IC E Lesson: Work for Equity Deals Part 2: Avoid the Pitfalls
In last week’s e-lesson, I talked about how awesome it would be if Dodd-Frank were repealed and we could go back to doing work-for-equity deals for folks with more skills and time than money and credit.
At the end, I sort of felt like I’d only told half the story, because, like any real estate transaction, these can go wrong if done with the wrong people or not set up correctly to begin with.
So this week, let’s talk about how to set up these deals so that they have the maximum chance for success.
The primary pitfalls you need to avoid are:
1. The buyer doesn’t make payments, and you’re forced to take the property back through foreclosure. In states where judicial foreclosures are the rule, this can take months and cost several thousand dollars.
a. This usually occurs when the buyer can’t complete the work that the property needs in order for the buyer to live in it or, if the buyer is an investor, to rent or sell it. The buyer becomes frustrated with the property and stops making payments.
2. The buyer doesn’t pay the real estate taxes due on the property, and it’s sold at tax sale or a tax lien is issued against the property. You’ll end up paying the taxes in order to retain your 1st position lien on the property
3. The buyer doesn’t purchase insurance, or the insurance lapses, and a fire or other damage to the property occurs
For these reasons, it’s crucial that you do the following:
* Screen the buyer as you would any other borrower or tenant. Make sure that he has the income to support the entire principal, interest, tax, and insurance payment AND that he has the excess income AND skills to do whatever work is necessary. Check his criminal and civil record, employment, and so on.
* Make his taxes and insurance part of his monthly payment. The simplest way to do this, AND make sure that the tax and insurance bills are being paid, is to get a loan servicer involved. For under $30 a month—usually paid by the buyer—a loan servicer will take in the payments, pay the underlying mortgage payment, if any, and escrow the taxes and insurance for payment when the bills are due. The balance is, of course, sent to you, and the servicer notifies you if payments are late or not made.
* Make the amortization period of the loan as short as practical. As we discussed in last week’s article, under the Dodd-Frank Act as it currently stands, it’s not legal to put a balloon into financing when the borrower is a homeowner.
It is, however, legal to make the amortization period—the number of years over which the payment is made—shorter than the usual 30 years. By making that period as short as practical, you shorten the time during which something can “go wrong” with the buyer’s life or finances, and thus the deal.
As short “as practical” generally means the minimum time over which you can amortize the loan while still keeping the principal, interest, taxes, and insurance payment in the range of $100-$200 less than monthly rent on the same house. This attracts the maximum number of qualified buyers and also gives them some room in their budget for buying materials.
* Make sure that the paperwork is detailed, correct, and correctly recorded. You may use a contract for deed strategy, or you may choose a wrap-around mortgage or deed of trust to memorialize these deals. Whichever you choose, you and your buyer both need to understand your rights and responsibilities under the terms of the contract, and any contract you use will need to be recorded in the public record. Each of these contracts is heavily governed by and state law, so don’t just grab one out of some course and use it. Have a local attorney draft and/or review the contracts before you use them.
* Address default at the beginning of the deal. Sometimes, buyers default on these deals due to reasons that neither of you can control or predict. Divorce, illness, job transfer, and other unforeseen problems can force the buyer into a position where he can’t pay. His options at that point are to 1) resell the deal himself to pay you off 2) give you a deed in lieu of foreclosure or 3) be foreclosed on. I strongly suggest that you outline these options (with a heavy emphasis on why #3 is an option he wants to avoid at any cost) and get his agreement that #2 is the most right, fair, and pleasant of his choices. This won’t guarantee his cooperation in case of default, but will make his cooperation more likely.
* Where practical, a contract for deed may be the safer option for you. When the buyer has the deed to your property, he also has the ability to “further encumber” the property—that is, get additional private loans against it. If he then defaults, you’ll have no real options other than to foreclose the other lender out of the deal. Taking a “deed in lieu” on a property with a junior mortgage means that you’re buying your property back subject to the 2nd mortgage; giving the buyer a contract for deed means that he doesn’t have title, and can’t secure other loans against the property.
* Do a real closing. You’re selling a property; there are tax pro-rations, transfer taxes, and county forms to be dealt with. There should be a closing statement prepared. The purchaser should be encouraged to get title insurance, and you as the lender should get a lender’s policy. These things—especially the latter—require a qualified attorney or title agent.
* No one gets in no money down. A buyer without a down payment is a buyer who’s not qualified. If he can’t make a down payment, how will he pay the costs of getting his own loan later? Or, for that matter, of buying materials for the repairs?
A buyer who hasn’t made a down payment is a buyer who’s practically guaranteed walk away from the deal. If the property needs little to no work, 3-5% of the purchase price would be a minimum down payment; for a property that does, at least 2x what the rental deposit would be in a minimum.
* Selling these deals to people without the skills to renovate them is an invitation to disaster. You’ll often hear this: “If I get the property back with half the repairs made, I’m ahead of the game, because I’ve got a more valuable property to resell.” That’s all well and good, except in the case where the buyer’s repairs are of such poor quality that they must be redone, or where the buyer does things to the property that make it less valuable.
Any buyer of a repair for equity deal must, him or herself, have actual rehab experience. Do NOT fall for the story of, “My brother/father/babymama is a contractor, and he’s /she’s going to do the work for me.” If the “Do-er” isn’t also living in the house, it’s never going to get done, AND the person who does live there will eventually move (and probably be angry at YOU) because they didn’t actually want to live in an unfinished house.
* Be aware of the requirements of the Dodd-Frank Act as it relates to these deals. You can read up on that in last week’s IC eletter.
In years past, before I more closely controlled these deal, I had a number of problems along these lines: one buyer removed the supports for the porch, intending to rebuild it, then left in unsupported until the porch collapsed, pulling off part of the siding in the process. Another “Handy Harry” framed a 5×5 bathroom in a 12×9 living room, creating an l-shaped 4×7 living space. Another cut a “pass through” between the kitchen and living room, in a load bearing wall, without supporting the resulting opening.
Each of these “buyers” had something in common: they were not experienced renovators. Today, my buyers must have the background to do the necessary upgrades, or must have an experienced rehabber who will sign an affidavit that he or she will be doing the work on the property.
Today, I’m much more careful about who goes into these houses. Like any deal, repair for equity arrangements must be carefully controlled to be advantageous to both you and your buyer. But the demand is high enough, and the deals available enough, that they are, once again, worth adding to your exit strategy arsenal.