Are you a buyer looking to purchase a property using creative financing but are unsure about how to structure the transaction? Then this article is for you. How to structure the transaction will depend on many factors, including what you are looking to accomplish. This blog will discuss three main ways to structure a creative finance transaction.
Creative financing refers to when a buyer acquires a full, partial or long-term possessory interest in real property without using the buyer’s personal cash or obtaining a traditional mortgage loan. A type of financing that is commonly used in these transactions is known as seller carryback financing. Rather than the buyer obtaining a traditional loan, the seller acts as the lender. Seller carryback financing can be used for transactions where the property is owned free and clear, as well as “subject to” transactions. For subject to transactions, the buyer will acquire an interest in the real property with the seller’s existing loans remaining in place and not being paid off through the closing. The buyer’s monthly payments will include the amount of the monthly payments required to be paid to the seller’s lender.
The two main creative finance structures are: (1) warranty deed purchase with the seller being provided a promissory note secured by a deed of trust or mortgage against the property, or (2) an agreement for sale, which is also known as a land contract, installment contract, or contract for deed. Although it does not technically involve financing, a lease with an option to purchase can also be an effective way of obtaining an interest in real estate with little to no money out of pocket.
Warranty Deed Purchase
This structure is what most people think of when purchasing a home: the buyer will pay the seller for title to the property and the seller will provide the title through a warranty deed. This is generally the preferred method of acquiring property through seller financing.
When the property is owned free and clear, the documents required for a seller financing transaction are: (1) purchase contract with a seller financing addendum; (2) warranty deed from seller conveying the property to the buyer; (3) promissory note for the amount and terms of the seller financing in favor of seller; and a (4) deed of trust/mortgage in favor of seller that will secure the repayment of the promissory note.
For a subject to transaction, the documents needed for the seller financing transaction (aka “wrap financing”) are: (1) purchase contract; (2) Wrap/subject to financing addendum; (3) warranty deed from seller conveying the property to the buyer (4) promissory note for the amount and terms of the seller/wrap financing in favor of seller; and (5) deed of trust or mortgage in favor of the seller that will secure the payment of all amounts under the promissory note. The wrap/subject to financing addendum will fully disclose the seller carryback financing terms and the nature of the transaction, including information about the existing loans that the buyer will be taking “subject to”. The wrap/subject to financing addendum will be one of the most important documents that is prepared for this type of transaction and should be carefully prepared. There are certain provisions that should be listed, including that the seller will still be liable on the existing loans as well as certain representations, warranties, and acknowledgements from both the seller and buyer.
What happens if the buyer fails to make payments under this type of transaction? The deed of trust or mortgage will be recorded against the property, which gives seller all the rights of a second position lender. The seller will be able to keep the existing loans current and initiate a foreclosure of the property, which, when completed, will terminate the buyer’s interest.
Agreement for Sale
An agreement for sale is also known as a contract for deed or land installment contract. It is an executory contract in which the buyer does not receive legal title to the real property but is given possession of and all other rights regarding the real property in exchange for agreeing to make future payments to the seller. The seller agrees to provide buyer with legal title to the real property upon buyer’s full payment of the amounts set forth in the agreement for sale.
An agreement for sale is often used when (1) title issues need to be resolved, (2) there is a pending divorce of the seller or the buyer, (3) the parties are concerned about the Due on Sale Clause found with the existing loans, (4) the parties are waiting for liens from grants to fall off, or (5) there is pending litigation concerning the property. An agreement for sale can be used for properties that are owned free and clear by the seller, or for properties with an existing loan, just like the warranty deed purchases.
When a property is owned free and clear, the only document needed is an Agreement for Sale, which includes terms such as the purchase price, initial payment amount, terms of the seller financing (interest rate, amortization, monthly payment amount, maturity date), and the identity of the account servicing agent (highly recommended). If there are existing loans that will not be paid off (a “subject to” transaction), the documents required are an Agreement for Sale and Subject To Addendum. The Subject To Addendum will be very similar to the Wrap Financing Addendum, with some changes to properly reflect the realities of the Agreement for Sale transaction.
Unlike the warranty deed purchase, an agreement for sale, in Arizona, has different time frames for when the seller can terminate the purchaser’s interest in the real property if the purchaser stops paying as agreed: if there has been paid less than 20% of the purchase price, 30 days; if there has been paid 20% or more, but less than 30% of the purchase price, 60 days; if there has been paid 30% or more but less than 50% of the purchase price, 120 days; and, if there has been paid 50% or more of the purchase price, 9 months.
Lease with Option to Purchase
Another structure for acquiring possessory and equitable interest in real property is using a lease with an option to purchase, which is a hybrid real estate arrangement combining elements of a traditional lease and a purchase agreement. This type of contract provides tenants the opportunity to rent a property for a specified period while providing the tenant with the option to purchase the real property property at a later date.
A lease with option to purchase is often used when (1) title issues need to be resolved, (2) there is a pending divorce of the seller or the buyer, (3) the parties are concerned about the Due on Sale Clause found with the existing loans, (4) the parties are waiting for liens from grants to fall off, or (5) the seller needs the lease to qualify for future financing.
For this type of acquisition structure, you will need (1) a residential lease (with an addendum giving the tenant greater control over the property than normal) and (2) an option agreement.
The lease should be thorough and include the following key provisions: tenant’s ability to change locks and make alterations on the property; a limited role of the landlord for maintenance, repairs and upkeep of the property (with statutory disclosures regarding the same); and, the appointment of a property manager or licensed servicer to collect rent and make payments on the existing loans.
The option to purchase should contain the following provisions: the purchase price; close of escrow date, amount of the option fee; that the buyer can record a memorandum of the option; and that full performance under the lease is a prerequisite to the buyer exercising the option. In other words, the buyer must be making the rent payments and performing their obligations under the lease in order to exercise the right to purchase the property.
What if the buyer fails to make rent payments? If the buyer fails to make rent payments under the lease, the landlord can initiate an eviction action.
If you have any questions about the different structures for creative financing or the acquisition of an interest in real property using a lease with an option to purchase, reach out to one of our knowledgeable real estate attorneys for a consultation.