The following is adapted from Creative Cash.
When you use creative and seller financing (CSF), which is a non-traditional or creative way of buying land or property, there’s a higher level of risk involved for you. This makes conducting accurate due diligence (DD) on a property and seller just as important as analyzing the financial data.
You’ll want to do your DD as if you were buying the property and paying all cash. After all, if you were about to spend that much of your hard-earned money, then I imagine you’d want to know what you were buying, right? The DD for a Master Lease Offer (MLO) deal is no different.
I’m going to show you how to conduct DD on all items from the seller to the existing mortgage on the property. Your DD into the MLO is a crucial part of the deal if you don’t want to be left with an expensive mistake.
Once the Offer Is Accepted
Once the offer is accepted, then the real DD starts. My suggestion is to do as much “free” DD as possible before you start spending money. What is “free” will be different for each deal, so start by making a list of DD items to be accomplished, ranging from the least to the most expensive.
In some cases, walking the property and looking at the condition of the area may be the cheapest step to start with, but if the property is in another market or state, then that may need to be placed further down the list. Keep in mind you want to spend as little money as possible until the offer process is much further along and the deal is more likely to close.
Record the Contract
The MLO contract must be filed with the court system at the time of your signing. This is called recording the document. You will add the MLO contract to the title documents in the legal system. The point in doing this is to “cloud” the title.
By recording the document, anyone who pulls the title to this property will find your MLO contract. This prevents the seller from selling the property without you knowing it.
When the next buyer/attorney researches the property’s deed, they’ll find the contract and it will prevent the sale. If the document is not recorded, it will not be found. This is an extremely important part of the MLO process and protects your interest in the deal. This is yet another reason to have a local attorney involved in every step of an MLO deal.
Before you sign the MLO contract or give any option money, have the seller disclose all the loan documents as part of your DD work. A seller cannot give interest in a property they don’t have.
When you review the loan documents, look at the time frame for the loan. If a seller has a loan for 2 years, they can’t give you a master lease for 4 years. This would be giving you interest in a deal they don’t have.
Loans do renew but not always. Don’t let the seller give you a time frame for your MLO that extends past the terms of the loan.
If the bank doesn’t renew the loan, then the seller must refinance elsewhere. If they don’t, the property will go into foreclosure, which overrides your MLO contract and you will lose the deal. You also need to look at the term of the loan and make sure it gives you a long enough time period to do what you need to accomplish, such as working on renovations.
Also, look at the terms, such as the monthly payment and escrow accounts. Make sure the numbers you originally analyzed are the real numbers. Defeasance for prepayment penalties is something else to keep in mind when looking at loan documents.
Some loans have prepayment penalties if the loan is paid off early. If you plan to exercise your option to purchase and pay off an existing loan as an exit strategy, this may be an important factor. A prepayment penalty has to be paid from the owner’s profits, or it could raise the cost/price of the deal. This is something to negotiate into the option price if the penalty exists.
When You Shouldn’t Do a Master Lease Option
Here are some situations you may encounter in the DD process that are major red flags and that indicate you should not do an MLO deal:
A property won’t ever cash flow. Some properties will never make money simply because the seller paid too much. Don’t assume someone else’s problem unless the work will be profitable.
The property is too big for you. Don’t do a deal that puts you on a property that is far above your level of experience
The seller doesn’t have a clear title. Don’t do an MLO with a seller who cannot show you a clear title. They may not have the right to enter into the MLO with you.
The terms of the existing loan are too short. Don’t do an MLO if the underlying loan term doesn’t give you enough time to complete your exit strategy.
You can’t identify a clear-cut exit strategy. Don’t go into a deal when you don’t have a great plan to get out of it. Identify your exit strategy early in the analysis process.
Anyone who has experience in multi-family real estate will tell you that most of the work in this business consists of finding good deals. If you add creative and seller financing (CSF) to the mix, a non-traditional type of financing, it becomes even more complex.
Position Yourself for Success
Begin your DD with the seller. Why are they selling? What is their plan B if they don’t accept your offer? How can your offer solve their problems? If cash is the only reason a seller is willing to sell, CSF probably won’t work. Look for distressed owners.
Have an attorney clear the title before executing a CSF contract. You need to make sure the seller has the right to commit to the offer.
You also need to do a full inspection on any property if you are getting a CSF. Act as if you are paying cash or getting a loan.
With these tips you’ll be better positioned to make your MLO a success. Now is not the time to cut corners. When you do your DD, you’ll protect yourself and your interests.
For more advice on doing your due diligence, you can find Creative Cash on Amazon.
What started out as a conversation at a live event one hot, sunny day in downtown Atlanta has blossomed into an amazing collaboration between Bill Ham, Jake Stenziano, and Gino Barbaro (Jake & Gino). Bill was instrumental in helping Jake & Gino launch their mentoring program and is one of the lead trainers in the company. With over twenty-five years of experience in operating vertically integrated real estate businesses, and over $100 million in assets under management, Bill, together with Jake & Gino, strive to teach others the strategies that have allowed them to become financially free.