8 Considerations for Seller Financing Free & Clear Single-Family Rentals to Tenants
Are you a landlord? If you are, then I’m willing to bet that you have had days when you said to yourself ‘if only I could get the cash flow without having to get phone calls from tenants about sewer backup or late rent payments.'
Well, if you own your single-family rental free and clear or if you can pay off the mortgage loan on your rental from equity from another rental if you are in “consolidation mode” (the opposite of BRRRR in “accumulation mode”), you can “convert your rentals into notes” through seller financing. When you seller-finance your rentals to tenants, there are definitely tradeoffs relating to simplification of your life, return on investment, compliance with the law, taxes and more.
In this article, I will highlight 8 considerations for converting free and clear single-family rentals into seller-financed notes. This article is not meant to be comprehensive and you should always consult with licensed professionals (attorneys, accountants, financial advisors, mortgage originators, etc.) before making any decision or taking any action. Every investor’s situation is different.
For the purpose of this article, we will assume that the seller financing is a promissory note secured by a mortgage, not a land installment contract, a lease-option or other type of creative seller-financing.
1. Cash Flow as a Rental Versus Cash Flow as a Note
For most of us, the first step in considering whether to convert a free & clear single-family rental into a seller-financed note is to calculate the ACTUAL cash flow from that rental after taxes, insurance and VRA costs (vacancy, repairs and administration costs: click here) and compare that with the cash flow from the seller-financed loan.
In one case, the cash flow from a single-family home rental after taxes, insurance and VRA was $1,105 last year. If the property is seller-financed to the tenant with a 30-year amortization and only 3.5% down payment, the monthly payment from the tenant-buyer will be $1,203 of which $110 will go to principal in the first month and we also have to subtract from that the $30 per month loan servicing fee. In this case, the actual cash flow from the rental can be converted into a monthly note payment that is slightly higher, though some of the payment is applied to principal (loan balance reduction) which you need to figure into your feasibility calculation. Please note that in this case, the interest rate of the seller-financed note to the former tenant is higher than market rate, but not unconscionably higher.
2. Tenants & Toilets Versus No Tenant Management
The major motivation for landlords to convert a free & clear rental to a mortgage loan note is to remove the time and financial burdens of maintenance calls, tenant excuses, annual inspections by the authorities, liabilities such as slip & fall, pet bites, etc. If you have a property manager take care of all of that, you still need to manage the property manager and the property manager eats up a non-negligible portion of your remaining cash flow. If you convert the rental into a note and have a third party loan servicer collect the mortgage payment, escrow the taxes and insurance and deposit the remaining proceeds into your account by ACH (automated clearing house), then the cash flow from the note becomes TRULY passive. Rentals are purported to generate passive income, but every landlord knows that the reality is that rentals are really only semi-passive. Read my article on the “passiveness” of rentals.
3. Non-Payment: Eviction Versus Foreclosure
If a tenant does not pay rent, you go to landlord-tenant court and file for eviction. The costs and duration of an eviction case from the time of filing to lockout varies from jurisdiction to jurisdiction. The filing costs are usually under $100 without an attorney and hundreds of dollars with an attorney and the total elapsed time for an open and shut case of non-payment of rent is in the order of weeks (about 6 weeks in my jurisdictions). The costs of repairs and holding costs to prepare the property for the next rental are much higher. In contrast, if the buyer (former tenant) defaults on a seller-financed note, we are talking about a foreclosure process and that can take a very long time, often a year or more, during which time, you are not receiving any payments and your legal costs are high (much higher than for an eviction). This is one reason that you want to be extremely selective in choosing which tenants are good candidates for a seller-financed purchase. I do not consider a seller-financed purchase to tenants unless they have a long enough history of on-time rent payments with my entity.
One of the smartest investors I know is in his 70’s, owns more than 100 single-family home rentals and he does not use an outside property management company. He says that the only real estate deals he has regretted were the few homes he sold. He loves the cash flow and the equity and for the most part enjoys dealing with people. When I first considered seller-financing a rental to a tenant, I ran the idea by him and he IMMEDIATELY pointed out that a big financial risk with converting a rental into a note with a fixed interest rate and amortized loan is that high inflation will erode the economics of the monthly payment within a few short years of high inflation. We need to recognize that inflation has been unusually low over the past decade and many of us have been lulled into complacency when it comes to inflation. If we charge 8% interest these days for a seller-financed mortgage loan which is high relative to today’s mortgage loan market, that same 8% was standard for many years not that far in the past. So, the buying power of a cash flow of $1,100 per month today erodes sharply at “normal” inflation. Even at 3% inflation per year, the buying power of a dollar drops by a huge amount over 10 years. Depending on your time horizon, goals and structure of the note, inflation might be enough of a disincentive to disqualify seller-financing of a free & clear rental as an option.
