Seller financing is my favorite way to buy real estate. It is often faster, easier and more profitable than any other financing technique because no banks or third parties are involved.
In this article, I'll tell you how to find the best seller financing deals by targeting a particular type of property owner.
Why Seller Financing is So Powerful
Although most of my real estate deals involve seller or creative financing, I don't hate banks. I just like keeping the profits banks normally take for themselves. Haven't you noticed that the biggest, most expensive buildings in towns are banks?
Here is why.
When a person with equity sells a house, that cash usually goes into a bank at a wonderful rate of .5% interest. Then that bank loans you (if you are lucky) that same money at 6%. This concept is called making "the spread" or a profit from other people's money (OPM). Banks are masters at this, and the formula allows them to build those big, fancy buildings.
Seller financing, on the other hand, is all about keeping those profits and splitting them between you and the seller.
My First Seller Financing Deal
Before my first seller financing deal, I had only read about the concept, so after this article you will know about as much as I did. My real world education came from a wonderful, retired couple who owned a house near me and who decided to call me after I sent them a letter.
My letter to them stated that I would like to buy their house. They received this letter because they owned a house in my target market, but their mailing address was in a different town (called an absentee owner list).
This sweet couple's house was vacant. It had been empty ever since the last tenant tore it up and moved out without paying. This had been their residence for years, and they then decided to rent it out to supplement their tiny retirement income. It broke their heart to see the horrible treatment of the home by the tenants, and they could not bring themselves to rent it out again.
This is the big clue to find your ideal seller financing candidate. They need to be a burned-out landlord or someone who is fed up with tenants, toilets and headaches.
This particular negotiation was a learning experience for me. Convincing them to finance the purchase was not a quick, easy sort of transaction. The fast, sleazy, manipulative, NLP-type junk that you'll hear from some investors and educators would not have worked.
Why? Because a prerequisite to seller financing deals is a relationship. To have a relationship, you need to have mutual trust. And to have trust, you can't be a slick slime-ball!
Do yourself a favor and just be yourself during negotiations. Drop the one-liners, be sincere (even if that means showing you are brand new and nervous) and ask questions.
Once I had built some trust, I earned the right to explain my case and to present options to the couple. One of my options was an all-cash offer, but the price was too low for them.
My second option was for the couple to get a higher price, receive a small down payment from me and then receive the balance of the price in monthly installments of principal and interest. After some discussion and thinking on their part, they accepted my offer.
This type of deal benefited me and benefited the seller. In the end I made a good profit by selling it to my tenant. The selling couple relieved themselves of a headache property, and they supplemented their retirement with a nice income stream and eventually a big lump-sum payment.
Why Is a Burned-Out Landlord More Likely to Finance to Me?
I have bought properties with seller financing from all types of people. One time I sat down to study the most common types of sellers who had financed their property to me.
The results confirmed what I already suspected -- well over 50% fit into the category of a burned-out landlord.
I define a burned-out landlord as any rental property owner who has become fed up with the business of owning rental properties. If you study landlording, you know how difficult your life can be if you don't maintain your property, if you don't screen your tenants properly or if you don't run your rental like a true business.
The truth is that many landlords do not study best practices. If they would read Brandon Turner's awesome tenant screening guide or the BiggerPockets Forums, they would avoid half of their problems. But they don't.
So mismanagement leads to property problems, and these problems make the sellers more motivated. Often these sellers think they just want to cash out like everyone else does.
But there are several reasons that these burned-out landlords might want to consider financing instead of cashing out right away.
3 Reasons Landlords Would Consider Seller Financing
1. Burned-Out Landlords Still Like Monthly Income
In the very beginning, the burned-out landlord started renting the property for a reason. They probably liked the idea of regular, monthly income. When the tenant paid on time and never complained, it was a great deal. But once the tenant problems started, the fun and games were over.
