Most real estate is bought with paper. Whenever you sign a mortgage to buy property, you create paper as part of the transaction. Paper is “any written and executed right, obligation or promise that has monetary value and is negotiable.” Most of the examples here involve real estate promissory notes and their security agreements (mortgages or deeds of trust), but leases and options are covered too.
Why sellers will accept paper instead of cash
Many property sellers will accept paper in a transaction. Some prefer to keep the paper (carry the loan) if the down payment is large enough. Why?
- They may want regular payments instead of cash.
- They may get a higher price by offering the buyer financing.
- They may want a higher return than CDs pay.
- They know the property, and the down payment makes them feel more secure than other investments would.
Many sellers carry the loan because they can’t sell any other way, or would have to cut their price too much to get all cash. A seller who will carry a note may accept a substitute note on another property if:
- It has a record of prompt payments.
- The substitute paper has higher payments.
- The substitute paper has a shorter term.
- The substitute collateral property has greater value.
- The substitute collateral is more attractive.
A knowledgeable seller makes sure the substitute paper doesn’t have a higher senior lien value or a higher final loan-to-value than the transaction property would. Even without that precaution, a seller may accept substitute paper if its present value is greater than the note he’d otherwise receive.
In the techniques that follow, knowledgeable investors are willing to be either buyer or seller. They make the transaction favorable to themselves whichever role they take.
Using notes in place of cash and down payments
Paper out
Seller has a $100,000 house with a $75,000 first lien. Buyer offers to assume the first and give a seasoned first lien note on another property with a $25,000 balance, which he bought for $15,000. Seller accepts because he’s leaving town. (It would be even more acceptable if the note were larger than $25,000, giving a higher price.)
Seller gets his full price and can move with peace of mind, without making payments on a vacant house. Buyer buys at a discount with no cash down, and converts equity he gained by discounting the note into real estate equity.
Create paper to buy property
Seller likes to carry paper but wants protection. He won’t finance his $600,000 apartment building 100%. Buyer owns a free-and-clear strip shopping center with good cash flow that he doesn’t want to sell or trade. Buyer creates a $150,000 first lien note on the shopping center and uses it as part payment. Seller carries back a $450,000 first lien note on the apartments.
This is like a blanket mortgage on two properties for extra security, but the two properties aren’t tied together, which gives Buyer more freedom to manage his investments. Seller is happy with good notes and plenty of equity.
Paper for down payment
Buyer offers to buy by assuming the $60,000 first lien and giving Seller a $40,000 second lien for 15 years at 10%. Seller is tempted because he’d receive more than an all-cash price, but he’s afraid Buyer might default and hand back a mismanaged property.
So Buyer offers paper he owns worth $16,000 as a down payment and asks Seller to take a $24,000 second lien for 15 years at 10%. Seller feels protected and accepts, because now Buyer has something invested in the deal.
Using notes to pay debts and buy options
Paper to pay the payments
Buyer still owes Seller 36 payments of $350 on a 10% note with a remaining balance of $10,847. Buyer has a chance to buy a trust deed with a remaining balance of $10,728 (it pays $500 a month at 11% for 24 months) for $8,900. He buys it and offers it to Seller in exchange for the remaining payments on his note. Should Seller accept, even though the balance is $119 less than the note he holds now?
Seller wants an 18% return. Discounting both notes to yield 18%:
| Note | Payments | Remaining balance | Present value at 18% |
|---|---|---|---|
| Existing note from Buyer | 36 × $350 | $10,847 | $9,681 |
| Trust deed offered in exchange | 24 × $500 | $10,728 | $10,015 |
Seller accepts, since the notes are of similar quality. He gets a higher present value, higher payments and a quicker payout. Buyer benefits too, because he pays off his loan at an 18% discount.
Paper for an option
The owner of 30 acres wants to sell, but development is 5 years away. A developer wants the land, especially since the asking price is below market, and wants a 7-year option on it. As option consideration, he offers Owner an existing first lien note on another property with 5 years remaining, a 10% interest rate and a balance equal to 20% of the land’s asking price.
Owner knows the economy is slow and a sale may take two or three years, but he needs money now. Since the option may not be exercised for 7 years, he asks for and gets a 10% higher price.
