Self Storage University Podcast: Episode 80

Tips On Wrap Notes

You’ve got bank debt, and you’ve got seller carry – and then there’s the hybrid called a “wrap” note. But what does that mean, how do they work, and what do you have to watch out for? That’s the focus of this Self-Storage University podcast. If you’re looking at alternative financing options in the current interest rate climate, then this topic should be of great interest.

Episode 80: Tips On Wrap Notes Transcript

You've got bank debt, you have seller financing debt, and then you have this hybrid called the Wrap Note. This is Frank Rolfe, the Self Storage University podcast. We're gonna focus in on the strange financing construction called the wrap. Now, here's where a wrap comes from. Let's assume someone borrowed on their self-storage facility, when they bought it, $400,000. So they've got a note they're paying on every month for maybe a 20 year amortization on $400,000 of debt. And now you come to that mom-and-pop seller and say, hey, I would like to buy your self-storage facility. And you agree to a price, let's say, of $800,000, and so you're gonna put down $160,000. But on that other $640,000 of debt, there's that already existing first lien, that $400,000 first lien sitting there at a much lower interest rate. And the seller wants to get the park sold and you wanna get the property purchased, but the issue is that you've got this note that's so attractive you really don't wanna lose it.

So what mom-and-pop say is they say, well, you know what, let's just go ahead and do a Wrap Note. Let's leave that loan in position for 400 and then I'll go ahead and I'll do the other 240,000. I'll seller finance that. And you put down your down payment and that's how we'll do the deal. Now, is that attractive to you as the buyer? Well, sure. Because you're gonna get a lower interest rate than you could get right now on that first lien note, and then the seller's gonna carry the paper on the second lien note. That's the wrap. And on the wrap, you're gonna again, you're gonna get a lower interest rate than you would get on a bank. So from a construction perspective, as far as alternative financing, it's not a bad idea. It's been around for decades. People have done Wrap Notes forever and ever and ever. However, there are some things you have to know about Wrap Notes that can make them a little risky. And there's some things you can do to safeguard your investment if you only know about it.

So what are those? Well, the first thing is you need to know that when you do the Wrap Note, that first lien that the bank currently has, in this example, $400,000, it's got a note. And that note has various conditions that the borrower must work around. And the first one is typically what's called a due-on-sale clause. It says if mom-and-pop sell that self storage facility, then they're going to have to go ahead and pay off the loan. So wow. Okay. That's kind of a problem because now you're doing a construction that really isn't legal. You can't really cause the bank to continue in the first lien position when they're not supposed to be in that position other than with that original mom-and-pop. So a good idea when you start out, the concept of even doing a wrap is a look and review a copy of that first lien and see if that first lien is going to allow that property, that storage property, to be constructed into a wrap without violating the agreement. Now, some bank loans do not address it.

I have looked at some bank loans and we have done wrap deals in the past. The situations where the bank does not have a due-on-sale. It simply says we have a first lien on the property and you pay this much for this amount of time, and as long as the bank has that first lien, it seems perfectly happy. So in some cases, the wrap is fully fine because the underlying note says, sure, you can wrap this thing. As long as we're the first lien, we don't really care. But what do you do if the bank says, oh, well, my first lien, you gotta pay it in full. Well, that puts a huge amount of danger upon your deal. Because what do you do if the bank calls that $400,000 note due in full? Mom-and-pop don't have the money to pay it off. You're only putting $160,000 down, that's not gonna cover $400,000 and you probably don't have the $400,000 to pay it off either. So technically your loan would go into default, then they would then take the property into foreclosure, you would lose your entire down payment, lose the property, it would be the biggest mess of all time.

So that's the true risk of the Wrap Note. Now, if the Wrap Note is legal, and again, if you really wanna know it's legal, you'll have to have an attorney read it to advise you that it is fine. But you yourself can see whether it addresses the situation or not. And if it doesn't address it and the attorney says it's legal, then there really isn't a problem with the Wrap Note construction. But if there is a problem with it, as you can see, if you go forward, you could get in real trouble. So how do you defend against that? Well, if the lien is truly not allowable to transfer on to the next owner, then really the only thing you could do is to go in with a very, very small down payment. That's how you would mitigate your risk. So going back to our original concept here, the $800,000 self-storage purchase, maybe instead of putting $160,000 down, you put $60,000 down or $30,000 down, or in some cases $0 down because you are afraid they're gonna call that note due. And that's a very reasonable request.

Now, another problem you have with the seller note is on the wrap, remember that property is not titled into your name. So think about that for a minute. You put down 160 grand, but who is actually the title holder? Well, it's still mom-and-pop, right? Because the first lien is with mom-and-pop on that property. If you go ahead and go to a closing, it's probably pretty sure that that bank isn't gonna go forward with this concept. Just another danger you've got with the Wrap Note. Again, the only way you can defend yourself in that case is with a lower amount of down payment because it's the same movie all over again. What happens if mom-and-pop dies? What if mom-and-pop go crazy? What if mom-and-pop claim you lied to them and they won't transfer the property over? Then what the heck do you do? You're pretty much stuck. Not much else you can do. Now, another option you can do when someone's got an existing first lien and you wanna be constructive and alternative in your investing concept would be to do a master lease with option.

Now, a master lease with option means that you would make a master lease on the property, but you're not buying it, so it doesn't typically trigger the deal on sale, but instead allows you to take over the property and run it as you like and to make the payments and everything else, without having that issue with the note. So does that work? Well, it could work, although often mom-and-pop are not really happy about the idea of turning their entire property and its future over to you, a relative stranger, not knowing how you'll steer the car or will you steer the car off the cliff. But we have done those kinds of deals before, so that is another alternative you would have to do something alternative when there is an existing first lien. So that is still out there on the table, but in the current climate with interest rates where there are it doesn't hurt to try some alternative vehicles, and the Wrap Note is probably one of the most classic of the alternative bank financing concepts. Now, a couple other tips on a Wrap Note.

If you have a Wrap Note and the seller makes payments every month and you don't really want the bank to even recognize the fact that there's been a transference, it might not be a bad idea to go ahead and have the seller continue to make the payments, you make the payment to the seller and the seller then forwards it to the bank. Now the risk there would be, of course, what if the seller doesn't make the payment? But you'd have to imagine that they do. Remember that in a Wrap Note construction, who's on the hook on the first lien is in fact the seller. If that's a specific performance Note and they don't pay the payment, well, the bank will foreclose on that storage facility and then go after them for them for the deficiency, they have much more skin in the game than you do, however, you've got your fresh capital at risk, and so that means you also have a whole lot at stake. The bottom line to it is, Wrap Notes, if properly structured through an attorney can be a fine form of alternative financing, they're in this high rate interest rate environment. So don't overlook the options, but you've gotta protect your interest.

Then maybe to do them, you've gotta go in through a very small amount of down payment, you need to have the loan probably thoroughly checked out by an attorney, and you need to really just generally understand what you're doing. You need to have a plan B, and a plan C if anything should happen. One final note, don't forget, when we talk about things such as the bank note, not legally allowing transference to a new buyer, remember you didn't sign that note, so most of the problems from a legal perspective, and you should check this out with your attorney, fall upon the true borrower who signed the note. You don't really have any obligation to the bank, you never met with the bank, you never signed the deal to begin with, and you surely didn't sign the note, but the problem you have is sometimes that self-storage seller is so eager to sell that they're willing to bend the rules of what they signed. And that's why it's always important for you to check it out and not look to them as being the referee. This is Frank Rolfe, the Self Storage University podcast. Hope you enjoyed this. Talk to you again soon.