The Subordination Technique (Seller Financing Series part 3)

Hey!

This will be the third and final strategy I talk about regarding purchasing using seller financing techniques. This last technique I will share in this series is one of my all time favorites! I have used this strategy multiple times, and I will share it’s many advantages. ( If you haven’t seen any prior posts about seller financing strategies, you can start by visiting here )

What do you do in this situation ? :

A seller is more than willing to finance you the purchase of their property. They are also willing to give you reasonable terms so that the property can perform and cashflow well. The problem is this: The property is not in the best shape, and it needs some work to get it into good condition. If you plan to keep the property in the long term as a rental, then this can be a problem. Having to pay a large chunk of cash upfront on a rental property can reduce your ROI and delay your returns. And, you wouldn’t want to refinance the property later on (to pull back your upfront cash) because it can ruin your great terms that you have with this seller by replacing it with less desirable bank terms. What do you do ?

This is where the Subordination technique is useful.

The subordination technique basically means that you bring on an additional loan in the first position (1st lien position) to fund the rehab and upfront expenses in the purchase. Then, the seller ‘s loan will be ‘subordinate’ and take the 2nd lien position. Make sense?

Here is an example of a past transaction that I have done:

I had a seller want to sell a long time rental property. It was in pretty good shape, however, it was very dated and would need some more expensive repairs done in the upcoming 5-7 years. The seller only wanted to sell because they were tired of being a landlord. However, they did not need (nor even want) all the cash proceeds from a sale, and preferred a monthly income still.

So here’s what I did : I asked if they would be willing to allow me to borrow money on the upfront costs, which included : Their down payment, the closing costs, the repairs of the property, and a jumpstart on escrow savings for insurance and annual taxes. They agreed to do this. Then, I simply made an offer based on the cashflow analysis of the property as such:

-Market Rent
-Less 1st loan payment
-Less rental expenses (taxes, insurance, maintenance)
-Less my desired cashflow
=The monthly payment that I could offer them.

I took this monthly payment and multiplied it by 20 years. I used 1.25% interest for the loan. This was the price offer I could give them.

The seller agreed on the price because it was a pretty fair price considering the condition of the property. They also agreed on the payment, although a little low, because they no longer had to deal with any management headaches, upkeep, etc. . They also understood that I would need to cashflow myself on the property in order to keep this investment transaction safe and profitable for the both of us.

You can use a private lender loan for this first position (who wouldn’t want to be in 1st position at 15-25% LTV????) or, you can even use a bank. In this example, I used a bank.

The total price that I borrowed on the property was full retail . It looked something like this:

Purchase price: $220,000
Down payment : $10,000
Seller carry back : $210k, 1.75% interest, 20 years
Buyer has right to borrow up to $45,000 on a 1st lien position on this property.

I borrowed 45,000, and paid the seller 10,000 at closing. After closing fees I had about 33,000 left. I had plenty to fund the rehab and fund my escrow account for this rental. It cash flowed nicely and everyone was happy.

The property had an after repaired value of about $240,000. You can see right away that I may have “over leveraged” borrowing a total of $255,00 0 on it. But what do you think happens on the amortization schedule of a 1.25% loan?

Today, this property has been very profitable. This is the power of using creative seller financing techniques, and the subordination strategy is a great one.

A second part of this story is that I actually have sold this property at a profit, and, left the seller’s loan in place and replaced the collateral with other properties. I kept the profit proceeds at the closing, and when I moved the seller’s loan to other properties the seller now is in 1st position on multiple properties, which reduces their risk and puts them into better position. The properties that I moved this loan on paid off existing bank loans, and made my cash flow that much better. It truly is a win-win if you can structure them correctly.

I hope this helps , and as always,

Happy Investing

-Justin

Let me know if you are interested in these types of purchases, I do not mind walking you through a transaction.


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