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Just curious...

I spoke with two different people recently. Both were female but both were married and largely talking for the couple as a unit. Both cases the couple was retired.

At some point in the past each couple had sold a property of some sort. For what ever reason at the time they decided to provide seller-financing to the buyer.

The comment made by both was something along the lines of...

"I am getting 8% interest and that is a lot better then the alternatives."

Any views as to if 8% is a good return for a secured investment? Yes, I know the security for the investment is something they owned before. I am just curious as to how other fools would respond/react to 8%. These ladies really like the return.

John
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When looking at other fixed income investments currently available, 8% sounds pretty good to me. With money market funds at about 1%, CD's up to 3 years at less than 2%, government securities at 5% or so, you would have to go into high yield junk bonds to get that kind of yield.
As a rate of return it's good. The question is whether one wants to be a lender on residential property and its potential problems.

Bob
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activeREinvestor asks,

Just curious...

I spoke with two different people recently. Both were female but both were married and largely talking for the couple as a unit. Both cases the couple was retired.

At some point in the past each couple had sold a property of some sort. For what ever reason at the time they decided to provide seller-financing to the buyer.

The comment made by both was something along the lines of...

"I am getting 8% interest and that is a lot better then the alternatives."


Since someone with average credit can get a mortgage for 5% or 6%, how far down the deadbeat scale do you have to go to find a buyer that thinks 8% is attractive?

intercst
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"I am getting 8% interest and that is a lot better then the alternatives."

For fixed-income investments, this is a very good rate! Today one can get a mortgage for ... (consulting bankrate.com) 30-year FRM@5.92%, 15-year FRM@5.25%. These are with good credit ratings.

Depending on when those mortgage were taken out, 8% could have been the going rate (e.g., around February-June 2000). If the buyers had good credit, they can refinance at the current rates and then the sellers would have the same poblems as other collateralized mortgage obligation investors: having the "bond" called and now have a bunch of cash with no where to invest at such attractive rates. If the buyers can't refinance at a lower rate, it would have been because of poor credit, which means the sellers are taking on risks for carrying those mortgages.

So, while 8% sounds attractive in light of today's rates, they are far from a "free lunch".
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intercst writes:

Since someone with average credit can get a mortgage for 5% or 6%, how far down the deadbeat scale do you have to go to find a buyer that thinks 8% is attractive?

The original poster does not know what type of property was seller-financed. 8% is currently about market for unimproverd land which can nor be financed at the preferable rates available for umproved properties. Also, sellers who finance can frequently achieve both a jigher sales price and a higher interest rate because the buyer does not have to pay points or deal with the other inumerable fees associated with obtaining conventional financing.

I love to finance sales of raw land. I sell the property using a land cantract (contract for deed) and I carry the note with a small down payment and interest rate from 8-10%. The buyer does not get a deed until I get paid. Since I buy the property wholesale by finding a bargain or by creating value through subdividing, and can get a superior resale price by providing soft terms, I can frequently realize a yield on the note thus created of 10-25%. I essentially create my own discounted notes. If the buyer defaults, I get the property back, get to keep the original down payment and all payments already made and I get to sell the property again. 8% is good. 15-25% is better.

Regards,
FMO
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CABob writes:

As a rate of return it's good. The question is whether one wants to be a lender on residential property and its potential problems.

Who said it was improved residential property? Owner financing is much more common with raw land. Banks do not provide as favorable terms for land because it generates no income (usually) and is more difficult to appraise and sell.

Regards,
FMO
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Depending on when those mortgage were taken out, 8% could have been the going rate (e.g., around February-June 2000). If the buyers had good credit, they can refinance at the current rates and then the sellers would have the same poblems as other collateralized mortgage obligation investors: having the "bond" called and now have a bunch of cash with no where to invest at such attractive rates. If the buyers can't refinance at a lower rate, it would have been because of poor credit, which means the sellers are taking on risks for carrying those mortgages.

Or, it's possible that the buyers aren't very savvy. Or, they may have gotten 100% financing from the sellers and the properties have not appreciated to the point where pmi wouldn't be required.