Owner gets the monthly income from the note and a probable sale within 7 years. Developer secures choice acreage for future development at a good price, with no cash outlay.
Note holders will usually accept other notes of similar quality for part or all of the payments due them, if the payments are larger and they get their money sooner. This little poem helps with notes and present value:
Whenever you get money,
Sooner is better than later
And more is better than less
And more sooner is best.Whenever you must pay,
Do this the other way.
Using paper to rescue and balance deals
Overpay with paper, buy at a discount
Buyer offered to assume a $30,000 first lien, pay $10,000 cash and give Seller a $60,000 second lien note. Seller wavered and wouldn’t accept. Buyer owns three good-quality second lien notes with a total remaining value of $69,000 and a slightly faster payout than the note he first offered. He offers these instead of the $60,000 seller-carried second.
Buyer bought the three notes for $48,000, which gives him a $12,000 discount on the property price. Seller gets a higher price and a faster payout.
Paper as a sweetener
A large transaction is about to collapse. Seller wants $510,000 with $100,000 down. Buyer has only $80,000 cash and asks Seller to carry a $430,000 first lien. Buyer learns that Seller doesn’t need the extra $20,000 down but wants it for protection and peace of mind.
Buyer restructures: $75,000 cash, a good-quality $40,000 first lien note (which he bought for $30,000), and a $400,000 first lien note carried by Seller on the property. Seller gets the security he wanted and a slightly higher price. Buyer saves a deal he was about to lose, with a slightly lower net price and $5,000 less cash out of pocket.
When a deal starts to bog down, adding a note as small as $5,000 may sweeten the pot enough. The price is higher, but a good deal gets done for a little extra and no more cash.
Paper to balance the exchange
New or existing paper can balance exchanges. Developer has agreed to trade his small apartment complex, worth $240,000, for 10 acres worth $350,000. The landowner would gladly take secured paper for the $90,000 difference, but Developer needs the land free and clear to get a construction loan. So Developer gives the landowner a $90,000 note he creates on another property he owns, in place of a carry-back note on the 10 acres.
Curing negative cash flow with paper
Cure the “eat” #1
Seller has an apartment building with high vacancy, and he expects the “eat” (negative cash flow) to continue for three more years because of poor management and overbuilding in the area. Buyer offers Seller an existing first lien note on another property in exchange for his equity, but the note payments are assigned back to Buyer for the next 3 years to cover the negative cash flow.
Seller escapes the eat, saves his full equity, sheds his management worries and holds a more secure investment. Buyer trades a non-appreciating asset for one that will appreciate under his management and gets some tax shelter. The note payments give him a break-even investment that he may turn into positive cash flow in less than three years.
Cure the “eat” #2
Seller has a shopping center with negative cash flow and is tired of managing it. He also has a good-quality second lien note on which he’s been offered 75% of the remaining balance. Buyer offers to exchange his smaller shopping center, which has positive cash flow, for Seller’s larger center plus Seller’s note to balance the eat.
Seller gets out of management and removes his negative cash flow. Buyer grows his assets and estate, improves his tax shelter, and gets a note to compensate for the eat.
Trading notes for property and other notes
Paper for property and cash
Seller has a vacant warehouse and cash for rehab, but not the time or expertise to do the job. Buyer has several medium-quality first liens but not much cash. Buyer offers the $200,000 remaining balance of his notes for Seller’s $150,000 building, if Seller adds $50,000 cash for fix-up.
Buyer gets full value for his notes and a property with enough cash to make it productive. Seller trades idle assets for a good income stream.
Paper overtrade
Buyer owns a well-seasoned 6% first lien note on land with a remaining balance of $150,000, but after taxes his return is poor, and he needs tax shelter. Seller has a full $450,000 apartment building with positive cash flow and $125,000 of equity. Buyer offers his note for Seller’s property, equity for equity.
Seller gets a larger equity and a slightly higher return than he has now. Buyer gets a well-maintained, full apartment building with positive cash flow and a tax write-off, for a total return greater than he’d get on a $150,000 note.
Definance
Investor wants to move the second lien off his property to increase his equity and make the property acceptable for an exchange. He asks the note holder to accept another property as substitute collateral. The note holder agrees if Investor raises the interest rate by 1% for the rest of the term. Investor accepts, because it lets him complete a profitable exchange.
