Creative Financing Is Back: - Beware of the Hidden Traps of Leasing, Contract for Deeds and Seller Financing- December 2007 Nash & Lodge, PLLP By: Stephen J. Nash "Rent to Own", "Lease With Option to Buy" , "Buy on a Contract for Deed" and "Seller Financing" are phrases that are popping up all over. A win-win for sellers who can't sell and buyers who can't buy? It can be but there are many traps for the unaware. Seller/Buyer issues: 1. Does the sellers' mortgage/s permit the seller to rent, to provide an option, to sell on a contract for deed or any other seller financing? In almost all cases the answer is no. 2. Will the transaction actually result in a sale? If the buyer cannot qualify for a mortgage today, sellers and buyers often assume that in a year or two that the buyer will be able to qualify for a mortgage without checking with a reputable loan officer to see if that is likely. Even if it appears that they might be able to qualify in a year or two you have to remember that many factors can derail the plan. The mortgage world is changing every day, there is no way to predict what the credit situation will be in a year from now. The plan is also dependent on the buyers paying their bills on time, sustaining their income and not running into any other financial problem. 3. Vague agreements. Most agreements that I have seen do not spell out all of the terms of the deal or deal with all of the potential issues. For example, what will the ultimate purchase price of the property be? I have seen it commonly described as “to be determined by the parties”. This really is creating an agreement to agree—how do you force someone to agree? This gives either party an absolute ability to walk away from the deal. If that is understood, you can use that terminology. If you don’t want to give the other party a way out of the deal, you need a more specific purchase price. 4. Is insurance a concern in these types of transactions? Yes. The insurance on the property has to accurately reflect the true interests that each party has in the property. If not, the insurance maybe invalidated when a claim is made or may only protect some of the parties involved in the transaction. An example of this would be a transaction whereby the property is sold on a contract for deed. Since the mortgage does not allow this type of transfer the parties don’t want to do anything to bring the transaction to the attention of the lender. Since the lender is on the insurance policy and actually makes the insurance payment through the escrow, the parties decide to leave the current policy in place. The seller still owns the property so what is the problem? First, the buyer has no protection. The buyer will not be able to make a claim and will not have his/her losses covered. Second, the policy itself may be invalidated because the insurance company was not made aware that the owner no longer occupied the property. Third, if you don’t have the right coverage a defense against one of the other parties maybe used against you (for example the buyer on the contract for deed commits arson) - you need coverage that protects you even if the other party loses their protection. Seller issues: 1. Is the seller protected if the buyers default? None of the documents used in creative financing are “standard” forms. Many times the documents need to be drafted or revised to properly protect the seller. I often see sellers who thought they were protected but in reality were not. Even if properly drafted to protect the seller one of the biggest risks is that the seller is giving up possession of their property. If the buyer/renter defaults you have to go through some type of legal proceeding to get them out of the house. If they cause damage to the house the seller will have a claim against the buyer/renter but this is another lawsuit, an other cost and the judgment won’t get you paid if they have no money. 2. Can the seller get a higher price for the property by using “creative financing”? The buyer/renter may agree to a higher price because it is the only way they see to get into a home but that doesn’t mean that they will ultimately buy it. They may agree to the deal because they want to be in a house and are okay with the monthly payment but have no intention to buy at the agreed upon price. Even if they want to buy at the higher price they will have to qualify for a mortgage to buy it and if the house does not appraise, they will not get the loan. Buyer issues: If I pay extra money for an option to purchase how do I know that the Seller doesn’t take off with the money? If the seller has equity in the property it is unlikely that the seller will leave the equity to leave with your option payments; however, if the seller has no equity or loses the property in a foreclosure the buyer is at great risk. One possible solution is to have the rent/option agreement to require that the option payments be placed into a trust account. Of course, the agreement will have to address who is holding the trust account and on what terms the money will be released. Is the buyer protected if the seller loses that property in a foreclosure? The buyer/tenant may have some protection in his/her lease; however, if the lease violates the terms of the mortgage the lease will not be recognized. If the lease contains an option to purchase that violates the terms of the mortgage (and they generally do), the option to buy will not be recognized. The money paid to the seller will not be refunded by the lender. Any improvements made to the property will not be paid for by the lender. A buyer/tenant must protect themselves as best they can and also recognize the risk that they are taking. What if the property doesn’t appraise when it comes time to buy or pay off the contract for deed? Even if you personally qualify, the property is still going to have to appraise. Many deals are being written with a contract price or an option price that is based upon what the seller wants (or needs) but cannot get in today’s market. Unless the fair market value of the property rises up to the purchase price before it comes time to buy, the deal will fail. What if the seller doesn’t have good title when the buyer is ready to buy? If the seller is willing and able to correct the title problem the buyer should be okay. If the seller cannot or will not correct the title problem, at best the deal will die at worst it will create a lawsuit. It is best to get title work done when you first enter into the deal and then a follow-up before the purchase to make sure nothing has changed. Anyone can find a lease/option agreement, a contract for deed or a mortgage to be used to get a deal done when conventional financing is not an option. To structure a deal where the buyer or seller is protected is not so simple. As shown above, there are many issues that must be considered and dealt with. If these issues are not properly dealt with disaster will follow. For those of you old enough to remember, during the 1980’s creative financing was quite common. Generally, it involved the use of contract for deeds. While they were quite common, many mistakes were made, many risks were taken by people who didn’t understand them and many turned into an expensive mess that sometimes showed up 5 to 10 years after the contract was signed. Don’t let your clients take a shortcut, don’t let them force you into guiding them through complicated legal issues that can only come back to haunt you - either they make their own decision to go forward without legal representation or they hire an experienced real estate attorney. If they go forward on their own decision, the consequence of their decision is theirs to bear. If you make the decision or “advise” them, when something goes bad, they will blame you. You are not getting paid for this liability, don’t fall into the trap. NOTICE The foregoing is not intended to constitute legal advice for any specific circumstance, but is intended to reflect broadly applicable principles, under Minnesota law, relevant to a typical situation. Each set of facts and each contract is, or can be unique; the unique facts and specific language of the contract may require a different legal analysis and may result in a different outcome. Before proceeding in reliance upon this or any other general description of law, consult with an attorney competent in the field of practice relevant to your situation. Copyright 2007 Nash & Lodge, PLLP