So if you earn the right to present your case to a seller, your task is to show them that regular, monthly income is a primary benefit of seller financing.
I like to share with the seller that I will take over all rental headaches. I will handle all communications with the tenant, all toilet and maintenance problems and all risk of vacancy. They will get a check from me on the first of every month no matter what, and they will never get requests from me unless it's to ask them if they liked their annual Christmas cookies!
If they believe me, I have essentially taken away their biggest reason for selling and then given them back their original reason for renting in the first place. That's a powerful combination!
2. Burned-Out Landlords Still Like Real Estate as Security
The sellers I like to talk with usually either own their property free-and-clear or have a large chunk of equity. This means that if they were to sell for cash, they have a serious dilemma. Where will they put that big chunk of money?!
Let's think about their options.
First, if they value security, they may put the money in a bank account. This is certainly safe, but they have traded away any hope of a decent yield for that safety.
Second, they may consider the stock market. If they are anywhere near retirement, this option will give them the cold chills. They have probably been around for a while, and they know the manic, up-and-down nature of stock market pricing.
Third, they could opt for bonds, insurance annuities or other more complex financial instruments devised by the experts on Wall Street. While these may make sense for some people, I am betting that an investor who got into real estate liked income properties because they were local, simple and understandable.
Based upon this reasoning, I sell security and simplicity as major benefits to seller financing. I remind them of my favorite investment questions, "What is the worst thing that can happen? Am I ok with that?"
I tell them that in that worst case scenario, I get run over by a bus and my heirs stop making payments. They would then keep everything I've paid them and then get the property back. So they are back where they started. Not great, but it better than uncertainty.
I have found that uncertainty is one of the most terrifying risks when making decisions. By reminding them that a property they already know very well is their security, I have reduced or eliminated much of the financial uncertainty and fear in their decision-making process.
3. Burned-Out Landlords Sometimes Have a BIG Tax Problem
This reason is especially important in high-priced markets where appreciation has grown property values for years (big cities, California, Florida, etc). Ironically, in the modestly appreciating market I live in (Clemson, SC), this reason has been the least important to convince sellers to finance to me.
Imagine an owner of a duplex who bought a property in a good location 25 years ago for $100,000. If her market price appreciated at 5% per year, the current price would be $338,636. That is a capital gain of over $238,000 recognized in one tax year!
The problem with this scenario is that the owner will pay taxes on this gain, and if the owner already makes a very high income, the tax burden could top out at 23.8% of the gain based upon 2014 tax rates. That would mean 23.8% of $238,000, or $56,644, would be owed to the IRS and would never earn interest again!
The owner could avoid this with a 1031 tax-free exchange, but my ideal seller isn't trying to get into more rental properties. She is primarily trying to avoid more hassles.
An installment sale (which is recognized by the IRS) is a way to defer a large portion of the tax until later without finding a replacement property. This can help the seller plan her tax burden more wisely.
In my example above, the seller could spread out the $238,000 gain over a longer number of years, which might result in a lower tax liability depending upon the particular situation. Very importantly, the seller will also earn interest on what would have been taxed. At 6% of a $56,644 tax liability, this could be a positive benefit of $3,399 in just the first year.
Because this situation can become very complicated, the seller should of course be advised to consult with their own CPA or tax attorney about the impact on their particular situation. It's your job to just bring the possibility to their attention.
Will You Do Anything With This Information?
Remember my first seller financing deal? The big step was that I learned a good idea, and then I immediately took action. Trust me, I was not perfect in that negotiation. Yet I still got a good deal because I was willing to ask.
So do you have a deal you're working on that you could make a second, higher-priced offer with seller financing? Do you know of any burned-out landlords in your town? Are you willing to mail letters to possible candidates or talk to property managers of those owners?
If you have at least a little bit of capital, and if you are willing to take action and ask questions, you can also land your first seller financing deal. Good luck!
This article originally appeared on The Bigger Pockets Blog.
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