Few practices divide the note business like simultaneous closings. In a simultaneous closing, the seller of a property agrees to seller financing, and the note that’s created is sold to a note buyer at the same closing. Are they legal? Ethical? Here, two note-buying firms make their cases: Robert Leonetti and Jayme Kahla of Success Mortgage Investments for, and Lorelei Stevens of Wall Street Brokers against.
The case for: a needed service done right
By Robert Leonetti and Jayme Kahla, C.P.A.
In every business owner’s career, there comes a time when not everyone in the industry agrees on certain practices. For us, that time has come. The debate over simultaneous closings is raging: are they legal, are they ethical, are they for real? (Yes, yes, yes!)
We fund simultaneous closings. In fact, we love them, because they let us and our brokers provide a necessary service to the real estate market. The other benefits are nice too:
- No one is competing against you for the note.
- You’re working on a note you know you can buy.
- You don’t waste time chasing notes others have “beaten to death.”
As a note investor and lender, we are very familiar with lending laws, disclosure rules and RESPA (the Real Estate Settlement Procedures Act). We like what these closings do for everyone involved: the borrower avoids costly lender fees and doesn’t have to qualify through traditional channels, and the seller and any real estate professionals get what they need.
However, these closings must be done legally, ethically and with full disclosure to all parties. As with everything, there is a right way and a wrong way.
Answering five common objections
Leonetti and Kahla take on the common objections one at a time.
Quality of borrower. A common belief is that these deals are only done with people who have bad credit, which wrongly implies that all notes have bad credit. Most of our home buyers come to us because they don’t fit Fannie Mae’s guidelines. They may be self-employed and write off most of their income, own more than four properties, or have used “mattress” money for the down payment. In a properly done transaction, the borrower is scrutinized even more closely than with existing notes.
Quality of property. Another misconception is that the properties are in poor condition or sold far above their value. We see properties in all conditions. We fund based on appraised value from a nationwide appraisal company, sometimes with an appraisal review. As investors, we care about the marketability of our collateral.
Usury. This is a very valid concern, and unless you structure the deal correctly, you may run afoul of it. One reported lawsuit involved a buyer who ended up paying $59,900 for a house he originally agreed to buy for $43,000, and signed a note for more than the original asking price. Usury comes into play when the borrower pays more interest than the state allows. It applies to the rate the borrower pays, not the yield the investor receives. Make sure the discount is taken by the seller and not passed on to the buyer. Under no circumstances should there be a side agreement for the buyer to reimburse the seller for the discount. Your best bet: let an experienced note investor guide you.
Licensing. A few states specifically require a license to buy seller-financed notes. Most states’ laws, however, apply to third-party transactions, where an outside lender funds money directly to the borrower, which is not the case with simultaneous closings. Check with your investor (our attorneys won’t let us draw closing documents in states where funding without a license is against the law). Stay away from straight loans, since you are not a mortgage broker, and learn how the law applies in your state.
Disclosure. This issue is often ignored in real estate. Any time a private seller carries a note and has sold more than five properties in a calendar year, he or she must disclose interest rates and closing costs to the borrower (Reg. Z, RESPA), as any licensed mortgage broker or lender must. However, you are not a lender. Still, doesn’t it make sense to tell the borrower well in advance what the rate and closing costs will be? Last-minute surprises cause trouble. Avoid them by letting all parties know the details early, and put it in writing.
In short, done correctly, simultaneous closings can be a profitable alternative to conventional financing and a much-needed tool for the real estate community. Their four rules:
- Always disclose everything to all parties, up front.
- Be truthful in all statements, written and verbal.
- Close through a legal closing entity, such as a title company or attorney.
- Most important, let an experienced note investor guide you through the process.
The case against: a loan in disguise
By Lorelei Stevens
Some note buyers do not fund simultaneous closings. In a simultaneous closing, the home seller sells the property, carries a note and sells the note at a discount, with the home seller, home buyer and note buyer all involved before the note is created. The property and the note sell at virtually the same time.
There are two major reasons some note buyers avoid them:
- They fall into a gray area of the law. A simultaneous closing could be considered a loan disguised as a sale, with serious legal consequences.
- They are used almost exclusively with “credit-challenged” payors, or with properties best described as “dumps” or homes sold at inflated prices, inviting costly defaults.
The industry is divided. Supporters see no problem and even call simultaneous closings beneficial: they help people buy homes they couldn’t otherwise get, make more real estate deals possible and create more notes for note buyers.
But an impartial observer could see a scheme in which the home seller never meant to carry the note, and the home buyer is really getting a loan from the note buyer. From this viewpoint, the home seller is just a conduit to avoid lending laws such as licensing, disclosure and usury.
How a simultaneous closing can become usurious
Usury means charging an illegally high interest rate. Usury laws protect people from being gouged. Most states have them, a few do not, and the maximum legal rate varies from state to state.
If the home buyer pays any part of the note discount, or any loan points or fees, that cost combined with the interest rate could exceed the legal limit and raise questions of usury. There are two ways a buyer ends up paying the discount:
- Indirectly: the home seller raises the sale price to make up for the discount. Watch for two prices offered to the buyer, a lower one for cash and a higher one for deferred payment. The higher price could be seen as the buyer indirectly paying the seller’s discount.
- Directly: a “side note” between buyer and seller. If the seller wants to recoup the discount, the buyer repays it through a second note, and the note buyer may not know it exists.
Usury is only one of the laws lenders must follow. Many lenders need a license to make loans, and various federal and state laws require detailed disclosure of loan terms. Some even require waiting periods during which the home buyer may cancel.
Why timing decides whether it’s a loan
Many supporters know these transactions may be loans. Some take steps to avoid the appearance of a loan, such as not talking to the home buyer before the property is sold, or waiting an extra day after the sale to buy the note. Such steps can be seen as deliberate subterfuge.
The issue turns on timing. A lender is involved before the note is created. The sale of a note implies the note existed first, and a note buyer later learned of it and bought it.
In a simultaneous closing, the note buyer is, and must be, involved before the note exists. The note buyer agrees to buy the note once it’s created, and the note seller will only create it if there is an immediate buyer. Simultaneous closings are pre-planned by all parties. It’s easy to see how that could be considered a loan under the law.
So why not just make the home buyer a loan? Note buyers use simultaneous closings for three main reasons:
- To earn a higher yield than a loan would allow.
- To avoid the costly, time-consuming red tape of lending laws.
- To increase their inventory of notes.
These are legitimate business motives. A higher yield fits these risky notes, as long as it stays within usury limits. Most note buyers don’t want to become lenders, and in a scant market, building inventory is a laudable goal.
Supporters say the home buyer pays less in closing costs than with a loan. That’s true. But the buyer usually pays a much higher price for the property itself, which makes the closing-cost savings irrelevant.
If the transaction is judged a loan, it could be usurious and could violate licensing and disclosure laws, with severe penalties. Add the greater default risk and poorer note quality, and simultaneous closings are coming under closer scrutiny.
The path increasingly seen as most prudent is to buy only notes that are “old and cold.” A reasonable guideline: buy only notes with a record of one or two payments, and only those you had no involvement with before they were created. Otherwise, just make a loan and comply with the lending laws.
