As published in Scotsman Guide's Commercial Edition, November 2007.
One often-overlooked creative-financing option to consider is a wraparound encumbrance, or wraparound financing. The basic idea is that sellers use their equity combined with money they borrow to provide seller carry-back financing to buyers while charging an override in the form of a higher interest rate.
It involves two loans -- a smaller loan at a lower interest rate in the sellers' name and a larger loan carried back by the sellers in the buyers' name. While this approach is not appropriate for every transaction, it is a form of creative financing that can allow a transaction to close that otherwise would not. A wraparound is typically most useful in two scenarios:
When an existing loan cannot be paid off because of a lock-in clause or punitive prepayment clause, yet the owners still want to sell.
When buyers cannot qualify for favorable loan terms, but motivated sellers can.
When the existing loan can't be paid
In the first scenario, assume that a property is being sold for $100,000. The current owners have a $70,000 lien against the property. This is a 10-percent, interest-only loan with one payment per year.
The owners want to sell, but they discover that the $70,000 lien cannot be paid off because a lock-in clause prevents it.
Or in another case, a prepayment clause in the note is so punitive that the owner can't afford to pay it.
Let's look at how the wraparound scenario can be implemented. First, the sellers and the buyers execute a land-sales contract selling the property to the buyers. The buyers then contribute $20,000 in cash as equity for the transaction. And the sellers carry back an $80,000 note for the buyers. Assume this is a 12-percent, interest-only loan with one payment per year.
At this point, the sellers have to make yearly payments of $7,000 on the existing note they have against the property. At the same time, the buyers must pay the sellers $9,600 per year for the money carried back by the sellers. The sellers net a before-tax profit of $2,600 per year as the difference between what they pay in debt service on their loan and what the buyers pay them in debt service on the carry-back financing.
Because the sellers only put $10,000 of their own equity into the carry-back financing, they are earning a 26-percent yield on their investment.
Weak buyers, strong sellers
Assume that a property is being sold for $100,000. The current owners owe $10,000 on the property. They have a strong balance sheet and can obtain favorable financing terms. Let's look at the potential wraparound scenario if the sellers want to sell to buyers who cannot obtain financing or can't get favorable terms.
The sellers refinance the property by borrowing $60,000. Assume a 6-percent, interest-only loan with one payment per year. The sellers and buyers execute a land-sales contract selling the property to the buyers. The sellers loan the buyers $80,000 via seller carry-back financing. Assume an 8-percent, interest-only loan with one payment per year. The buyers pay the sellers $20,000 in cash to meet the sale price.
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