This real estate investing article will look into some strategies you can use when you put up real estate as collateral.
* contracts of sale 
* lease options
* other advanced strategies

Contracts of sale - also referred to as land contracts, real property sales contracts, conditional sales contracts, agreements of sale, contracts for deeds, and conditional contracts of sale, are agree ments to convey title to property when certain specific conditions are fulfilled, with title staying where it is until these conditions are met.

Contracts of sale are often used as alternatives to all-inclusive trust deeds. The two types of agreement have many features in common. In both types the buyer pays the seller, who is still responsible for payments due on existing mortgages against the property. Most of my pointers about one type apply to the other too.

However, some tricky differences arise from the fact that title doesn't pass to the buyer, under a contract of sale, until stipulated conditions are met. A buyer entering into a contract of sale must wait until the conditions of the contract are fulfilled in order to acquire title, but in the meantime he does become an equitable owner of the property with rights of possession.

To protect himself, he should insist that the contract be recorded and that title insurance be issued in his favor. The seller will usually prefer to leave the contract unrecorded. Why? Because if the buyer defaults, having the contract recorded would cloud the title. Court action would be needed to clear the title if the buyer refused to grant a release.

Many lenders flinch at the thought of accepting an equitable interest instead of an equity interest as security for their loan. Another problem: after having made all payments in accordance with the contract, the buyer may find that the title is defective or that he can't obtain title at all. And what happens if the seller should die, become incompetent, or be adjudged bankrupt? The buyer would have to go to court to acquire title.

The seller is uneasy because he might have to institute court action to regain possession if the buyer stops paying and refuses to move out. Or he might make the painful discovery that there are liens against his title because the buyer was negligent or dishonest.

Even so, a contract of sale can be a useful instrument. It just needs to be drawn up by competent legal counsel with a view to protecting both parties. It may become still more useful in the years ahead, if more and more state courts follow the lead of California's Supreme Court.

Until 1974 courts did little to prevent a lender from enforcing a ferocious "due-on-sale" clause in his loan if property securing it was sold under a contract of sale. Due-on-sale clauses are essentially "acceleration clauses." They make the whole debt due and payable immediately if you sell or refinance or in some way change the original financing agreement.

These clauses were originally written because lending institutions didn't want to lose control over properties that were mortgaged as security for their loans. But even well-secured loans to solid borrowers became a burden to these institutions when interest rates began to climb. The climb meant that a savings and loan could only attract new funds by paying higher rates to depositors and lenders than it was earning from its outstanding mortgages, most of which were made years earlier at fixed rates below 8 percent.

Consequently, the lending institutions began using due-on-sale clauses to force home buyers to replace old mortgages with new ones at the current high rates. When a borrower tried to sell his mortgaged property, the lenders refused permission for the sale unless the would-be buyer took a new higher mortgage. Often they not only blocked the sale but demanded that their borrower pay the whole debt immediately. It didn't make any difference if this borrower hadn't actually transferred title to the property; he got socked because he had merely agreed to do so at some future date if certain stipulated conditions were met.

An all-inclusive loan is probably a better choice where there are no due-on-sale clauses in the existing loans. It is generally much cleaner and more forthright from a legal point of view. It leaves less room for acts by either party that could lead to litigation. Here too, an attorney should approve the documents. You can buy under a partnership name as another way of protecting yourself when due-on-sale clauses hang over you.

If a husband and wife take title to an investment property, they usually do so as "joint tenants with right of survivorship" or as "tenants in common." They seldom think of forming a partnership and taking title in the partnership name. Yet this is usually just as easy, and the legal and tax angles are about the same. As partners, when they get ready to dispose of the property, they sell their interest in the partnership. The due-on-sale clause can't be used against them because there's no alienation of title.

To illustrate, suppose Mr. James are buying an office building. They form a partnership, they'd better not use their own names, however, as this would cause complications if they later sell their interests in the partnership to someone else. Using the address of the property as the name of the partnership is probably best. They register ownership in the name of the partnership, and take out a loan that gives the lender the option to demand that it be paid off in full if title to the property changes hands.

But title never changes hands. If a Mr. and Mrs. Smith come along and strike a bargain with the Joneses to acquire the prop- erty, they don't buy it from them and they don't buy it from the partnership. They buy the partnership instead.

If you are considering ownership in the name of a partnership with this sort of switch in mind, of course you'll want to get good legal advice in drawing up the documents. The lease-option is another method of private financing that may protect you from due-on-sale clauses and similar speedup demands by a lending institution. Instead of selling your property outright, you enter into a master lease and option-to-purchase agreement with the prospective buyer, so that he need not pay current interest rates if they are impossibly high.

Typical loan agreements say nothing about a right to call the loan if the owner gives some third party a lease with an option to buy.

Furthermore, granting someone an option to buy isn't the same as signing an agreement to sell. Giving an option is simply promising to hold an offer open for a period of time, usually in return for money or some other consideration.

Suppose you want to sell your apartment house for $360,000 and a Mr. Jim has agreed in principle to buy it at that price with $90,000 down. However, the proposed sale is snagged by the fact that the nice $270,000, 6 percent, seventeen-year loan you have on the property has a clause in it that makes the whole amount due on sale. Mr. Jim figures he can't afford to buy the property at the price you're asking if he must refinance it at the prevailing 13 percent interest rates. Seemingly you'll have to lower your price, or else the proposed sale will fall through.

You and Jim consider various alternatives but discard them for one reason or another. Then you solve the problem by working out a lease-option proposal. Here's how it might go:

Of Jim's $90,000 cash that he has available for a down payment, he'll put up $76,500 as a security deposit for a twenty year lease on your apartments. Under this lease, he'll make monthly rental payments to you equal to or slightly larger than the payments you're committed to make on your $270,000 loan.

(One reason for making them slightly larger would be to compensate you for your trouble in the matter. The transaction would still be sound if Jim's payments to you were just the same as the payments you were making on your loan. In fact, you might conceivably arrange to have him pay your bank, and have the bank pass along the payments to the lender on your loan.)

At the same time you give Jim an option to buy your property at any time during the twenty-year term of his lease. By the terms of his option, he can buy it for $13,500 cash plus whatever amount is then required to pay off the loan on the understanding that he'll also forfeit the $76,500 he paid you as a "security deposit." These two amounts, of course, add up to $90,000--the same amount he's already agreed would be his down payment.

The agreement also commits Jim to pay all property taxes and other expenses. The entire agreement is filed with the county recorder. You're free of all expenses connected with the property. You're in essentially the same position as if you'd sold it and you're better off in at least one way. You can still take tax deductions for depreciation because you still legally own the apartments.

After Jim's payments reduce the balance on the seventeen- year loan to zero, the due-on-sale clause is no longer an obstacle to selling the property. Thereupon, Jim pays you the $13,500 option price, forfeits his $76,500 security deposit, and takes title to the property.

This same strategy is one more solution to the problem of a down payment that the prospective buyer feels is too big for him. By some quirk of human nature, the same seller who demands a $20,000 down payment will often settle for $5,000 as a "lease security deposit" and let the prospective buyer lease the property for ten years, say, with an option to purchase it at the seller's original price by putting up the rest of the $20,000 any time during those years. Although a seller may not think of it this way, what he's doing is roughly the same as selling his property for $5,000 down on an interest-only basis with a $15,000 balloon payment due in ten years.


So, you see, a lease-option arrangement can be useful to a buyer or seller or both. Just in case you may want to use it as the solution to some difficult investment problem, I'm inserting here a copy of an old agreement worded so that it gives good legal protection to both sides.

 

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