Subordination

Posted on December 5, 2014 by

This technique will be used frequently and is one of my favorites to make a property easy to fund. It simply means the seller will take back a second, allowing you to get a new first to cover down payment and other costs.

The big advantage is it sets the stage for you to negotiate a deal that’s easy to fund because you can borrow the first at a low LTV making a hard money loan easy to get.

Example:

Seller wants $1,000,000 for an apartment complex that needs $100,000 in work. She owns it free and clear and fixed up and rented, you feel it’s worth $1,800,000. Seller says she’ll take $100,000 down and the balance within 24 months but will subordinate to a new first and take low or no payments or interest on the $900,000 second.

Purchase price $1,000,000
Down payment $ 100,000
Seller second $ 900,000

New hard money 1st $300,000
Less down payment -100,000
Less rehab costs -100,000
Cash to you $100,000

Financing structure
New 1st $300,000
Seller 2nd +900,000 – no or low payments
$1,200,000

Your exit is to buy, fix and refinance with a good, permanent loan, or sell. You should be able to get a $1,350,000 loan (75%) or more and pull out cash once it’s stabilized.

Subordination can also be used in a more common manner by borrowing as much as you can on a first and getting the seller to take back a second for the difference with a longer payoff period. In this case, the financing is your permanent financing, so the first will be on good terms through an institutional lender and no short-term balloons on the second.

Example:

You can buy an office building worth $1,300,000 for $1,000,000 and if you get the seller $700,000 he will take back a second for $300,000 with monthly payments over a fifteen year period.

Purchase price $1,000,000
New bank 1st $750,000
Seller 2nd $300,000

The total new debt will be $1,050,000 and there will be an extra $50,000 to cover costs. Of course, the new first is a qualifying loan so the borrower and the property must conform to the lenders standards, so this will only work on stabilized properties with sufficient income to support both debts. The bank must know this second will be on the property– full disclosure.

Here are some notes on subordination:

  • Make sure you do your best to lower the amount of new financing and increase seller financing.
  • Won’t work on properties with high existing debt.
  • Be sure the property will easily support both payments if applicable.
  • Don’t over borrow and get yourself in a trap.

Now let’s look at a sample house deal:

ARV $200,000
Asking $150,000
Repairs $25,000
Seller Needs $40,000 Cash Now

Your Offer
Price $130,000
Down $40,000
2nd to Seller $90,000 Subordinate to a new first, no payments, 5-year down

You Borrow
Private Lender $75,000 First mortgage, 8%, $500 per month interest only, 5-year balloon
-$40,000 to Seller
$35,000 Cash to you for repairs and extra income

Total Debt
1st to Lender $75,000
2nd to Seller $90,000
Total Debt $165,000 on a $200,000 house with $25k in your account for repairs

Results

  1. You get $35,000 the day you buy (25 in repairs).
  2. You get $35,000 less cash when you sell.

For subordination to work, you need a seller on a property with a problem and free and clear or close. Here you have all three ingredients.

Ron LeGrandRon LeGrand is the world’s leading expert in residential quick turn real estate and a prominent commercial property developer. Ron has bought and sold over 2,000 single family homes over the past 30 years, and currently owns commercial developments in nine states ranging from retail, office, warehouse, residential subdivisions and resort

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