Almost all real estate deals revolve around debt. Not that we’re a nation of debtors – it’s simply the fact that leverage is what gives real estate superior returns to other investment options. And since debt is so important, a key to successful real estate investing often revolves around the way the financing is structured. In this Create Real Estate Mastery podcast we’re going to review all the creative financing options, their strengths and weaknesses, and how you can harness some clever ideas to make your real estate investments more successful.
Episode 6: Creative Financing Its Potential And Limitations Transcript
Almost every real estate deal requires financing, and how well you approach financing can make all the difference between winning and losing. And being creative with financing is essential, particularly at times like right now when interest rates have gone up so far and so fast. This is Frank Rolfe with the Commercial Real Estate Mastery Podcast. We're going to talk about creative financing, its potential and limitations. Now, on my very first mobile home park I ever bought, I was able to get a $400,000 price on the deal under the following structure. $10,000 down, and the seller would carry $390,000 at 30 years, fully amortizing, non-recourse. It was an incredible deal. So I was able to buy that very first mobile home park with only $10,000 down. Now my next park was even better, only $5,000 down. And in the past 30 years, we've done 12 zero-down deals, which means you put no money down. And the very first time I found you could get financing like that in commercial real estates when I was completely hooked, because I realized that for me to amass a large portfolio would be possible without having a lot of capital to start with.
But doing creative financing has both potential, good things, good attributes, as well as limitations, bad attributes. So let's explore the good things and the bad things about creative financing. Well, the first thing is low down payment. There is nothing nicer than buying commercial property with zero down. That's living the dream. But you can find situations where even though it's not zero down, 5%, 10%, that's amazing. Because with everything else in the world, you can never get financing typically better than 70% or 80% loan-to-value. And when you can beat that number and get in with even lower capital, that's amazing because it reduces your risk. It also allows you to buy more deals with the same amount of money. So that low down payment angle, that's one of the best things about finding creative financing. Also, you typically get a lower interest rate because when you're having mom and pop carry the paper or whatever other creative financing thing you've put together, you're going to beat those bank rates. And even those starting in Q1 of 2022, Jerome Powell at the Fed decided to take the rates up farther and faster than anyone had in almost half a century. You can still get around that issue by finding creative ways, typically seller financing, that got you the interest rates the way things were prior to that run up.
So getting low interest rates is another huge potential benefit of creative financing. And then non-recourse. Now, what is non-recourse and recourse? What that means is if you have a recourse loan and the bank takes a loss on the loan, they can come after you personally for the amount of the deficiency. But on a non-recourse loan, they cannot come after you. All you do is give the property back and you walk clear. And you always want non-recourse debt. If you can get it, you always take non-recourse debt. But most of the creative financing angles that you can do through seller financing are automatically already non-recourse. So that's another huge plus. And then you have the fact you get to potentially stair-step interest rates. So what that means is that you can start off with a low rate, maybe year one, 1%, year two, 2%, year three, 3%, year four, non-4%. That's always a sweet way to structure a deal. Or possibly get interest only and not have any principal payment at all to reduce the amount of pressure on what your monthly payment is.
And one of the big benefits to seller financing and creative financing is that you don't have any of the stress you have when you get traditional bank loans. You don't have to go and make application. They don't do credit checks. They don't ask for your financial statements. So you get to avoid all of that stuff that makes your blood pressure rise and makes you worry a lot. So those are all the good things. But then what are the bad things? Well, one problem you have with creative financing, seller financing, is you sometimes can get conned into buying things that you shouldn't because you get to sidestep traditional lending. And sometimes the lending needs to be there to sober you up. And you really need to get that appraisal, need to have that dour banker to question what you're doing to help point out that maybe you shouldn't be buying that property. And when you have seller financing, what happens is, since there is no financing hurdle, all you do is complete due diligence and then you buy it.
Now, if you're really seasoned at what you're doing, then you probably would be fine. But if you're more of a novice, you might make some rookie errors in your numbers and you need someone to point that out for you. Now, you can get around that by asking people who really know what they're doing to look over your work and make sure that you didn't make a mistake. But that's one problem with it is by sidestepping banking, which is also in the good category, the bad attribute is that it also means that you theoretically should have been limited in what you were doing. Also, another limitation of creative financing, seller financing, is that it's not always possible. Because to do seller financing, the seller has to own the property outright. So right out of the chute, one problem with this concept is it may not be possible on every property. If someone just bought it, if they've got a big mortgage on it, well then there's probably not much that you can do.
Also, you got to make sure that the seller note is long enough to be of value to you. Because here's what happens sometimes, you go to the seller and say, hey seller I need you to carry the paper, and they say, okay, I'll carry it for three years. Three years doesn't do you any good at all. Let's look at why. When you refinance a property, you got to give yourself at least a year to do that. You need to go out there, go out to the marketplace, find a bank, negotiate the terms, get the third-party reports, get the lawyer to drop the agreements and all of that stuff. And you can't give yourself a short time frame to do it. And the bank wants to see your last, typically, last two or three years of performance. Well if you bought it with a three-year note, you don't even have any time to turn the property around really before you have to go to market to find a replacement loan. So to have a really good seller finance creative loan, you need to really try and get 10 years on that loan, or at a minimum at least five years.
And if you get five years, see if you could buy an option. How that works is you give them extra money as a note is approaching its conclusion as a good faith down payment to extend the term out another let's say two years, just in case there is a banking crisis going on. Now that option doesn't cost you anything because you're not giving them any money as a premium, you're simply prepaying down some small portion of the mortgage. But the argument would be that you wouldn't walk it if that was what you were doing, right? You wouldn't put more money in if you intended to walk it. But you got to make sure you get a lengthy note. This two and three year nonsense that really does not work at all. Also don't let it suck you into a deal you can't get refinanced. Now there are deals out there that can be successful yet they're illiquid when it comes to banking because it doesn't meet all the typical thresholds that bankers like to see. There may be some problem with the property, maybe the permit is a little gray area, that type of thing that will scare lenders off. But yet, you can run it successfully maybe forever.
But it makes it a little hard to finance and you typically want to know that on the front end when you're buying a property. If it's vetted through a bank on the fact you got that first bank loan then you're probably golden. But the problem is if you do a seller note or some other creative structure and you bypass banking, what happens when you try and re-enter to get real banking and they say nope you can't do it, can't get the loan. So that could be a real problem for you. Also don't let it also suck you into a deal that has lots of capex. What I mean by that is, you buy the property but then you may not realize it now or maybe you detect it in due diligence that you've got to do a whole lot of additional work. You've got to fix roofs or foundations or roads and those type of things. That all adds on to the pile of how much you should be paying for it and often that can just ruin, it can cash strap you if you didn't plan for it. Sometimes on a seller note we get we get sucked into it because we're so excited to get the note that we aren't paying attention to all those costs after closing.
Those costs need to be deducted from your down payment or from the purchase price but don't get too excited on that seller financing such that you buy things that you really should not just because it was such an attraction and later you have regret. The bottom line to it is that right now one of the great weapons you have at your disposal when you're buying property is creative financing which is typically in the form of seller financing. It allows you to bridge the gap between values and current interest rates. It allows you to take a lot of risk off the table. It's just generally a great idea and when you see it add it to your toolbox. This is Frank Rolfe with the Commercial Real Estate Mastery Podcast. Hope you enjoyed this. Talk to you again soon.