The following post has been copy and pasted from my REI blog - where I try to give a play by play account of a poker player turned REI fish - can be read at this address -

http://justinsadauskas.wordpress.com...=6&postpost=v2

It's pretty long for a 2+2 post so continue at your own peril. Special shout out to Tien for helping me out and letting me bug him with questions.

Land contracts versus rentals

No ice cream anecdotes today – I’m all bizness….

I got an email from a real estate agent I worked with about a year ago, when I was still living in Chicago. The subject read: Money Man deal. The body…. 174k 7.5% amort 5yr 10k balloon 3-4k down. That jibberish was the whole email. I remember being irritated with the brevity and lack of detail. It was a foreign language to me, so I told him to pound sand cause I didn’t know what that meant and I sure wasn’t nobody’s money man! As it turns out that deal was not only illegal but also financially terrible. It did however, open me up to the idea of selling notes. Though it wasn’t until six months down the road that I got wise to the beauty of the land contract.

From Wikipedia: A ‘land contract’ (sometimes known as a “contract for deed” or an “installment sale agreement”) is a contract between a seller and buyer of real property in which the seller provides financing to buy the property for an agreed-upon purchase price and the buyer repays the loan in installments. Under a land contract, the seller retains the legal title to the property, while permitting the buyer to take possession of it for most purposes other than legal ownership. The sale price is typically paid in periodic installments, often with a balloon payment at the end to make the timelength of payments shorter than a corresponding fully amortized loan without a final balloon payment. When the full purchase price has been paid including any interest, the seller is obligated to convey legal title to the property to the buyer. An initial down payment from the buyer to the seller is usually also required by a land contract.

You probably didn’t read that. Here’s what you need to know. The best way to think about a land contract is that you are essentially “the bank” giving a note/loan (like a mortgage). You set the rules, down payment, interest, and the purchase price (amount of note). Unlike a mortgage, you have title interest in the property rather than a lien, giving you more rights on a default. The buyer is required to maintain the property, pay property taxes, and property insurance - just like a mortgage. So you don’t have to manage the property, all you have to do is make sure your payments come in. If the land contractee fails to make these payments, you take the property back. After X number of years and payments, they own the house (like a mortgage). You can charge up to 11% interest on land contracts in the state of Michigan.

Now land contracts tend to get a bad rap because in the last decade people used them to sell houses to people that couldn’t get a loan at a time when all you needed was a pulse to get money from a bank. So the absolute worst financial candidates were getting these land contracts and no shock, some of them defaulted, trashed the house, didn’t pay taxes etc. You can’t make it around the block without some old-timer in a cowboy hat giving you a land contract horror story. But times have changed!

I will use an example of a land contract deal that I hope to close on next week. This guy bought his house for 130,000 in 2005, it’s now worth around 40k. Either by choice or by inability to pay, the house was foreclosed by the bank. The house went to auction and the bank bought the house back for $28,000. Now under Michigan law, the owner has 6 months to redeem the property (buy it back for the price it sold at auction). This right is transferable. He obviously doesn’t have 28k in cash or he wouldn’t be in his situation and he really wants to stay in his house, so the deal got brought to me. I will redeem his house for him under the agreement that I will land contract it to him. We negotiate the terms. We agreed upon 5k down, 10% interest, 60k note amortized over 5 years. So my initial investment is 23k (28k-5k down payment) plus closing costs (commission and interest to the bank) puts me around 28k total, maybe a little less. After 5 years and 60 payments, he will have paid me $76, 500. So my ROI (if I did it right) is 34.6%. If he defaults, you can quickly see that i am getting the home a great discount and because it’s essentially his home, I see him fighting like hell to keep it, so the chance of default is pretty low in my estimation. He gets a little higher payment than he used to have, but he owns the house outright in 5 years and gets to a keep his home he otherwise would not be able to keep. Definitely a win/win. These deals that were once pretty lousy are now much better because of the changed market conditions. Specifically, the difficulty in getting a loan and the drastic housing value collapse.

Now every land contract does not have a ridiculous ROI like the one above, the negotiation depends on a lot of factors. However, they are usually quite a bit higher than the ROI of a rental in my area – and a LOT LESS work. There are two problems however. I want to be in this business for life and if I have all land contracts after 5-10 years – whenever these notes get paid off – I’m left with a pile of cash and no passive income. My fear is that the market condition will change and reinvesting the money won’t be as easy, especially if the housing market improves drastically. Also, you can’t refinance the money out like you could in a rental. At the current >5% interest rates, this is a problem. You can refinance money out of an income property out at 70%. So if you make 15% ROI on a rental and refinance it out and repeat – your ROI keeps going up on that same amount of money. My plan right now is to resist the urge to snap up every good land contract and get a 50/50 split of rentals : land contracts. In the future when I get a little more seasoned, I might start hedging one way or the other, but I think it’s safest to see how everything goes first before going all in on just one of the other.

Some tips – don’t set up a balloon – nobody can get financed or save enough to pay it by the end. Escrow the taxes and insurance – too big of a risk to let them handle it. Add it to their payments. Definitely get title insurance – I had some clown with like 50k in back taxes try to get me to buy his house so he could stick me the bill. A lot of these deals come through short sales where you land contract it back to the owner. Sometimes the banks make you sign an arms length transaction waiver to prevent this type of circumvention, sometimes they don’t.

caveat - I am just starting out and don't want to sound like an authority or law expert. These are all my original ideas and I come up with this stuff on my own so do your own due diligence cause its always possible I'm out to lunch!

thanks for the link

Really interesting

Interested to see others' comments. Like most people, I've heard the good and bad of LC's. Good luck, OP!