5. Dodd-Frank Compliance Versus Landlord-Tenant Law
One way to possibly minimize the impact of the risk of inflation is to incorporate a balloon payment into the loan terms to shorten the duration of the loan (reduce time-based risk). For example, you may decide to provide seller financing using a 30-year amortization schedule but require the buyer to pay off the remaining loan balance after 5 years or 10 years, for example, by refinancing the loan. However, if you put a balloon in the loan and/or make more than 3 loans in a year and/or don’t verify that the borrower has the financial ability to reasonably expect to repay the loan, and/or incorporate any of a variety of other terms in your seller-financed note, you may run afoul of a law known as Dodd-Frank if you are not a licensed loan originator. You need to learn all about Dodd-Frank before entering into a seller-financed loan. In contrast, if you keep your rental and continue as a landlord, most of the laws for which you need to be in compliance are landlord-tenant laws. There many more rentals in the market than seller-financed loans and more sources to learn about compliance for rentals than for seller-financed loans. Regardless, if you seller-finance the sale of a rental to your tenant, you MUST comply with Dodd-Frank and all other potentially relevant laws.
6. Appreciation for Landlord Versus Buyer
Some landlords buy properties in up-and-coming neighborhoods and use rentals in those neighborhoods to generate positive cash flow while waiting for the properties to appreciate. If you sell the house to the tenant using a seller-financed loan, the buyer (former tenant), not you, will benefit from the appreciation. If the house depreciates, the buyer (former tenant) may have incentive to stop paying if the value of the house falls below the loan amount and then you have to deal with the foreclosure discussed in Item 3 above. In other words, if the market goes up, then seller-financing the purchase of the home by the tenant means that you are giving up the appreciation, but if the market goes down, you risk having to foreclose. You need to be sure of the reasons you want to get rid of this rental so you can properly assess the tradeoff’s you are making. This can be another disincentive to convert a rental into a note.
7. Loan Balance Reduction for Landlord Versus Buyer
Part of the calculation of the economics of an amortized loan is the reduction of loan balance with every payment. That is the good news AND the bad news depending if you are the borrower or the lender. For my financed rentals (not the free and clear ones), I look forward to reconciling my loan balances since the loan balances go down every month which results in increase in net worth if the property value does not change. When you sell a house to a buyer with a seller-financed mortgage, the BUYER’S loan balance goes down and you, the lender, must realize that a portion of each payment to you is reducing the loan balance owed to you. In other words, a disadvantage of converting a free and clear rental into a note (assuming no arbitrage) is that the value of your underlying asset (note) goes DOWN every month when you are the lender. This is the opposite of the value of your underlying asset going up or at least staying stable over the years when you remain the owner. This is the major reason that I did not consider investing in notes until recently.
If much of the equity of the free and clear rental you are selling with seller financing came from appreciation over the years (at least 1 year), then you might have a huge long term capital gain when you sell the property. On top of that, you may have a significant tax bill due to depreciation recapture when you sell a rental property that you held for a long time. Taxation in such situations is different for every investor and recent/future changes in taxation of long term capital gains are likely to affect the economics of seller-financing the sale of a rental to a tenant to the point that you really need to consult with a licensed tax expert when considering converting your rental into a note.
Again, this is NOT a comprehensive discussion of seller-financing free and clear rentals to your tenants, especially since every investor’s situation is different. We are all in different stages of life with different income, different net worth, different available time, different skills, different diversification of assets, different asset protection needs, different access to capital/credit, different level of personal expenses, different goals for happiness and different investor status such as accumulation mode (most of you) or consolidation mode (me). Due to these differences, you should consult with your licensed advisors before making any decision or taking any action.
For example, I am currently seller-financing a house to tenants in my self-directed retirement plan. For that reason, taxes were not a consideration for me, but they could be a big consideration for you, especially if you will realize a big gain in the year of the sale. The considerations outlined above were factors I used in my decision, especially being in consolidation mode and owning the rentals in my retirement plan. You must evaluate sell-financing your sale of rentals to tenants customized for YOUR situation and consult with licensed advisors in your state before pulling the trigger on such a sale.