Or, they're not planning on staying in the house for more than a couple more years. Which brings me to a question. If the buyers decide they want to move, whose problem does this become? Do the buyers have the same latitude to list and sell the residence as a person financed by a bank? Would the previous seller attend the closing or be the "invisible" third party with the payoff obtained by the title company as a corporate lender would be? Does the present buyer-cum-seller have the option of doing an FSBO and would the previous seller have any say/stake in how the sale was handled, e.g requiring a title company or attorney closing?

just curious
3MM
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Who said it was improved residential property? Owner financing is much more common with raw land. Banks do not provide as favorable terms for land because it generates no income (usually) and is more difficult to appraise and sell.

One more wrinkle. Due to FDICIA, banks cannot lend more than 65% max on the appraised value of the land without having to put it on a list supplied to the regulators each time they come calling for an examination. If the land isn't utilized/improved within a certain amount of time, most banks will consider this speculation and rarely are interested.

3MM
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If the buyers decide they want to move, whose problem does this become?

It would be prudent for the original seller to have filed the note against the property at the place where the title is filed (usually the county seat) so that every time the title is pulled the note will be pulled with it. Typically one wants the clause in the note that the balance of the note is payable in full upon sale of the property. (That is how most mortgages are written.) If the note is payable in full when the property is sold, then buyer 1 (seller in this new transaction) would have to come up with enough cash, which typically means that even if buyer 2 wants owner financing, enough cash would still have to be provided so the closing agent can distribute the loan balance to the original seller. The cash for the original seller could come from buyer 2 or a loan that buyer 2 comes up with (which could be from other cash from buyer 1 that buyer 1 agrees to loan to buyer 2 but is used to pay off the original seller). It is even possible that the original seller could negotiate terms for buyer 2, but at today's rates it is unlikely that the original seller would be able to get 8%. It is up to the closing agent to see that the ultimate distribution of funds and title filing are taken care of once all the conditions are met.

Now if the seller did not have a note filed against the title of the property, or if the note did not state that the loan balance is payable on full on sale of the property, the loan becomes an unsecured loan on sale of the property to buyer 2 since the collateral will no longer be owned by the buyer 1, and that makes the loan a lot riskier.

Titles, notes, and property are all local issues, which means the details can vary between states. A real estate lawyer that practices in the state where the property is located can make sure all the t's are crossed and all the i's are dotted.
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Bob,

Thanks for the reply. You wrote:

As a rate of return it's good. The question is whether one wants to be a lender on residential property and its potential problems.

What problems do you see? I can make up my list but I want to hear what you would list.

Thanks in advance,
John
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Intercst,

Since someone with average credit can get a mortgage for 5% or 6%, how far down the deadbeat scale do you have to go to find a buyer that thinks 8% is attractive?

Lets try to be a little bit kind.

Mostly we are dealing with people who rent. What are their credit issues?

Well, the obvious ones like getting out of control with a credit card. Then again these are not the ones normally trying to buy a house.

Categories that do apply...

Divorce - some divorces are rather nasty. Sometimes the person was responsible for the divorce and sometimes they were taken for a ride.

Medical - they might have be just as good a person WRT to bill payments as you. They an accident happens, major illness, on the job issues, etc. Some people really get nailed when suddenly facing 100K and the death of a child after 2-3 years of medical issues. These people want to get on with their life and would like a house prior to waiting 7-10 years for the credit report improves. Something like their living child would do better in a different school district so they want to move now.

As an investor...You are taking a calculated risk. Similar to owning the property and renting to them but without the management issues. Definitely more difficult to foreclose then if it was a rental and you were only evicting. Larger deposits then 1st & last months rent.

I just do not see all of them as deadbeats when I rent to folks. Hence I might consider being a lender (I have not done this yet).

John
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Any views as to if 8% is a good return for a secured investment?

There are plenty of corporate bonds paying 8% secured by the company's assets. The question both corporate bondholders and your seller financing friends have to ask is: "Does the 8% return compensate me for the risk I'm assuming?"

It's impossible to answer that question without knowing the risk profiles of the transactions. But there are certainly risks involved, including default risk (it could take a lot of time and money to reacquire the property and evict the occupants if they stop making payments; if the property is damaged then abandoned, the seller may also be out of luck) and interest rate risk (what if rates/inflation skyrocket, but the seller is stuck with an 8% note for 30 years?)

And with other investments you can diversify; here a good bit of the seller's wealth may be locked in a single income stream.

Nick
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Mark,

Good points.

We are definitely not talking about A quality credit risk in such cases. There needs to be a higher rate of return as there could be a default.

