Buyers and Sellers: Beware of Crazy Financing in a Declining Real Estate Market

Westcoe Realtors, Riverside, California…While it seems ironic to be concerned with “crazy financing” in our current real estate market (since one could say crazy financing has led to our current real estate predicament), there are some “less-than-optimal” financing schemes that always seem to resurface during lean real estate times…and today is no exception.  Having gone through 4 of these up-and-down cycles in my career, I thought it might be useful to forewarn both buyers and sellers of the pitfalls of the “new” financing options that are once again being trotted out as alternatives in our current market.

These financing options I will soon discuss always float to the top when we have two simultaneous things happening:  sellers who are having trouble selling their property in a conventional manner (owe too much, prices have fallen, want too much for the home, etc.) and buyers who cannot purchase in a conventional manner ( bad credit, lost their home, cannot qualify for current financing, etc).  When these two forces come together in the marketplace, driven by a desire that is not necessarily backed-up with ability, then it is a recipe for misunderstandings at best, and future disasters at worst. 

While all of this “alternative” financing can go by many names (those in a minute) THE COMMON FEATURE THEY SHARE IS THE PURCHASE OF THE HOME BY THE BUYER WITHOUT NOTIFYING THE EXISTING LENDER THAT A SALE HAS TAKEN PLACE.  This financing can be called “AITD (all inclusive trust deed), wraps, land contracts, and “subject to” financing.  Lease options can sometimes be included here as well, although we will discuss them separately at the end of this blog.

Understand, the scenario generally goes something like this.  The seller is desperate, and really wants/needs to sell the home.  In a market like this, the loan balance is generally higher than the current value of the home, so they cannot sell without having to bring forth some cash…cash that they do not have.  They are stuck, and cannot sell the home in a conventional way.

Enter the buyer…who is also equally desperate.  This buyer cannot purchase in a conventional manner either, generally because they have poor credit (possibly foreclosed upon which is happening a lot these days), lack the necessarily income to purchase at the price they desire, etc.  SO…what happens when these two highly motivated parties get together…maybe with the help of a less than honest real estate broker?   Generally speaking…a short term solution and a long term mess.

 Here is the problem.  When everyone in this equation gets their heads together, all they do is form a rock pile!  Eventually, no matter how one slices it, these enterprising people decide to let the buyer take over the existing financing on the home, not tell the lender, and then worry about it later.  Understand that almost every loan has a clause (alienation clause, or due-on-sale clause) that is very specific here.  It says, in legalese, that the seller cannot sell the home and keep the financing in place without the lenders specific approval.  If they don’t get this approval, then the lender can call the entire balance of the loan due and payable the minute they discover the transfer of title has taken place.  Simple, clean, and deadly to our buyer and seller in this situation.

Knowing this, the buyers and sellers proceed anyway.  Why?  Because they are desperate, and they think they can outsmart the bank.  The problem here is that this type of financing is the “real estate gift that keeps on giving”…and what it generally gives are headaches for both parties.

First, the bank is like your parents…they have seen it all.  No matter what mechanism you come up with to keep the payments going to the bank, the outcome is that they will eventually find out.  Trust me.  They can check the utility bills now in the new buyers name…the tax write-offs by the new buyer instead of the old seller…the new mailing address for the old seller…they can check with title because something will have to be recorded or the new buyer is merely renting the property with no legal protection from the seller selling it again to someone else!…and I could go on.  It may take a year or two, but in the end, the lender will find out, and they get very angry that you tried to pull a fast one on them.   They will have every right to call the entire amount of the loan due right now, and if the buyer doesn’t have the cash the lender wants (and few of us do), then foreclosure will ensue.

Ready for more downfalls?  I know everyone thinks that if the lender does find out in a couple of years, then the buyer can simply refinance at that time, and all will be well.  But…doesn’t that sound a lot like the same line that has currently gotten a lot of people in trouble today?  Remember…there is no guarantee that either the buyer will be able to refinance in 2 years, or that the home will qualify.  So…Once the you-know-what hits the fan, now what?

Well…assuming the buyer still cannot qualify for a new loan to replace the one now being called by the lender, here’s what happens.  FOR THE BUYER:  unless you can replace the existing loan, you will lose all the money you have paid the seller (down-payment and monthly payments) and you will lose the home as well.  FOR THE SELLER:  for you, it is worse.  Since in the eyes of the lender you are the rightful owner of the home, it is your credit that is now going to be harmed.  The foreclosure will appear on your record, and will stay there for 3-5 years.  Like I said…this type of financing can be the real estate gift that keeps on giving.

Lastly, let me discuss briefly “lease options…or rent to own” type of transactions.

Whereas in these cases, the “buyer” is really just a glorified tenant who is making extra payments towards the ultimate purchase of the home at some later date, please beware.  You may not run afoul of the existing lender (in most cases, the lender allows the seller to rent the property),  but there are plenty of issues here as well.  The traditional structure of a lease option is to establish a purchase price now, a time frame to exercise this purchase price (usually 1-2 years out), and then a rent (plus some extra to be applied towards the tenant/buyer’s ultimate purchase) to pay until this “sale” is finalized at the appointed time in the future.

Sounds simple, BUT IN OVER 30 YEARS IN THIS BUSINESS I CAN COUNT ON ONE HAND THE SUCCESSFUL LEASE OPTIONS THAT HAVE EVER BEEN CONSUMATED.  The bottom line is that in the 2 years it takes to make this sale happen, too many things can go wrong.  First, who can say if the price you negotiated today is even remotely accurate two years from now.  Someone is going to feel they have been taken advantage of.  Second, what if the buyer still cannot swing financing?  Extend…kick out…raise the rent/purchase price?  Lots of choices.  Thirdly, since there is nothing filed with the title company to show that the tenant/buyer has any interest what-so-ever in this property, we have seen instances where the seller has refinanced, or even sold the property to another party without the knowledge of the tenant until they get a knock on the door from the “new” owner.  Far-fetched, but it has happened.

In the end, regarding all of the above types of financing, unless all parties are highly aware of all the pitfalls and potential disasters, and have been fully informed by an attorney, we really do not recommend you get involved at all with transactions of this type.  They just spell trouble, and at best, provide a short-term solution…but that short-term solution can cause such a long-term problem, that in our opinion, is just isn’t worth it.  We know your situation may appear desperate at the moment, but be very careful that by solving one problem now, you don’t create a larger one for later.