Real estate seller financing: So many options; what do they mean?

November 17, 2014

With today’s low interest rates and relatively available money from traditional commercial and residential mortgage lenders, seller financing of real estate is not the most popular alternative, but it remains an option. This article explores the positives and negatives of the three major means of seller financing of real estate transactions.

The three major options are: (i) Lease (with option or obligation to purchase), (ii) Land Contract and (iii) deed with a note and mortgage back to the seller. Each of the three has its advantages and drawbacks, depending on whether you are the buyer or the seller.

As a general proposition, the “risk” a seller holds is that the buyer defaults, the physical condition of the property when returned is impaired, and getting clear title back in the seller is expensive and time consuming. From the buyer’s perspective, he does not want to improve real property and pay significant sums toward the purchase price only to learn at later date that he has to fight to get clear title into his name. The three instruments offer essentially a spectrum of rights from least to most in the buyer: a lease (with either option or obligation to purchase) gives the least protection to the buyer, a land contract (depending upon its terms) moderate protection, and a deed with a note and mortgage back to the seller the most protection.

Lease. A lease essentially gives possessory rights to a tenant in exchange for payment of rent. Under a lease with an obligation to purchase or option to purchase, some portion of that periodic payment can be applied to the ultimate purchase price. From a buyer’s perspective, a lease is a precarious instrument, as a default extinguishes the rights of the tenant — potentially both to occupy and buy. Notice of default and written right to cure provisions can make the instrument more palatable for a tenant, but it is as a general rule the least favorable instrument for the tenant of the three options.

Land Contract. A typical land contract is simply a contract to to purchase real estate with (i) a delayed closing and (ii) possessory rights vested in the buyer until closing. Under O.R.C. Section 5313.07, which applies only to residential property, if the buyer has paid either for five years or more than 20% of the purchase price, in the event of a default a the seller must pursue a foreclosure action, with the proceeds beyond the contract price payable to the buyer. For commercial contracts, a simpler “forfeiture action” is available, but it still remains more involved than a simple eviction action called for with a lease. If the instrument is placed of record, a buyer achieve some protection — perhaps greater than that under a lease — from a land installment contact.

Deed, note and mortgage. The final method of seller financing is the delivery of a deed from seller to buyer, and taking back by the seller of a note for the payment of the remaining purchase price and a mortgage securing that payment. This method necessarily entails vesting in the buyer the equity in the property net of the balance due the seller. All that’s left in the seller is the right to collect payment of the mortgage balance, and whatever protective covenants are there for seller’s protection.

All three methods of seller financing involve risk on the seller that the buyer impairs title to the property through unpaid taxes, utility bills and the like, or, more likely, failure to maintain the property in the fashion that the seller anticipates. These issues can be addressed to some extent through good contract terms and tight management of the asset, but in the end the seller will retain some risk as to these issues.

But fundamental structure of the transaction, choosing one of the three options set forth above, will dictate the relative position of the seller and buyer in that deal.