Is the spread between 2% as a bank and 8% for a private mortgage more than compensating? If the LTV on the loan is low enough the equity in the property provides added protection or added profits in a foreclosure.

On the issue or early pay-off, if you are buying at a discount to par then an early payoff will increase the overall return rather then the risks CMO investors are taking (if they buy at par or above).

Side note: I buy and hold property for the long term gains. Hence I am comfortable with the risks of owning property and the potential market volatility. Property management is not fun so being the lender might have a good bit of the upside if the market goes flat or dips without the property management risks.

I have not bought notes before so no direct experience there.

John


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activeREinvestor writes,

Intercst,

Since someone with average credit can get a mortgage for 5% or 6%, how far down the deadbeat scale do you have to go to find a buyer that thinks 8% is attractive?

Lets try to be a little bit kind.

Mostly we are dealing with people who rent. What are their credit issues?


Heck, I'm a renter and I have an 820 FICO score. <grin>

intercst
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So maybe they would not all deadbeats.

John
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activeREinvestor writes,

<<Heck, I'm a renter and I have an 820 FICO score. >>

So maybe they would not all deadbeats.


That's true, but if I saw value in owning real estate, I wouldn't accept a mortgage at 8%.

intercst

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Is the spread between 2% as a bank and 8% for a private mortgage more than compensating?

Well, you can do better than 2%- banks will pay you 4% on a 5 year CD. Again, it depends on the risk profile. A definite drawback is the lack of diversification, assuming the sellers had much of their wealth in home equity, as most people do. I might be happy earning X% on a diversified fixed income portfolio, but if I had to invest all my wealth in a single income stream with a single duration and a single credit risk, I'd demand a higher return. Put another way: I'd demand a greater return on my 1st investment property than my 10th.

Nick
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Very true.

If you saw value in RE would you be a buyer of RE notes at 8% or higher?

John
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Interesting.

In effect you are saying that spreading the risk over say 10 notes with a blended rate would be more attractive. It figures when I think about it.

I suspect there is not much of this out there given the issues of securities law vs. real estate. If the notes are seperate and you build a portfolio then there are no restrictions.

Anyway, I get the point. Thanks for the post.

John
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FoolMeOnce:

<<<<Since someone with average credit can get a mortgage for 5% or 6%, how far down the deadbeat scale do you have to go to find a buyer that thinks 8% is attractive?>>>>

"The original poster does not know what type of property was seller-financed. 8% is currently about market for unimproverd land which can nor be financed at the preferable rates available for umproved properties. Also, sellers who finance can frequently achieve both a Higher sales price and a higher interest rate because the buyer does not have to pay points or deal with the other inumerable fees associated with obtaining conventional financing."

Agreed to all those things.

"I love to finance sales of raw land. I sell the property using a land contract (contract for deed) and I carry the note with a small down payment and interest rate from 8-10%. The buyer does not get a deed until I get paid. Since I buy the property wholesale by finding a bargain or by creating value through subdividing, and can get a superior resale price by providing soft terms, I can frequently realize a yield on the note thus created of 10-25%. I essentially create my own discounted notes. If the buyer defaults, I get the property back, get to keep the original down payment and all payments already made and I get to sell the property again. 8% is good. 15-25% is better."

If you truly selling on a contract for deed their is no note, there is only the contract, and the interest rate is implied (or imputed, if you prefer) in the cash price differential between the cash price you would accept and the payments required under the contract.

Regards, JAFO

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Are these 1st Trust or 2nd Trust Liens?
Either way, you look to the LTV for protection, but the cost/hassle of foreclosure on a 2nd trust is greater and merits a greater spread.

Yield Maintenance?
Can they payoff the 8% notes at anytime without prepayment penalties?
If so, 8% for two months, then getting cashed-out via refinance, may not be what the investor had in mind ... i.e. reinvestment risk. This would be particularly so, if the "above-market 8%" was compensation for a low price for the property, i.e. $100k @ 8% vs. $120k @ 5%.

Liquidity?
Property type and market descriptions are not disclosed. This is obviously a better deal for the investor if it is secured by a SFH in an active sales market than if its a land-locked parcel with no sales activity.

just a few thoughts ... 11
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activeREinvestor: "I spoke with two different people recently. Both were female but both were married and largely talking for the couple as a unit. Both cases the couple was retired.

