBER ONE
Most often the Buyer is responsible for paying the taxes and insurance on the property. A clause in a Land Contract where the Buyer makes those payments might be:
"The Buyer agrees to pay all taxes and assessments hereafter levied upon said premises before any penalty for non-payment attaches thereto and submit receipts to Seller upon request as evidence of payment thereof; also at all times keep the buildings now or hereafter on the premises insured against loss and damage in a manner to an amount approved by the Seller and to deliver the policies as issued by the Seller and to deliver the policies as issued to the Seller with the premiums fully paid."
NUMBER TWO
Since failure to pay either the tax or the insurance can seriously jeopardize the value of the property securing the Land Contract (what's it worth of the home burns to the ground?) some Sellers insist on paying the tax and insurance themselves. After paying those bills the Seller just adds the costs of them back onto the balance of the Land Contract. Contracts of this type are sometimes referred to as "Add Backs".
In that case one-twelfth of the estimated taxes and insurance will be added to each payment. These larger payments are treated just as if the entire amount of each payment was for principal and interest. This makes the balance on the contract drop more quickly, but when the Seller pays the taxes and insurance he adds the amounts spent to the balance due on the land contract. The balance on the land contract, after having been reduced each month by the greater amount is re-adjusted upward when the amount paid for taxes and insurance are added back to the contract balance.
The contract clause might read like this:
"The Buyer is to pay monthly, in addition to the monthly payment hereinbefore stipulated, the sum of $________, which is an estimate of the monthly cost of taxes, special assessments, and insurance premiums, which shall be credited by the Seller on the unpaid principal balance owed on the contract. If Buyer is not in default under the terms of the contract, Seller shall pay for Buyer's account the taxes, special assessments and insurance premiums mentioned above when due and before any penalty attaches, and submit receipts therefore to Buyer upon demand. The amounts so paid shall be added to the principal balance of this contract."
NUMBER THREE
A third way to have taxes and insurance handled, similar to the above way is for the Buyer to pay approximately one-twelfth of the estimated taxes and insurance along with each monthly payment. The Seller then sets this extra part of the payment aside each month into an "escrow account" to pay the bills as they come due.
If there is not enough money in the escrow account the Seller notifies the Buyer and a larger payment is included along with the next monthly payment. The contract clause could be like:
"The Buyer agrees to pay monthly, in addition to the monthly payment hereinbefore stipulated, the of $______________, which is an estimate of the monthly cost of taxes, assessments, and insurance premiums, which shall be deposited in a non-interest bearing account."
It is the Buyers duty to protect the value of the property he or she is buying until it is paid in full. There must be a clause in the contract that requires that of the Buyer. The value of the property is what keeps the Buyer making payments. If the Buyer ever defaults and suffers foreclosure, it is the value of the property that should enable the Seller to re-sell the property without a financial loss.
Most contracts require the Buyer to notify the Seller in writing before the Buyer or any third party commits waste (neglects the property or allows it to be used in a way that lessens its value) or removes, changes or demolishes any buildings or improvements on the premises in a way which may diminish the property's value.
After the Buyer makes the final payment on the contract without default, the Seller must convey title to the property by signing a Deed to the property.
At the time of deliver of the Deed, the Seller often also delivers an abstract of title or a policy of title insurance showing that the property is free and clear from any lien that the Seller may have remaining on the property. Who will pay for the title insurance should be agreed upon when the land contract is created.
It is the Buyer's responsibility to record the Deed after making the final payment. The fee is nominal and recording will show, as a matter of public record, that the Buyer is the new owner of the property.
The Seller has the right to borrow against his remaining equity in a property sold with a Land Contract. If a Seller owned an $80,000 free and clear property and sold it to a Buyer for $10,000 down, the Seller could borrow $70,000. The loan would be secured with a mortgage on the property. (If a lender would make that loan.) The mortgage lien would have priority over the Land Contract.
Seller must always be in a position to convey a Deed to the property to the Buyer should the Buyer prepay the total amount owing. So the Seller should never owe someone else more than the Buyer owes him.
To protect the Buyer the Seller should provide notice of any subsequent mortgage and its terms in a certified letter to the Buyer. The Buyer has the right to make the payments for the Seller on any debt for which the Seller is in default. Such payments made by the Buyer will be deducted from the monthly payment owed Seller. Law covering this situation varies from state to state.
Again, Seller should never owe more on the property than the Buyer owes him. In some states there is a law that makes it illegal.
Unless the contract says otherwise the Seller has the right to freely assign his interest in the Land Contract to a third party.
The Buyer may have the right to assign his or her interest in the contract only after obtaining written permission from the Seller.
This protection for the Seller exists because the Seller may have sold the property to the Buyer on the strength of the Buyer's character, time on job or credit rating, among other things. If the Buyer then proposes that a new person is to become primarily responsible for making the payments to the Seller, the Seller has the right to know and approve of the change.
Such an assignment by the Buyer to a new party may not release the original Buyer from the obligation to perform under the contract if the new party fails to live up to the terms of the original contract.
If the Buyer fails to perform any significant part of the contract, the Seller may have the right, after notifying the Buyer in writing of the exact nature of the default, to treat all payments already made on the contract as mere rental payments made by the Buyer.
Some states have very specific guidelines regarding default, so be sure and check with your attorney for details. If the default continues, the Seller can begin steps to regain possession of the property. Improvements made to the property by the Buyer then become the Seller’s property.
Default by the Buyer may include failure to make timely payments, failure to maintain the property, failure to adequately insure the property or failure to pay taxes as they become due.
All contracts have a series of miscellaneous provisions regarding where payments and notices should be mailed, which state laws govern the contract and so forth. The provisions in a standard pre-printed land contract are not nearly as important as any typed (or hand written) provisions. Read and enforce these provisions carefully.
To have a contract that can be recorded in the county records where the property is located, be sure to have the contract notarized. You can record the contract, but a better choice would be to record a Memorandum of Land Contract. This is an official notice that a Land Contract is connected to the property, but does not reveal the details of the contract.
No one can attempt to sell or encumber the property without both parties being alerted if the memorandum has been recorded.
(In the technique we describe later you will not want the land contract recorded in any form, so do not allow it to be notarized.) 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. |
