SF Apartment : October 2017

FEATURE

Carrying the Paper

by Nick Bonn

Over the past year, my colleague Clinton Textor and I have represented a property owner in the sale of six properties, all of which were seller-financed transactions. The landlord, Ralph Geissler, began purchasing buildings in the 1960s and, one by one, he acquired a portfolio of investment properties that included eight multifamily apartment buildings located within a half mile of Mission Dolores Park.

The operation of the buildings—all of which he painted the same burgundy color with a tan and blue trim—became a full-time job and very much a labor of love. He takes pride in owning apartment buildings and he always says he would never rent an apartment that he wouldn’t want to live in himself. For more than half a century, Ralph did nearly all his own management, from cleaning and repairs, to renovations and tenant communication. One of the first times I met Ralph, he was on top of a twenty-foot fence, one leg on each side, using a top-heavy electric saw to trim tree branches, nearly throwing himself off with every swoop. I found myself standing beneath this man whom I barely knew with my arms outstretched, ready to catch him if he fell. He never did fall, and I quickly learned that this was commonplace for the German landlord who immigrated to the United States from England.

Eventually, the work became too much for Ralph to handle. So, in 2016, approaching the age of 80, he decided to sell his portfolio. There was just one problem: the properties had appreciated in value so significantly that the capital gains taxes would be through the roof (he sold one property for 53.33 times what he originally purchased it for). He did not want to acquire new properties through a 1031 exchange, nor did he want to pay taxes on 100% of the profits upon sale. He decided the best thing to do was to carry the financing. This allowed him to generate passive income from the interest payments each month, eliminate all landlord responsibilities, and postpone paying capital gains taxes on the portion that he carried back. He has had tremendous success implementing this strategy, and working with him has given me a strong understanding of how seller financing works, what the benefits and risks involved are, and why it can have consequential benefits for sellers.

How It Works

Seller financing, commonly referred to as “carrying the paper,” is the act of a seller lending a buyer a specified amount of money to purchase a property. In other words, they are acting as the bank. To do this, typically, the building must be owned free and clear of any existing loans. When preparing to market the property, the seller should decide on the parameters of the seller carryback loan. In the offering memorandum, or marketing package, there should be a section that outlines the key terms of the note that are important to the seller, including down payment or loan amount, the interest rate, the length of the loan, whether the payments are interest-only or amortized, whether there is a prepayment penalty, possible late payment fees, consequences of default, and assumability of the note. These are the most important terms that will allow buyers to understand the financial implications and, ultimately, what they are willing to offer. It will be a guideline for prospective buyers as they underwrite the deal.

The seller should seek assistance from financial and legal professionals to create a Promissory Note and Deed of Trust. Both the buyer and seller execute the Promissory Note, which is the legal instrument that binds the buyer to the promise they will pay back the amount of the loan in full and abide by the other agreed-upon terms. A Deed of Trust is issued to transfer the interest in the property to a trustee, who will hold the interest until the debt is repaid. The collateral is typically the property and the down payment. When the loan has been paid in full, a Deed of Reconveyance is issued to the borrower to serve as proof that the debt has been released.

The Benefits

For sellers, one of the great advantages is that they can market the property to a larger pool of buyers who would not be interested if conventional financing were the only option. I am not referring to non-creditworthy buyers who couldn’t qualify for a loan otherwise. I am referring to qualified buyers who may not have time for the tedious and prolonged process of applying for a conventional loan. Those who have ever applied for a loan from a bank know that the paperwork is endless and differs between every bank. Banks have strict review and underwriting processes, and a conventional loan usually takes a minimum of 60 days to finalize. This can deter buyers from even starting the process in the first place, whereas a seller-carry can excite and motivate buyers to participate. In addition to saving a lot of time and effort, a seller-carry can save buyers money by cutting out bank fees, appraisal fees, and loan origination fees.

Sellers acting as lenders can create a passive income stream by charging interest on the money they lend out. While managing an investment property comes with a lot of duties and responsibilities, charging interest only requires the collection of a check each month. It is a great option to consider when approaching retirement. Since the terms of a seller-carry back loan are negotiable, the seller and buyer can work out an agreement that is mutually beneficial. A seller may be able to achieve a higher-than-market price by offering a lower interest rate or a lower down payment requirement. Or a buyer with a long-term vision may pay a lower purchase price but agree to a higher interest rate and monthly payment amount. Everything depends on the goals of the seller and buyer, but through negotiation, both parties may find a way to achieve what they want.

The Risks

Taking on the role of the bank and becoming the lender does not come without risks. Lending the funds to and selling an asset to an irresponsible buyer can lead to a sticky situation. If the buyer fails to make payments, the carrier of the note will ultimately have to foreclose on the property and reclaim ownership. Several different factors, such as mismanagement or market conditions, may account for the property being less valuable than it was at the time it was originally sold. The goal of selling a property, ideally, is not to end up with the same building at a lesser value.

Certain precautions should be taken, such as collecting financial and credit information from prospective buyers to make sure they are qualified. Preference should be given to buyers with a vested interest in the property, which better ensures careful maintenance and control, which in turn means the property can service the debt. A buyer is also more likely to operate the property effectively if he would otherwise lose a significant down payment.

Consequential Benefits

Offering something that is both rare and desirable, such as seller financing, could bring more potential buyers to the table, which could create a competitive environment and allow for the negotiation of a higher price.

As noted above, Ralph sold six rent-controlled apartment buildings over the last year through seller financing. On nearly every sale, he received multiple offers with few to no contingencies. On average, the six burgundy buildings sold for more than $750 per square foot and $600,000 per unit, with a total dollar volume exceeding $25,000,000. The average price per square foot is currently $592 for apartment buildings in San Francisco—$158 per square foot less than what Ralph sold his properties for. We estimate the sale prices to be 10% to 20% higher than what he would have achieved without seller financing. Still, in each of these agreements, the buyers also accomplished their goals.

Despite selling the lion’s share of his portfolio, Ralph has yet to slow down, but that is by choice rather than necessity. Ralph spends most of his days working on his country estate, drilling through bedrock and transferring hundreds of buckets of dirt each day. He is currently constructing his fifth retaining wall and enjoying the activities that make him happy on his own schedule. Ralph is a hard worker, endearing, and easygoing and his number one rule is that the buyers must keep the buildings the same burgundy colors that he adorned the neighborhood with so many years before.

Nick Bonn is a senior investment associate at Marcus & Millichap who specializes in selling rent-controlled apartment buildings in San Francisco. Nick can be contacted at (415) 625-2107 or [email protected].