AMA - Should I Take Seller Financing?

Today is another AMA episode.

On today’s show Richard asks

“I have a seller who is in their mid 80’s and has been a little difficult to work with. He has a development site that is zoned R3 and we can build a profitable project on it. We can get 5 units by right, and maybe 6 if we are granted a variance. The land is expensive and therefore that sixth unit really makes the project profitable. I’m wondering if I should try and negotiate seller financing so that the borrower contribution is fully funded by the seller financing. What are your thoughts on the strategy?”

Rich, that’s a great question. Seller financing can be a great way to raise capital for a development project. It can also be the undoing of a development project. I’ve seen both happen. It all comes down to convincing yourself that you have a reliable partner in the development. Understand that the seller is going to be required to sign virtually every piece of paper that affects the title.

The debt structure is going to look something like this. You will have your senior construction lender in first lien position, and the seller financing will be in second lien position. But if the construction financing isn’t secured prior to purchasing the property, the seller will actually be in first lien position. They will need to sign mortgage subordination agreement in order to allow the construction lender to assume first position.

When you transition from your construction financing to your permanent financing, you will need to go through that process again. The seller’s signature will be required.

Any time the seller’s signature is required in order for you to make progress on the project, it represents an opportunity for someone who is not in control of the project to exercise a full veto on your project. That’s a risk.

You mentioned that the seller is in their 80’s. You are probably not 100% up to speed on their health. They could have a health condition and may be unable to sign when you need them to. They may have granted a power of attorney to a family member, and now all of a sudden you’re dealing with a family member who you’ve never met and who knows nothing about the project. They might be unwilling to take the risk of signing anything. If the seller dies, you have the same issue.

The alternate approach is to raise the capital to make a clean purchase of the land. Yes, when you raise money, that often means giving up an equity share to your investors. But here too, you may be better off than dealing with someone who you said could be difficult.

When you raise money you have a few choices.

The first is equity. You’ll need to decide how much equity you will need to give up in order for the project to make sense for you and for your investors.

If you can secure a loan from the seller in second lien position, you could secure a loan from someone else in second lien position. The source of funds will be different, but the security would be the same. It won’t be as lucrative as the 100% financing you’re contemplating with the seller financing.

Understand that your risk with the seller is higher that if you bring in investor funds. The construction loan will have a finite time period. This is usually less than 2 years. If the second lien mortgage holder delays you for whatever reason, you could face the problem of running out of time on your construction loan. The construction loan is in first lien position, but most construction lenders require the sponsors to sign a personal guarantee, or as a minimum they would require a completion guarantee.  A default on a construction loan with personal guarantees could effectively end your career as a developer. So in my opinion, it’s not worth the risk.

Your description of the relationship sets off some flags for me that suggest you look elsewhere for the money in this instance.