Paper for paper
Allen, who will retire in 4 years, has a $43,183 first lien note at 10% with monthly payments of $800 and 72 months remaining. He’d prefer a longer income stream for retirement. Bradley has a newly created $50,000 first lien note at 10% with monthly payments of $483.51 and 240 months remaining, but he needs more cash flow now.
| Note | Payments | Balance | Value at a 14% yield |
|---|---|---|---|
| Allen’s note | 72 × $800 | $43,183 | $38,824 |
| Bradley’s note | 240 × $483.51 | $50,000 | $38,802 |
Bradley discounts both notes to a 14% yield and offers to trade. Since the extra income now is worth more than 14% to Bradley, the trade is a good deal for him even though his note’s balance is higher than Allen’s. Allen gets what he wants: a longer income stream for retirement.
Transaction techniques with lease paper
Lease paper is valuable because it’s a right to receive an income stream. Leases are usually secured by the tenant’s furniture and equipment in the property, and often by the net worth of a substantial corporation or individual.
Sale-leaseback
A corporation needs operating capital. It sells some of its property to Investor, then leases it back long-term on a triple net lease. The corporation keeps control of the property and runs it as it wishes. Investor gets good-quality paper with a long-term income stream, which he can also use in other transactions.
Lease for equity
Seller has a property with a small cash flow and management problems he can’t solve. The economy is poor and buyers are scarce, but he wants to sell now. Buyer would like to buy but lacks the cash for Seller’s down payment.
Buyer offers to assume the first lien, give Seller a second lien for a total loan-to-value of about 80%, pay 12% of the balance in cash, and cover the remaining 8% with a 5-year lease on office space in another building. Seller gets his down payment, 5 years of prepaid office space and no more management problems. Buyer gets a positive cash flow property and uses a hard-to-fill vacancy as part of the down payment.
Lease returned as part payment
Seller wants to sell his office building, but it has a 30% vacancy rate and the income doesn’t justify a good price. Seller offers to lease 20% of the space himself for 5 years, giving Buyer a good positive cash flow.
Buyer gets a proper return. Seller sells his property and receives note payments, which he uses to make his lease payments. He uses part of the space for his office and subleases the rest.
Lease payments for equity
Seller has a commercial property with positive cash flow, but his health is bad and he wants to be free of management. He’ll accept paper for 100% of his equity. Buyer owns a free-and-clear single-tenant commercial building with an AAA-rated corporate tenant whose triple net lease has 10 years to run. Buyer offers to assume the first lien on Seller’s property and pay for Seller’s equity with that 10-year lease, which is good enough that Buyer could assign it to a bank for cash.
Seller gets out of management, gaining peace of mind, and a solid 10-year income stream for his equity. Buyer gets a new positive cash flow property with no extra cash or new mortgage payments, keeps his free-and-clear property and gets additional tax shelter.
Transaction techniques with option paper
The most valuable option paper is a long-term option with a substantial payment made that has had time to appreciate. This kind of option has real equity value, which can be realized by exercising, selling or trading it.
Option for down payment
Investor wants a shopping center owned by Developer, but Developer is happy with its income and doesn’t want to sell. Investor holds a long-term option on choice land Developer would like to develop. Since Developer must keep developing for his business to survive, he accepts Investor’s option as the down payment on the shopping center. Each party gets what he wants most.
Option back brings a better price
Seller needs cash fast and offers to sell his positive cash flow, triple net leased property at a small discount, though he’d rather keep it. Buyer doesn’t need tax shelter and doesn’t want to look for a new tenant in 5 years if the current one leaves. Buyer offers cash for 50% of the asking price and an option (paper) for the other 50%. Seller can buy the property back any time after one year and before 3 years for the cash Buyer paid plus 1.5% for each month Buyer has held it.
Seller gets the cash he urgently needs and a chance to buy back his prime asset. Buyer gets a good yield for 3 years. If Seller hasn’t bought it back after 3 years, Buyer can sell the property quickly at a discount and still make a good profit on the cash he paid.
Use your creativity and the assets you have, and you can make profitable transactions using paper.
