The Pending Opportunity of Owner Carried Financing

February 4th, 2019

Allow me to take us to a not-so-distant future and discuss a possible opportunity for an apartment owner in most markets. Before we do that let's set the stage a bit. Interest rates in this future environment are high and the net operating income for a property has remained largely the same. What this means is a buyer will have to pay less for this property so the cap rate remains higher than the going interest rate. Also, this large simplification of elements is supposed to illustrate a likely and not-so-distant future. So the question as an owner is how to extract the maximum sale price without scaring off buyers? The answer will have to be creative and one of those ways is the opportunity to offer seller financing. There are many ways to approach creative financing, but for this piece, we will discuss the way seller financing may happen and the intended benefits and potential pitfalls.

The owner will need to either have full equity ownership of the property or the owner has a very small financing liability left on the property. Understandably, there are nearly infinite ways to set up owner financing, but for scope and brevity, this will be the case study. We will use a hypothetical property valued at $1,000,000 with market interest rates at 7%, and for our purposes, we will only look at it from the owners’ perspective. In this case, the owner finds a buyer and they settle on the price of $1,000,000. However, a couple of years back the owner could have gotten $1,050,000 when properties traded at lower cap rates so the question becomes how to bridge the gap and capture that extra $50,000. One answer is to offer seller financing. We are going to exclude closing costs, broker fees, and prorated costs to help simplify this discussion. If the owner did a strict sale then they would walk away with the $1,000,000 and then immediately lose their monthly income generated from the property. In summary, this leaves a lot of money on the table so let’s look at it through seller carried financing.

The seller can offer the property at $1,000,000 with a 30% down payment ($300,000), 9% interest, 15 years amortized loan, with a 5-year balloon payment. What this means is the owner makes $300,000 today and gets about $7,100 per month of income. After 5 years the owner will receive the remaining full amount of around $560,000 which in present value terms of 5 years and 7% is equal to $400,000. Additionally, the owner will have received monthly payments totaling $426,000 which in present value annuity dollars is $359,000. In total present value dollars the owner will receive $300,000 (down payment) plus $400,000 (PV of principal) plus $359,000 (PV of payments) which is equal to the owner receiving $1,085,000 in today’s dollars. That means the owner ends up doing $85,000 better. All of this hinges on whether or not the buyer is on board and can make these numbers work.

It is important to talk about the inherent risks associated with this type of selling. The owner is running the risk of the buyer defaulting and giving the property back in any possible condition. Buyer due diligence is important in this regard. Secondly, the owner changes their role from an investor to a lender and at times an owner is uncomfortable with this type of relationship. Lastly, it’s important to rely on legal counsel and people with good knowledge of the needed paperwork. Consulting a CPA for advice on taxes is also highly recommended. The biggest benefits are a continuation of monthly income without worrying too much about day-to-day operations and the opportunity to get more in present value dollars with the exact same asset. Hopefully, this makes the future a little brighter in the face of rising interest rates.