Whether you are starter or veteran investor, mastering the ins and outs of financing and getting the right advice is crucial to your continued success.
We have seen a tightening in the lending guidelines and they are expected to continue tightening, especially of the economic situation changes. We have seen amortizations drop from 40 years to (25) years in most cases, tighter rules for buying as a self-employed especially if you don’t show much income on your tax returns as well the increase in down payment requirements over the years for rental properties.
The good news is that despite the tightening in guidelines, you can still buy and benefit from investing in real estate. It just means that you may now have to broaden the pool of lenders and financing strategies you deal with. It may also mean that there would be some increase to the cost of doing business.
In this issue, we discuss one of the key financing strategies that investors can tap into for lowering their out of pocket financing expenses and to save time: Vendor Take Back Mortgages.
What is a Vendor Take Back?
A VTB or Vendor Take Back is when the seller (vendor) of a property provides you with a some or all the mortgage financing for purchasing his/her property. This type of financing is more common on commercial properties (including multi residential) however you can tap into this strategy on residential purchases. A VTB can also entail the seller covering one or more of your closing costs such as land transfer tax, appraisal, survey or application fees.
Why Consider a Vendor Take Back
There are many reasons as to why seller-arranged financing may be attractive to you as a buyer:
1. Buying a distressed property. If you are a flipper or looking to buy distressed properties with the mindset of improving/renovating those to increase value then a VTB may come in handy, simply because some lenders may shy away from lending against such a property or may lend at whopping interest rates. When dealing with distressed properties, it is often beneficial that you finance your purchase through a combination of a VTB, Line of credit, your own cash and then approach a lender once you have brought the property to a certain standard.
2. You are unable to obtain Financing through the standard lending sources. Qualifying for a VTB is a matter of negotiating one with the seller while getting a mortgage requires you to qualify with the lender. If your financing application got declined and you have exhausted your sources, you may be able to finance your purchase through the seller. Your ability to negotiate a VTB would depend on how motivated the seller is and his willingness to continue to tie his capital onto the property.
3. Increase Your Return on Investment. Assume you have $50,000 in down payment funds to buy your next investment property. In today’s world, this is a 20% down payment for a $250,000 purchase.
If you were able to arrange first mortgage financing on this property for 80% of the value, so your first mortgage would be $200,000. If you are able to arrange with the seller a VTB for 10% of the purchase – which is $25,000 – , then you have effectively lowered your down payment for this property to $25,000 and as a result have boosted your return on investment due to the lower cash outlay.
4. Buy a Larger Property with the same amount of funds or less. As per the above example, you can buy a $250,000 property with $50,000 in down payment funds.
With the same amount funds, you can buy a $500,000 property if you were able to arrange a VTB first mortgage for 90% of the value.
5. Save on the costs and time associated with traditional financing. There are various costs associated with financing a property. Those costs are typically much higher in Commercial properties and include but not limited to the following: appraisal, survey, lender fees, environmental analysis fees and mortgage insurer fees. In addition to the costs, the process of getting approved for a loan may be lengthy – depending on the complexity of the deal – and often require providing the lender with one or more support documents such as: income and employment verification, details about your existing property holdings, credit, bank statements and tax statement. A vendor take back saves you the time and costs associated with getting approved as you are dealing directly with the seller.
It is also worth noting that with a VTB, generally there isn’t a penalty for pre paying the mortgage before the end of the term, while with traditional lenders such as banks for example, you will incur a penalty for prepaying the mortgage prior to the end of the term.
6. You can afford to pay more for the property. By negotiating a VTB with favorable interest and terms, you may be able to offer the seller a higher price for their property making your offer more attractive.
What is the Maximum Vendor Take Back that you can get from the seller?
If you are negotiating a VTB as a first mortgage, then the loan to value (the ratio of how much the seller is loaning you to the purchase price) is a function of what you negotiate with the seller. We have seen buyers able to arrange a VTB First Mortgage as a high as 90% of the price at which they are buying the property.
If you are arranging a VTB in a second position; meaning that you are going to an institution for your first mortgage; then the max you can use in a VTB is 10% of the purchase price.
Do Lenders Allow Vendor Take Backs?
Not all lenders allow a VTB. Your lending advisor would be able to assist you in placing your deal with the right lenders that support this strategy.
If you are planning on using a VTB for a particular deal, it is important to disclose this information to your lending advisor.
What are the Rate and Terms of a Vendor Take Back?
The rate and terms on the VTB are negotiable. In most cases however, the seller will charge you an interest rate higher than what you would typically get through your bank. This is reflective of the higher risks that the lender is willing to accept.
The terms on a VTB can vary from interest only payments with one balloon payment at the end of the term or interest and principal payments.
Why Would the Seller Agree to Such Arrangement?
The advantages of a VTB are many to the seller, including:
1. Monthly Cash Flow. A VTB provides the seller with monthly cash flow after the property sells. Some sellers are likely to charge higher than market interest rates on their loans , enhancing their overall returns and on-going cash flow
2. Obtaining a higher price for their property. A seller who is providing a VTB at attractive terms, can demand a higher price for their property
3. Deferring taxes. Instead of getting taxed on the full capital gains from selling his/her investment property, the seller can defer the taxes payable on some of those capital gains over a period of 5 years by arranging a VTB mortgage.
4. Avoiding pre-payment penalties on existing locked-in loans. If the property has a locked-in loan, the seller can sell without having to negotiate with the lender for a higher loan amount or permission to assign or repay the loan; saving the seller time and money
5. Selling in a slow market. Offering a VTB in a stagnant market offers an extra incentive to buyers. It also helps the seller successfully market a hard to sell property
What are the risks of a VTB?
Despite its advantages, a VTB mortgage should be entered into with caution. It is complicate and you should always consult with a real estate lawyer to review all documentation and for due diligence. From a seller’s point of view, he/she is dealing with the risk of default. From a buyer’s point of view, he may find himself having to pay off the VTB mortgage in a lump sum if the seller dies, goes bankrupt or needs to liquidate his estate.