Seller carry-back financing. So simple, so eloquent. So screwed up so often. This article will discuss seller carry-back from the sell side perspective. Most buyers are of the opinion that obtaining a seller carry-back is a good thing. Most sellers are confused on the matter thus refrain from its’ consideration (as a confused mind always says no- to everything).
I recently drove by a national burger chain advertising their latest fare: a Turkey Jalepeno Burger. Now that’s creative! Not very appetizing in my book, but creative. No doubt this offering is the product of hundreds of hours of market research and taste test. It was probably first offered in just a few stores. If it has legs the store expansion will continue.
Mortgage loan products are developed in a similar way. If you recall, CMBS (Commercial Mortgage Backed Securities) is a relatively new mortgage product. The first tranche was not a billion dollar portfolio, more likely one hundred million, then tinkered with until deemed viable to sell to institutional investors.
How old is seller carry-back financing? Likely close behind ancient man’s creation of language when the first farmer sold a developed field to another in exchange for a percentage of crops (for a period of time- of course). More likely after the invention of the abacus when bean counting transformed from hobby to profession.
The current day problem with seller carry-back financing is that most lending institutions are opposed to secondary financing. More succinctly, most financial institutions are opposed to non-institutional secondary financing. Mezzanine financing is fine on commercial deals where the first lien holder is involved in all layers wrapped into the mortgage.
A Seller Carry-back that works
A seller carry-back that works for the seller is when equity in the deal equates to at least twenty percent (20%) and the amount carried-back by the seller does not exceed one third (33%) of the senior mortgage financing.
Good Example: Deal strike price is $1,000,000. Cash down payment is $200,000, first mortgage is 600,000 with a seller carry-back of $200,000.
Why is this a good deal for the seller? Because it is a defensible position. There is equity behind the seller carry-back and a manageable first mortgage in front of the seller carry-back. If the seller had to foreclose on this position the mortgage financing in place at origination equates to a sixty percent (60%) loan-to-value of the originating purchase price.
A Seller Carry-back that doesn’t work
A seller carry-back that does not work for the seller, using the same dollar amount as in the prior transaction:
Bad Example: Deal strike price is $1,000,000. Cash down payment is $100,000, first mortgage is 800,000 with a seller carry-back of $100,000.
This is a precarious position for the seller carry-back mortgage. The likelihood of foreclosing on this position is improbable as even a successful foreclosure leaves the originating seller saddled with a property financed at 80% of the sales price. When considering a seller carry-back presume that you, the seller, will have to foreclose on the senior financing. Having sold the asset how many sellers have the mental stamina to take back this same deal highly levered? Very few. Thus, the carry-back goes up in smoke.
For a seasoned real estate investor doing so could be “just another deal” in the course of business. For the non-seasoned, having to proceed with a foreclosure to protect a secondary piece of financing deemed (by them) to be a valuable asset… this could be a life event. If so, avoid seller carry-back financing. For the seasoned, full steam ahead and please consider the rule of thumb presented here.
Another “trap” for sellers is when the only cause for using the carry-back is to overcome credit risk raised about the buyer. Here is where the scale of justice is in your hands. However, being a judge does not excuse you from being burned in the transaction. Becoming “the bank” brings with it all the rights and privileges of having to collect. Weigh carefully.
Comment here and tell us about your experiences with seller carry-backs… the good, bad and ugly.
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