by Dave Peniuk
If someone were to ask me what the toughest part of 2009 was I wouldn’t hesitate in saying it was finding financing for our real estate investments. We’ve spent a lot of time lately talking about private money as one of the solutions to the credit crunch, but it’s been awhile since we mentioned our preferred source of funds in many cases and that is a nice VTB! And for a change of pace I thought I would write about it from the perspective of a seller … because there are many advantages to offering a VTB to a buyer of your property and as a real estate investor you should not only understand why you should almost always want to ask if the vendor will finance a portion of your property, but why you may want to offer a VTB on a property you’re selling!
What is a VTB some of you may be asking? In a “nut”shell (yes, quite clever I know 🙂 ), a VTB is a Vendor Take Back mortgage or loan. It is simply where the seller (Vendor) of a property is willing to provide some or all of the mortgage financing on that property.
When times are good (economy is improving, employment is rising as are incomes, all is well), you often see fewer VTBs. This is because the access to credit (getting loans/mortgages/lines of credit) is often “easier” and houses are selling at a steady to fast pace. Vendors are not as willing to carry financing because it is not as difficult to sell their house. BUT, and this is a BIG BUTT, when the economy is slowing, access to credit is more difficult, and properties are not selling as quickly, Vendors may be willing to get more creative in order to unload that property.
But – for you – a potential VTB holder, it’s important to understand there are plenty of other advantages to holding a VTB that make it attractive even in a hot housing market.
You will often see investors more likely to hold VTB’s than a regular homeowner just trying to sell their house. This is because investors “get it”. They will likely know what a VTB is and know the advantages, both for themselves and for the buyer. In tough times, a VTB might make it easier to unload a property. But at any time, a VTB can allow a seller to make some additional money on the house by charging interest on the loan, as well as potentially defer some taxes.
Why earn 2% in a “high interest savings account” at your bank when you can earn 7% or more on your VTB?
But, there is risk involved with carrying “paper”. Let’s get the wrench out (remember we’re dealing with nuts and bolts!) and have a look!
VTBs are usually in 1st or 2nd position as a mortgage. If you, the VTB holder, are in first position you will get your money out first (assuming they don’t owe the government anything – because the government gets their taxes first!). You also are often able to get closer to your asking price when you offer a VTB. This is because the purchaser has fewer hoops to jump through, lower costs involved with purchasing (no appraiser is required, no lending fees to pay, less time involved seeking financing), and will often be willing to pay a higher price.
Second position has a few more risks. If you sell your property and your purchaser either assumes the current mortgage or brings in their own new lender but the purchaser wants to have higher leverage (increase the loan to value), they may want a VTB in 2nd position (behind the 1st mortgage lender).
Now, if you (the Vendor) are willing to hold that VTB in 2nd position, that means that you ONLY get your money back AFTER the 1st position Lender gets ALL of their money out first. This is only really an issue in the case of default, and foreclosure, but it certainly can happen! So, you need to think carefully whether you want to put yourself at risk.
So, why would you hold a 2nd position VTB?
- You cannot sell your property any other way (i.e. the property is “ugly” and needs a lot of work, banks aren’t lending, purchaser can’t qualify for enough financing)
- There is enough equity in the property even after holding a 2nd that you are somewhat “safe” and can earn a nice return
- You know the property – because you used to own it – and feel comfortable making a loan secured to that asset
- In second position you can charge a higher interest rate because there is more risk in the second position. So, instead of charging 7% in 1st position you can often ask for 8, 9, 10 or more percent interest. Of course it all depends on the other terms but you should be earning higher interest than the 1st position mortgage is charging
- You would rather loan to a qualified Purchaser at a nice interest rate than put your money in a crappy low interest bond, GIC, or unpredictable stock/mutual fund
- You want to delay Capital Gains taxes until the VTB is paid in full (you don’t pay Cap Gains taxes on any VTB loan amount until it is paid in full – but of course – I am not a tax accountant so be sure to consult your accountant for the nuts and bolts on that subject!).
So, you can see, there are many reasons why someone may hold a 2nd mortgage as a VTB.
And in some markets where people are struggling to sell it might be something to consider offering. As real estate investors we almost always ask for one, but we rarely think to offer one.
Julie and I have yet to carry financing on any of the properties we have sold. We always want our money out for a new investment opportunity, but we have asked (and received) several VTB’s when we have bought! Some were in 1st position (less risky to the Vendor), others were in 2nd (we couldn’t buy them without the 2nd in place), but to date none have been in 3rd position….but they do happen as well! I do NOT recommend anyone hold a 3rd mortgage UNLESS there remains still some equity in the property (at least 10% available even after your 3rd mortgage) AND the Purchaser/Borrower is thoroughly screened AND, ideally, you hold the mortgage payment in an interest reserve account. (An interest reserve account is where the monthly interest payments for the year are put in a separate account so you get 1 year of interest payments set aside at the start. You don’t have access to it until the end of the year typically but it ensures it’s there for you).
So, the lowest risk place to be a Vendor holding the mortgage is always in 1st position.
The challenge with that is unless you own the property free and clear from any current debt you probably won’t have enough equity to offer the buyer a mortgage large enough to put you in 1st position. Which means you’ll often have to be happier with the riskier but more lucrative second position.
From a real estate investors perspective, we suggest you understand VTB’s even if you’re never going to offer one. You want to be able to explain the benefits to a prospective seller in the hopes that you can secure many of them. A mortgage from the Vendor usually won’t be anywhere near as difficult to qualify for as a traditional bank. AND, quite often the interest rate and terms can be quite good. The Vendor continues to earn money on their now-sold property, they delay their capital gains taxes on the portion that is held as a VTB (still have to pay income taxes on the interest earned through the VTB though), and they know and understand the security behind the mortgage (as they owned that home and the mortgage is secured against it).
In terms of structuring the VTB and getting everything organized for one – whether you’re holding it or getting one from a vendor, you must always always work with a real estate specializing lawyer who will put the documents together on your behalf. Please do not hire the cheapest notary in town to save $100. Get it done right. This will protect you and your ass…ets. 🙂