There are many ways to finance a commercial real estate transaction, but one of the most intriguing and potentially beneficial strategies is owner financing. This type of agreement allows for more flexibility and can be an attractive option for both buyers and sellers. In this article, we'll look at what owner financing in commercial real estate is, when it's most commonly used, and important considerations for both sides in this unique financial arrangement.
What is Owner Financing?
Owner financing, also known as seller financing, is a type of financing where the seller acts as the lender. In this type of arrangement, instead of the buyer securing financing through a traditional commercial lender or a bank, the seller finances the purchase. This means that the buyer makes regular payments to the seller until the loan is paid off, and the seller retains interest in the property until the loan is fully repaid.
While the full purchase amount can be financed through owner financing, Pickett Sprouse Commercial Real Estate Broker Brad Gregory explains that it is more commonly used as gap financing. In other words, if the buyer can only get approved for a loan by a commercial lender for a portion of the purchase price, the owner financing could make up the difference.
For example, if the purchase price is $1 million and the buyer is only able to get a loan from a commercial lender for $800,000. The seller of the property might be willing to finance the remaining $200,000 for the buyer.
How Are Owner Financing Payments Calculated?
Payments in an owner-financed loan are usually calculated similarly to how they would be with a bank or other type of commercial lender. Brad walks us through what this might look like. "The seller might agree to finance the loan for a term of 3-5 years with an amortization period of 15 to 20 years. At the end of the 3-5 years, the remaining balance would be due as a balloon payment, but the loan could also be renegotiated at that time."
Of course, just as with any loan, interest will be charged on top of the principal. Brad says that the interest rate charged in owner financing for commercial property is usually prime +1 or +2, similar to the buyer's first mortgage.
What Are the Potential Advantages of Owner Financing?
Owner financing can be an appealing option for both commercial property buyers and sellers because it offers more flexibility than traditional financing. Here's a look at the pros for both sides.
- Provides an alternative source of funding. The most beneficial aspect for buyers is if they're struggling to secure full traditional financing from a bank. In this case, owner financing may provide an alternative route to property ownership.
- Potential for paying less cash upfront. Brad says the flexibility involved with owner financing may give the buyer the opportunity to negotiate less cash down upfront. This would give them the chance to put more cash back into their business at a time when they may be getting it up and going or expanding.
- Potential for a quicker sale. According to Bill Hutchins, a Board Certified Specialist in Real Property Law with Kennon Craver, PLLC in Durham, NC, offering owner financing may help sell a difficult property. Buyers who may not qualify for traditional financing may be able to purchase your property through seller financing. This can widen your pool of potential buyers and expedite the selling process.
- Potential for higher returns. As the lender, you can charge interest on the loan, which can result in more income over the life of the loan compared to a traditional sale.
- Provide a steady stream of income. This can be particularly beneficial if you are retired or looking for a way to diversify your income. The monthly payments from the buyer can serve as a reliable source of income.
- Ability to spread out capital gains taxes. Bill says, "You can potentially receive installment sales treatment, and so you could spread the taxation of your capital gains out over multiple years."
What Are the Potential Disadvantages of Owner Financing?
While there are benefits to owner financing, there are plenty of potential downsides to consider as well.
- Assuming all responsibilities and risks for the property. Brad points out that just as with a loan from a traditional commercial lender, once the papers are signed, the buyer becomes the owner of the property and assumes all responsibilities associated with it. This means they have to take care of all maintenance and repairs and any other associated costs.
- Dealing with multiple lenders. Owner financing means that the buyer is now dealing with multiple lenders. This means juggling multiple loan terms and conditions as well as payment schedules.
- Relegated to second position on the mortgage note. Brad cautions that this is the most important aspect for a seller to consider before offering owner financing. The bank or traditional commercial lender's loan will always take first position. If a buyer is struggling to make payments, they have to be made to the bank first. This puts more of the risk of default on the seller.
- Risk of default: Bill says that foreclosure is the only recourse available to sellers who provide purchase money financing in North Carolina in the event of buyer default.
Assumable Loans and Owner Financing for Commercial Real Estate
Brad points out that in the current market with higher interest rates, the ideal for the buyer in an owner financing situation is to be able to assume
the owner's existing loan. This would mean that the buyer takes over the remaining payments on the seller's loan from a commercial lender. They would then work out financing with the seller for the difference between the existing loan amount and the purchase price. The advantage for the buyer in doing this is that they would be assuming the loan with a presumably lower interest rate with the commercial lender.
It's important to note that it is rare for a traditional bank or lender to agree to assumable loans. Eddie Blount with Pinnacle Financial Planners explains why. "It's a lot of work. The bank is basically having to do all of the underwriting for the new buyer that they would have to do with a new loan. The bank is usually going to say, 'If we're doing all this anyway, we're just going to do a new loan.'"
To find out which types of loans are usually assumable, be sure to read our article on Assumable Loans in Commercial Real Estate.
The Role of the Real Estate Attorney in Owner Financing
In owner financing, a real estate attorney can play a vital role. They can help ensure that the transaction is legally sound and protect the interests of the buyer or seller.
According to Bill Hutchins, one key role of a real estate attorney in an owner financing agreement is the drafting of the loan documents. At a minimum, these will include a promissory note and the deed of trust. Only one of the attorneys involved has to draft the documents, but counsel for both sides should be involved with reviewing and negotiating them.
While it's typical and advisable for both buyers and sellers to each have their own real estate attorney, Bill says that some sellers forego representation by counsel. That's because the buyer’s counsel typically performs the title examination (rendering an opinion on it so that the buyer can acquire title insurance), handles funds, and records the deed and other instruments.
Finally, an experienced real estate lawyer can provide valuable advice and guidance throughout the transaction. They can help you understand the risks and benefits of seller financing and help you make informed decisions.
Legal and Financial Considerations in Owner Financing
There are several legal and financial considerations that are important for both buyers and sellers to keep in mind when considering owner financing.
- Due diligence: It is essential for the owner to conduct thorough due diligence on the buyer's financial stability, creditworthiness, and business plan. This may involve reviewing financial statements, tax returns, credit reports, and business projections to ensure the buyer has the means to repay the loan.
- Ownership of the property: Bill explains that after closing, the title to the property would transfer to the buyer, and the seller would take back the deed of trust (also commonly called a mortgage). So just like with a typical loan with a bank, the buyer becomes the owner at closing and the seller simply becomes the lender.
- In case of default: As previously noted, the only recourse sellers have in North Carolina if a buyer defaults on the loan is foreclosure. Bill points out though that even if there is a foreclosure, sellers only recover the price brought at the foreclosure sale. That means that if the seller financed $800,000 but the property sells at foreclosure for $600,000, the seller would suffer a loss of $200,000.
- Tax implications: Owner financing can have tax implications for both the buyer and the seller. It is essential to consult with a tax professional to understand the potential tax consequences, such as capital gains tax, interest income, or any tax benefits that may be available.
These considerations emphasize the importance of seeking professional guidance from attorneys, accountants, and real estate professionals who specialize in commercial real estate transactions and owner financing.
Bottom Line on Owner Financing for Commercial Real Estate
The bottom line on owner financing for commercial real estate is that it can be a viable financing option for both buyers and sellers. For buyers, owner financing can provide an opportunity to secure financing for a property that they may not qualify for through traditional bank loans. This can be particularly beneficial for small business owners or individuals with less-than-perfect credit.