At some point in the past each couple had sold a property of some sort. For what ever reason at the time they decided to provide seller-financing to the buyer.

The comment made by both was something along the lines of...

"I am getting 8% interest and that is a lot better then the alternatives."

Any views as to if 8% is a good return for a secured investment? Yes, I know the security for the investment is something they owned before. I am just curious as to how other fools would respond/react to 8%. These ladies really like the return."


We do not know whether these were improved or unimproved properties, or how big the note was in relation to total net worth (or at least investment assets) of the respective couples, which makes commentary diffiicult.

If the properties were improved properties, and especially as the face amount of the note is a larger percentage of net worth, any such couple needs to be concerned about (1) being too concentrated, in a relatively illiquid asset, and (2) bankruptcy risk associated with the buyer (especialy if the buyer has little skin in the game). If one does not have passing familiarity with the terms "automatic stay", "relief from stay", "not necessary for an effective reorganization" and "cramdown", then one might find not only that nice return, but a portion (or possibly all) of the principal amount at risk.

It is not a pretty sight if the buyer files bankruptcy and the sellers' had a large percentage of net worth represented by the note.

Regards, JAFO

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JAFO,

If one does not have passing familiarity with the terms "automatic stay", "relief from stay", "not necessary for an effective reorganization" and "cramdown", then one might find not only that nice return, but a portion (or possibly all) of the principal amount at risk.

I have heard the terms but maybe not in the context you mean.

1. Lets assume we are talking about improved property. A house. Further, assume the borrower put 10% cash into the deal.

2. What is the effect of the terms you raised? If the note was secured against the property and it was recorded 181 days prior to any bankruptcy, how is the position at risk?

I can understand that the payments would stop for a period. I also understand that the holder of the note would have to go to court to ask to the the note & property removed or otherwise dealt with outside the bankruptcy. Maybe I am missing something but I believe the lien is superior to the bankruptcy claim and therefore will be protected after you take the steps to foreclose outside of bankruptcy.

Not clean, in fact rather messy but not at risk in the same was as the other creditors. Correct?

Oh, I am ignoring FL and other states that have homestead exemptions. No comment either way about the impact of a homestead filing.

John
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Since someone with average credit can get a mortgage for 5% or 6%, how far down the deadbeat scale do you have to go to find a buyer that thinks 8% is attractive?

My question, too!

Couple that with the potential for problems down the road by being the lender yourself....

I don't think I'd want that headache as a retiree!

Vermonter
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activeREinvestor:

JAFO: "If one does not have passing familiarity with the terms "automatic stay", "relief from stay", "not necessary for an effective reorganization" and "cramdown", then one might find not only that nice return, but a portion (or possibly all) of the principal amount at risk."

"I have heard the terms but maybe not in the context you mean."

I suspect that you have.

"1. Lets assume we are talking about improved property. A house. Further, assume the borrower put 10% cash into the deal."

OK.

"2. What is the effect of the terms you raised? If the note was secured against the property and it was recorded 181 days prior to any bankruptcy, how is the position at risk?"

I am no bankruptcy expert (and to the extent I have any experience it is mostly with Chapter 13 business filings), but the bankruptcy filing stops any collection efforts (automatic stay)! The debtor has a 120 exclusive period for filing a plan. Unless the creditor wants to wait and see the plan, the only possible relief is to file a motion seeking relief from the stay, in which hearing the creditor must prove that the prperty is not necessary for an effective reorganization and that there is no equity in the property.

With respect to a personal bankruptcy and the home, I am not sure that condition one can ever be proven.

In addition, assume further that the real estate bubble burst and the 400k house for which the seller's took back a 360k note is now worth 350k. If the debtors can get one affected class to vote in favor of the plan, the plan can be approved and the nore restructured from its face terms against the wishes of the seller (cramdown).

"I can understand that the payments would stop for a period. I also understand that the holder of the note would have to go to court to ask to the the note & property removed or otherwise dealt with outside the bankruptcy. Maybe I am missing something but I believe the lien is superior to the bankruptcy claim and therefore will be protected after you take the steps to foreclose outside of bankruptcy."

Except that most residential sellers (1) are counting on the monthly revenue stream and find it difficult to go 4-6 months without payments, and (2) do not have bankruptcy attorneys on retainer and are shocked to discover the cost and the time delays.

