There are many creative ways to invest in real estate. While most investors first pursue traditional financing when it's time to purchase a property, there are certain circumstances in which traditional mortgages or even private money aren't options. That's when you have to get creative.
Subject-to real estate is a creative financing strategy that allows a prospective buyer to forgo the added burden of obtaining a new loan to purchase a property. Though it has its share of challenges, this creative real estate investment strategy can be a viable way to invest in real estate. This article will dive deep into what subject-to real estate investing is, how it works, who it's right for, and the pros and cons of this method of real estate investing.
What does it mean to invest in subject-to real estate?
Subject-to real estate defines a real estate transaction in which the buyer purchases a property subject to the existing mortgage. In other words, it's when the seller has an existing loan, and the buyer assumes the seller's mortgage, with its terms, remaining balance, interest rate, and mortgage payment included in the sale.
Unlike seller financing, which is when the seller holds or carries the mortgage for the buyer, in a subject-to transaction, the buyer assumes the loan and, stepping into the seller's shoes, pays the remaining balance.
Why buy real estate subject-to
Obtaining mortgage financing from a traditional lending institution is often one of the most challenging parts of buying a real estate investment. As an alternative, buying a property subject-to can be a lucrative investment strategy, given the right transaction and opportunity
When buying subject-to, you can eliminate the hassle of obtaining financing and, in many cases, inherit mortgage terms that are more favorable than you might otherwise be able to obtain at that moment.
For example, if mortgage rates for an investment loan are around 5% to 7% (depending on the property and borrower qualifications), but the seller's mortgage is a fixed-rate mortgage at 4.5% interest, the buyer can save money by assuming the seller's loan and, thus, interest rate.
Buying subject-to also means the buyer will have a shorter amortization period on the mortgage. This is because amortizing loans are repaid with principal and interest. Since the initial payments in the first few years of the investment-loan repayment schedule cover mostly interest, very little of the monthly payment goes toward paying down the balance.
However, toward the end of the loan term, more of the monthly payment is applied to the principal. A buyer who assumes a 30-year fixed-rate mortgage from a seller who has paid the mortgage down for 12 years assumes the loan at a more favorable time and now has a shorter amortization period.
Given the nature of the transaction, most subject-to sellers are in some sort of distress. For instance, they could be facing foreclosure, at risk for losing the property to a tax sale, in financial distress, or unable to maintain the property.
In any case, in most subject-to transactions, the investor is working with a motivated seller, which enables them to use this financing structure and, oftentimes, purchase a property with little money down while gaining favorable financing terms.
When buying subject-to real estate, investors generally intend to renovate and sell the property shortly after the sale or rent the property, earning cash flow from the difference between the total rental amount and the monthly mortgage and property expenses.
How do you buy subject-to real estate?
Subject-to real estate investing isn't as popular as one may think, mainly because lending institutions often include specific clauses prohibiting this sort of transaction. For example, most loans have a due-on-sale clause, which means the entire unpaid balance at the time of sale is due if the home is sold.
The loan also may have a loan-assumption clause, which specifically prohibits third parties from assuming the loan, making these types of transactions impossible. In addition, buyers will need to check out individual states' real estate laws regarding the legality of subject-to transactions.
However, there are some exceptions to these rules. Most lenders prefer payments over early payoff, meaning if you request a subject-to sale, the mortgage lender may accept, despite any acceleration clauses. However, you may be required to qualify for the loan, which defeats some of the benefits of buying subject-to.
Suppose this type of transaction is legal in that state, and a lender either did not include any provisions or clauses prohibiting a subject-to sale or is willing to accept a subject-to transaction. In that case, a buyer can use this strategy to purchase the real estate property.
First, the investor will negotiate the terms with the seller, which could include buying it subject-to either as a cash transaction or with seller financing. In the event of a seller carryback, the buyer assumes the existing financing and finances the difference between the purchase price and the loan balance from the seller, paying an agreed-upon interest rate. They'll then enter into a purchase agreement with a subject-to sale clause.
