When property sellers need to receive as much cash as possible immediately for the down payment on their next house, it is critical to anticipate this need in order to use seller financing to their advantage.
Getting top dollar for a note
In a typical seller-financed closing, the seller only receives cash from the down payment at the time of sale. This amount could be used to pay the real estate agent and put the remainder toward their own down payment on another house, but in many cases, the amount received is not enough. In addition, a seller who uses private financing to close the sale will not get the full amount financed when the note is sold.
Most sellers need as much money as possible when they "cash out" their newly created note, so their objective is to sell the note at the lowest discount possible. In addition, to do this, they will need to create a secured cash flow that is attractive to note buyers.
Note pricing factors
The size of the discount - i.e., the difference between the purchase price and the remaining balance - depends largely on factors such as the specifics about the payer, the property/price, and the note terms. If the note is created without these important criteria in mind, the seller may have a difficult time finding a buyer to pay the amount that the homeowner needs.
The Payer
Clearly, there is not much the seller can do about the "quality" of the payer because most people interested in accepting seller financing are higher-risk borrowers. Still, if there is more than one party interested in buying their property, sellers offering financing can still discriminate based on credit history or the amount of the down payment offered.
The Property/Price
Similarly, the seller cannot change the basic facts about their property - where it's located, the type of structure, or its age or condition. However, the seller can control the price they set for their property.
Most sellers have a specific amount in mind that they need to get out of a sale. In traditional real estate sales, getting that money usually is determined by the property's price. However, with seller financing, there is another step that is taken before the seller ends up with the total amount of money they were looking for - the note must be sold.
Since private notes are typically sold at a discount, the seller must set their price higher than the amount they were looking for to compensate for the drop that will come with the buyer's offer. By setting the price slightly higher than market value, the seller can create a note that sells with a minimal discount. Individuals that do not qualify for conventional funding are motivated to buy real estate, even if the price is somewhat higher than market value.
Increasing the sales price and the implied value of the property will not actually affect the buyer's discount, but the adjustment could lead to more money in the seller's pocket.
A higher sale price means a note with a larger unpaid balance, which could still bring the seller the desired net amount after discounting. Keep in mind that higher sale prices can also lead to larger down payments (as a set percentage of the price), resulting in more money in the seller's pocket.
The Note Terms
The most important thing for sellers to do is to structure their note so that the buyers will not be forced to incorporate a deep discount into their offers. From the buyer's point of view, higher interest rates and shorter terms are preferred. The actual offer made is based on the yield the buyer is looking for; in general, higher yields are associated with riskier notes. The discount is directly related to the difference between the interest rate on the note and the buyer's desired yield.
While sellers cannot know exactly what a buyer's required yield will be, the seller can certainly create a note that could minimize the expected discount. Generally, buyers will want to receive a yield anywhere between 12% and 20% on a note. While yield parameters will fluctuate with the market, a 10% yield is typically the lowest they will accept for new notes.
A note creation example
Because buyers usually want to earn a yield above 12%, creating a note with an interest rate under 10% would automatically mean a steep discount when the note is sold.
For example, creating a cash flow with a 3% interest rate does not make any sense if the seller needs to get top dollar for their note, because there is already a seven-point difference between the interest rate and the buyer's desired yield. In addition, most buyers will create a gap in their favor by yielding at least one point more than the interest rate.
Sellers can also avoid unnecessary discounts by reducing the terms of their notes. Another part of a buyer's discount is based on the time-value of money principle, meaning that notes that take longer to be paid off will usually be discounted accordingly. An ideal term for a private secured note is between five to ten years (60 to 120 months).
Conversely, it is not a good idea to shorten the term down to two years or less because a foreclosure situation will be created - the monthly payment will likely be too steep for the payer to keep up with for long.
By keeping the eventual note buyer's criteria in mind when creating a private note, property sellers can ensure that their real estate note deal works out the best for them. In addition, that they net the highest amount possible when a cash settlement is reached.
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