So he failed to keep up the repayments to the bank, but you think he will be able to repay your note even though the monthly payments are higher?

Part I is unclear. Many people just stop paying because they are so far underwater. If your house lost 75% of its value in 2 years would you keep making payments? And yes, I do think he will pay regardless of why he stopped making payments. And if he doesn't its not that big of a deal.

Land Contracts are interesting from many angles. First, as you have mentioned, they get a bad wrap because lower income purchasers can pay fourteen years on a fifteen year note, default on one payment and the property and payments are now the seller's. There are obviously inequities here which probably are not counter balanced by the risk of lending to higher risk purchasers. However, it can be great business as you don't haveto go through the normal foreclosure process. Additionally, this can be helpful for buyers who can't secure traditional financing.

These contracts vary state by state, where some states will consider them purchase money mortgages and find equitable title with the buyer. Obviously your homework should be done with this if you decide to enter.

This post isn't legal advice and i'm not a lawyer so do your own due diligence.

This isn't really true, but this would be good for the seller. If someone paid 14/15 years and stopped paying, I'd fist pump. I think you are assuming there is a end balloon payment, which sucks cause it turns it into an option to buy.

I got screwed pretty hard buying a house on land contract when I was ~20.

I had just started a new business and had very little/no credit history. I found a place in a decent location and the owners were willing to sell on land contract. I put 10K down and over the next two years invested another ~25K in improvements.

Just as I was planning to refinance through a bank I got a foreclosure notice on my door. The people that I bought it from decided to pocket the money I'd been sending them for the last 6 months or so.

The only thing that I could do was to buy it from the bank for what they owed which was within a few hundred dollars of the amount they originally sold it to me for (they kept my down payment too).

I know that's not really what what we're talking about but land contract/Michigan made me think of it.

More on track, and something I've always been semi interested in, is buying land contracts. When the RE market was better, I would occasionally see people offering to purchase land contracts for ~80%. It seems like that could be a pretty easy game.

No, I'm not talking about a balloon payment. In the traditional operation of a land contract a default, for any reason (missed payment, failure to pay property tax, keep the property insured, etc.), means the contract hasn't been fulfilled and the seller can take possession and retain the buyer's equity in the property. In many cases, the previous payments are characterized as "liquid damages." That is where a lot of the talk about issues regarding the "fairness" of a land contract comes from, I think. It provides more efficient remedy to the seller in the event of default with the additional windfall of keeping the equity and property, which has to attract some sellers, or at the very least be factored into dealing with such low-income/high risk buyers.

A buyer who is purchasing based on a land contract has other issues too. Land contracts are less liquid than a traditional mortgage, insofar as that in many cases approval must be gotten from the seller to transfer. Additionally, even if there is an interested party, if that party wants to take over the contract, he has to buy out the first purchaser which might be an issue based on how much capital is available.

I'm not slighting this as a business opportunity, for what its worth, I just think understanding the possible outcomes is important. In most cases I believe land contracts are good investments for sellers (provided you have the right buyer) but can be disadvantageous for buyers, and in some cases may even be predatory.

Ouch. I hope they went to jail. I'd want to kill the people. I bought the first two land contracts I purchased from another investor at 75%. But that discount served as my down payment essentially. It's risky because the seller has all the information on what type of person is in the house - you have to trust the seller quite a bit, imo.

That's why it's CRUCIAL to get title insurance and confirm that the people you're paying the note to do not owe someone for the property at hand. If they do, you need to make sure that you're paying directly to the lender that holds the note to begin with.

I've sold a few properties on a contract before that I owed the bank on. In my case, the bank handled everything for me, but the way the payments worked, they had to be two partied between me and the bank until the original note was paid off.

Good to see you're learning.

Just a few points:

Have you looked into becoming a hard money lender? You can receive more than 11%, but you must be licensed.

I would be careful, although it sounds like it may be easy to take control of the property and kick these guys out after a couple years if they miss a payment, it could be a lot harder than you think - a court might find that after years of payment a court rules that he has significant equity in the property and that you aren't able to.

I think the biggest risk is that you have multiple defaults and then you are running around doing tons of extra work trying to break even. In my opinion you won't find that having these people default becomes a windfall for you.

That said, with your current example, you say you see him "fighting like hell to keep (his home)", but obviously he didn't when the mortgage payments were lower. You can create a 1 year note with 10k monthly payments, but it's better for both of you if he makes the payments. You don't seem to know why he got foreclosed on - I think the barest minimum due diligence would be to say "Hey, what happened?" "How are you going to make the higher minimum monthly payments if the old ones didn't work out?"

Also, if there are 40k properties being sold at auction for 28k, maybe the real money is at attending the auction.

Have you spoke with an attorney about SAFE Act issues? In the post SAFE Act world I would be very thorough before I sold a person a home at 150+% market value carrying an interest rate more than twice the "market" rate.

Ok so I did a couple minutes of Googling. Here is the relevant excerpt:

Regardless I would seek the counsel of a competent attorney who specializes in these matters. Predatory Lending is no joke these days.

Having said that, thanks for the post and good luck; the numbers look great.