Real Estate Contract, or Land Contracts or Contract for Deed, can be a good tool for real estate investors to receive higher income (usually higher than rental income by around 30% to 70%) for a few years during the term of the contract.
One of the main disadvantages of Real Estate Contract compare with the “Long Term Lease To Own” is that the sale price is set, most of the time, at current market value without giving much time for the real estate investors to ride out of this real estate recession. However, depending on the interest the buyer is willing to pay (the *spread* in the case of wrap around mortgage) and reduced or eliminated payment of property tax and insurance, the investors can expect sizable cash flow each month, which should compensate the loss of potential capital appreciation. One caveat to this strategy is buyer’s ability to *pre-pay* the mortgage. See below for more discussion.
Real Estate Contract are common in some states, they are called Land Contracts, or Contract for Deed, but they all represent the same thing: a way of selling property where the buyer “borrows” from the seller for the financing rather than borrowing from a bank.
Within an agreed number of years, it is expected the buyer will be able to qualify for a loan. At that time, they will obtain a new mortgage and pay off whatever amount the land contract requires. Real Estate contracts vary widely from transaction to transaction, however the basics of the contracts usually are:
1. Seller retains legal title and the Buyer receives equitable title
The buyer will not receive the Deed to the property until the full amount the seller financed is paid in full. The seller remains the title holder while the buyer is making payments. The transfer of legal title is always done by a separate deed of conveyance, usually a warranty deed, which is placed in escrow when the contract is signed.
The contract does transfer an interest to the buyer, known as the “equitable title”. The buyer signs a special warranty deed which is placed in escrow together with the seller’s warranty deed. The seller can recover equitable title from the buyer in the event of buyer defaults by giving appropriate notices (typically 30 days) and terminate the contract. It’s a much faster process compare to foreclosure proceeding.
2. Purchase Price often set at current market value
The Purchase price is negotiated between the Seller and the Purchaser. Properties sold on a land contract do not necessary sell for more, because buyer bears great risks to receive all-important owner financing. On the other hand, Owner can usually fairly quickly recover title/deed back from the buyer in the case of Buyer defaults and retains all down payment and paid interests.
3. Down payment
The down payment should be at least 7% to cover closing costs (6% agent commissions and title/escrow fees). The bigger the down payment, the more committed the buyer is and the less likely the buyer will default.
4. Balloon Payment
A balloon payment is the term used for a lump sum, final payment on the contract. Balloon clauses usually call for the final payment to be made on a specified date. If the Purchaser fails to make a balloon payment when required, this will constitute a default on the contract.
5. Interest Rate and Monthly Payment
Usually the owner-financed amount (purchase price minus down payment) is amortized over 30 years payable monthly. The balance remaining will go down each month with the payments made by the Purchaser. Depending on if the seller has a mortgage, the interest rate should be high enough to cover the owner’s monthly payment. We will discuss wrap around mortgage or All-Inclusive Trust Deed (AITD) in the later blog. Typically the interest rate is set 1% to 3% above 30 years mortgage.
6. Taxes and Insurance
Most often the Purchaser is responsible for paying taxes and insurance on the property. The Buyer is required to pay approximately one-twelfth of the estimated taxes and insurance along with each monthly payment to escrow. The escrow then in turn pays for insurance and property tax. This is the safest way to make sure the all-important insurance and property tax are paid.
The insurance policy should be changed from homeowner policy to landlord policy and the beneficiary should remain the seller who holds the legal title throughout the Contract term. The Buyer should maintain his/her own insurance that covers personal property.
If the Purchaser fails to perform any significant part of the contract, the Seller may have the right, after notifying the Purchaser 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 Purchaser. If the default continues, the Seller has the right to declare the remaining balance due and payable, and if the default is not then cleared up or the contract is not paid in full, the Seller can begin steps to regain possession of the property. Improvements made to the property by the Purchaser then become the Seller’s property.
8. Pre-payment Provision
For real estate investors who like to receive positive cash flow to compensate for the sale of the property at current market value, be very careful that the buyer typically is allowed to make early payments to reduce the principal, hence reducing the interest you can charge, or worse pay off the entire loan to fulfill the contract early. The early payment will be detrimental to your strategy of receiving positive cash flow to improve bottom line. You can alleviate this risk by setting pre-payment penalty or disallow pre-payment in the contract. Alternatively, you can require the pre-payment is applied to the original loan (wrapped loan) first, not the owner financed mortgage. So as the seller you can pay down your mortgage principal faster than the buyer. This is greatly improve your yield.