This clause will outline the negotiated terms and conditions. As with other transactions, any deposits will be placed in escrow with a title company, and a title search will be conducted to make sure the property can be transferred without encumbrances and that no past-due balances remain on other accounts, such as property taxes or utilities.
Once closed, the title company should record the subject-to contract in public records, which transfers ownership to the buying party, and the buyer makes payments to the lender or seller as agreed.
Example of a subject-to real estate deal
Let's say a homeowner received a 30-year mortgage at 4% interest in 2012. The original loan balance was $180,000, making their monthly mortgage payment $859.35. The borrower is no longer able to maintain the property and decides they want to sell. Due to the condition of the property, an investor sale is the only option. Rather than sell the property for cash, the investor negotiates a subject-to sale purchase.
The borrower has made payments for nine years (108 payments), leaving a balance of $146,351 at the time of sale. The property appreciated 50% during those nine years, meaning the property's value is $252,000 today.
Due to the property's condition and the amount of work needed, the investor negotiates a purchase price of $166,000. The seller assumes the mortgage of $146,351, and the owner agrees to pay the difference of $19,649 as a down payment. The investor then takes over the monthly payment of $859.35 until the property is sold.
The investor makes moderate renovations to the property, roughly $15,000 worth, and rents it for $1,500 a month. After paying property expenses -- including taxes, insurance, and management fees (roughly 30% of the rental price) -- and deducting the mortgage payment of $859.35, the investor cash flow is $190.65, providing them with a 6.6% return on their upfront investment of $34,649.
The investor also gets the benefit of an 18-year mortgage, with the majority of the mortgage payments paying down principal over interest.
Example of a subject-to seller-financed deal
Using the example above, let's say the property appreciated at a rate of 75% during that period, which is the actual appreciation rate from 2012 to 2021, according to the Case-Shiller National Home Price Index. That means the home value at the time of sale is $315,000.
Again, because of the property's condition, the investor negotiates a discounted purchase price of $225,000 and assumes the mortgage at $146,351, meaning the remaining balance due to the seller is $78,649.
Rather than paying the entire amount as a down payment, the seller agrees to carry financing for $50,000 at 5% amortized for 30 years, with a balloon payment at the end of one year. The investor then pays $28,649 as a down payment and makes monthly payments of $268.42 for 12 months before paying the $50,000 seller-financed loan balance.
In this case, the investor decides the better option for a return is to fix and flip the property, putting $45,000 into the home and selling it six months later for $325,000. After closing costs (roughly 9% of the sales price) and paying off the two finance loans, the investor nets $56,632, which would equate to a total return of 197%!
Risks and disadvantages of buying subject-to real estate
The biggest con to buying subject-to real estate is the difficulty of finding a loan that will allow you to purchase subject-to. After the Great Recession, lenders tightened their underwriting criteria and expanded their clauses to more explicitly state requirements and rights for both parties, meaning most mortgages in today's market prohibit this transaction, making these types of transactions few and far between.
It also can be difficult to negotiate these terms with the seller. This financing structure is advanced, and it can be challenging to explain or convince a seller to agree to the terms. Having a carefully crafted script that breaks down the scenario and terms in an easy-to-understand manner should increase your chances of getting a yes with your offer.
Another con to buying subject-to is that neither the payments nor the loan amount improves your credit score. Mortgage loans, when paid on time, can do wonders for improving a credit score, as well as your lendability for future loans. Unfortunately, when you buy subject-to, most mortgages stay with the seller, meaning you're helping improve their credit score but not your own.
The Millionacres bottom line
Ultimately, subject-to transactions are a super-creative way to buy real estate but aren't always a viable option. The investor must conduct their research and due diligence on the investment property to ensure the terms and conditions of the mortgage, the state laws, and the property values allow this method of investing and justify the effort and cost involved.
Rather than being the only way you buy real estate, subject-to should be one strategy coupled with other offers to best meet the seller's needs.