If that 360k note represented 1/2 or more of their investment funds, then then were significantly overly concentrated in one asset and will really fell the pinch. The note is not the equivalent of a CD; there is no equivalent of FDIC insurance and collection may prove expensive. OTOH, if the sale is a 40k land note and the seller has investment assets exceeding $1M, then the note represents less than 4% of assets and it is a different story.

"Not clean, in fact rather messy but not at risk in the same was as the other creditors. Correct?"

Definitely messy, expensive and time consuming. I am unsure what "other creditors" to which you are referring, so I cannot currently respond. Definitely better than the unsecured creditors of the debtor; not as good as CDs, governemnt paper, or short-term A+ commercial paper.

Regards, JAFO



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JAFO,

Thanks for the info. Mostly what I thought or was aware of.

The only point that is really new to me is the idea that there can be a 'cram down'. I am not sure that this is possible on a mortgage secured by the property.

As to returns, I am talking about buying at a discount to face value and above average returns so more or less building in a risk premium and some added equity to compensate for the added risks. I note your point about the percentage of ones assets in this class. I take two views on this.

1. Is to not concentrate too much
2. Use other methods to compensate or otherwise provide protection or a risk premium.

Again, thanks for taking the time to highlight the points.

John
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activeREinvestor:

"Thanks for the info. Mostly what I thought or was aware of."

Your welcome. I just wonder how many sellers who take back financing, but are not otherwise real estate investors, are similarly aware.

"The only point that is really new to me is the idea that there can be a 'cram down'. I am not sure that this is possible on a mortgage secured by the property."

It is.

Cramdown - "The ability of the Bankruptcy court to confirm a plan of Reorganization over the objections of some classes of creditors."

http://www.trading-glossary.com/c0530.asp

Cramdown: "A court-ordered reduction of the secured balance due on a home mortgage loan, granted to a homeowner who has filed for personal bankruptcy. In a cramdown, the bankruptcy court splits the outstanding mortgage balance into two parts. The amount of debt equal to the current appraised value of the home is treated as a secured claim, which the borrower must continue to pay. The amount of debt in excess of the current property's value becomes an unsecured claim, which is usually not repaid in full. In areas where home prices have depreciated, cramdowns can result in significant mortgage reductions. In some cases, the judge may order the remaining secured debt amortized over the remaining life of the loan term, thus lowering monthly payments. In other cases, monthly payments remain the same as before the cramdown, and the secured mortgage is simply paid off faster."

http://www.docloan.com/loans/loan_terms/Cramdown

"The current conventional market rate of interest, rather than the contract rate, was properly awarded to a subprime lender in a Chapter 13 cramdown, the U.S. Court of Appeals for the Sixth Circuit ruled Jan. 8 (Household Automotive Finance Corp. v. Burden (In re Kidd), 6th Cir., No. 01-5074, 1/8/03).

The computation of the appropriate interest rate under Section 1325(a)(5)(B) of the Bankruptcy Code "does not entail an analysis of any particular debtor's credit rating but rather involves a more objective determination of the value of money over time so as to compensate a creditor according to the present value of its secured claim," Judge Martha C. Daughtrey said."

http://litigationcenter.bna.com/pic2/lit.nsf/id/BNAP-5HVPL7?OpenDocument&PrintVersion=Yes

Bankruptcy can lower the interest rate paid, and, if the lender is undersecured, reduce the principal amount of the loan secured by the house.

"Supreme Court to Decide Four Bankruptcy Cases This Term - how much the debtor will need to make in present value interest payments in a chapter 13 cramdown"

http://www.consumerlaw.org/initiatives/bankruptcy/sup_ct.shtml

See also:

http://static.highbeam.com/m/mortgagebanking/august011990/tamingthebankruptcybeastthechapter13cramdownmonste/

"As to returns, I am talking about buying at a discount to face value and above average returns so more or less building in a risk premium and some added equity to compensate for the added risks."

You are a note buyer, which is different than the seller who takes back financing, and only confirms the illiquidity and further discounts required to sell the note.

"I note your point about the percentage of ones assets in this class. I take two views on this.

1. Is to not concentrate too much
2. Use other methods to compensate or otherwise provide protection or a risk premium.

Again, thanks for taking the time to highlight the points."


Your welcome. Regards, JAFO






The ability of the Bankruptcy court to confirm a plan of Reorganization over the objections of some classes of creditors.
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You definitely did you homework on this post. One rec for you.

John
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