Commonly known as the “sales balance”, the balance of sale, which is relatively unknown to investors, is incredibly powerful in reducing one’s seed money and thus increasing returns significantly. Of course, you will have to be dealing with a flexible and collaborative seller in order to implement it during a transaction.
I thought it wise to share some important aspects on this creative funding technique with you this week.
How it works
Do you think that those who succeed in real estate do so by injecting their money? Not at all! Keep in mind that the biger the transactions are, the more creative funding is used by investors, including the balance of sale.
The principle is relatively simple in itself. It consists of obtaining nothing more or less than the funding from the seller.
Since this is a debt you will owe the seller, he will want to obtain a guarantee; fair enough. That’s why he will register a first or second mortgage on the property he sells you or, on a property you already own.
In the eyes of financial institutions
Many investors make the mistake of believing that the balance of sale can make up all of the seed money. Ror example, if the 25% seed money required by the bank is entirely produced by the seller, there is a good chance that the bank will reject it.
Why the refusal? The reason is very simple. Why would the bank take the risk of lending you money when you are taking none, with the seller taking the other half of the risk by agreeing to fund the seed money? Banks like it when you are involved in terms of risk and that is quite normal.
However, financial institutions sometimes accept that your seed money contribution should be 12.5% and the remaining 12.5% be funded by the seller.
Deferral of seller’s tax
Many sellers mistakenly believe that if they agree to finance a balance of sale over a 5-year term for example, the payment of their taxes will be automatically postponed for five years.
This is not entirely correct as explained by Richard D’Amour, Esq., tax lawyer for the Chantal D’Amour Fortier, S.E.N.C.L.R. firm.
Ways of repaying the seller’s loan
In most cases where the seller funds part of the sale, a mortgage guarantee relating to the building concerned by the sale will be granted and the reimbursement terms of the loan will be negotiated between the purchaser and the seller.
There are mainly three ways to payback the seller’s loan. Let’s look at them together.
1. Capital and interest
The balance of sale amount is amortised over a number of years (often 25 years) and an interest rate for the term shall also brokered between the parties. A common practice is that the term is set at 5 years.
Let’s look at an example to better understand.
The seller agrees to fund $50 000, amortised over 25 years at a 7% interest, all refundable in 5 years.
Your payments including capital and interest will thus be $350.21 over 60 months and the remaining capital of $45,522.15 at the end of the term will thus have to be paid back to the seller.
Your total borrowing cost will thus be $66,534.75 or 60 X $350.21 + $45,522.15.
2. Interest only
Let’s continue with the same example but only using monthly payments of interest.
Your monthly payments made up of interest only, will be reduced to $291.67 ($50,000 X 7% = $3,500/12) during the 60 months of the term but the remaining capital balance will therefore be $50,000 since you wouldn’t have made any reimbursements of capital during those five years.
In this case, your total borrowing cost will be 67,500.20, or 60 X $291.67 + $50,000. As you can see, the difference of $965.45 over 5 years is, let’s say, insignificant.
3. Balloon loan
Let’s now look at the total borrowing cost with a balloon loan which entails making no payments during the term and repaying the entire balance at the end of the term. For purposes of an example, the conditions shall remain the same as before but I must say that the composition of the interests is yearly.
Your total borrowing cost will be $70,127.59, an additional difference amounting to $5,000 compared to the previous two methods. Let’s look at how we got $70,127.59, 000.
The balance due after one year will be $53,500, or $50,000 X 7% = $3,500 + $50,000 which is the balance at the end of the first year.
The balance due at the end of the second year will be $57,245, or $53,500 X 7% + $53,500 (balance at the end of the first year).
The balance due at the end of the third year will be $61,252.15, or $57,245 X 7% + $57,245 (balance at the end of the second year).
And so on until the end of the fifth year when the amount due will be $70,127.59.
You now see why this type of loan is called “balloon loan” since the balance due increases from year to year. It’s a powerful funding tool that should therefore to be used with caution. Its main advantage is the increase in your cash during the term since no payments are made. But since practically nothing is free in life, you will have to pay the hefty bill at the end of the term. Make sure you have money available.
The importance of profit at purchase
Regardless of the repayment method you must have arranged with the seller, it is of utmost importance for profit to be made at purchase and to be able to refinance the property at its value otherwise you may have to dip your hand into your pocket when it’s time to payback the seller at the end of the term.
So you should have a game plan on how to repay the seller who, you mustn’t forget, has a real property mortgage registered on one of your buildings. He can therefore use the mortgage recourse in case of any failure to pay on your part.
To conclusion, keep in mind that the balance of sale is one of the best ways to acquire big buildings. However, if you are not sure how to get about it, seek help from specialists in the field. When it comes to the balance of sale, your creativity will work wonders if you know how to use it! Constantly develop it.
On this note of advice, I would like you to read my previous articles and share them on your social networks.