Self Storage University Podcast: Episode 8

Understanding Seller Financing

There’s no better form of financing for a self-storage facility than “seller carry” – the concept of the seller creating their own mortgage to finance the purchase. But how do you get it? And what should you watch out for? In this Self-Storage University podcase we’re going to review these questions, as well as a wealth of practical information on creative financing to buy storage properties. If you are looking at buying a self-storage facility, then this podcast should be of interest to you.

Episode 8: Understanding Seller Financing Transcript

What's the best form of financing in self storage? The answer is simple, seller financing. But how do you get it? This is Frank Rolfe for the Self Storage University podcast. We're going to be exploring all about seller financing for self storage facilities. So let's start off with the simple, how do you get a seller of a self storage facility to offer seller financing? Well, there's a couple of ways to achieve this. Number one: it makes sense to them. Let me explain why.

Let's assume I buy a self storage facility from a mom and pop seller and I buy it from them for a million dollars. If I gave them a million dollars cash and I made that possible by getting a loan at a bank, here's what would happen to mom and pop. They take the million dollars. They have to pay income tax on it. Sure it'd be capital gains, but there's also recapture from depreciation and there's state income tax.

So let's just say that everything combined is 30%. So mom and pop end up with $700,000. Sounds like a lot. It certainly is. But then when you go down to A. G. Edwards or your stockbroker and they asked them, "Hey, I want to go ahead and invest this." They say, "Well, how much risk do you like mom and pop?" And they of course say, "Oh, I don't like any risk at all." And they say, "Well, I've got a nice treasury deal here. That'll work for you. It'll pay out one and a half percent interest. So that $700,000 at the end of the day only is going to earn $10,000 a year, approximately, not very impressive.

However, let's change it around now and now they seller finance. Well, they don't pay any tax on the money until it's received. So let's say you give them $200,000 down and they carry a note for $800,000. Let's say on the $200,000 down, they pay their tax of let's say the same 30%. So they have $140,000 there. They take it down to A. G. Edwards and the interest earned on that is so small, I won't even use it in our analysis. However, the $800,000 that they carry, you're going to pay them 4% interest. That's $32,000 a year, and that's four times more than the stockbroker was going to get them. So clearly just from greed, there's every reason in the world in which they would want to seller finance.

Then why doesn't everyone do it? Well, some people want to go out and buy yet another bigger self storage facility, but not always mom and pop. That's not really their goal. Right? They just want to retire. They just want to move to Florida. They don't want to have to mess with the business anymore. They don't want to have to worry about anything anymore.

And if that's case, there's every reason in the world, why they would want to carry, because it makes sense to them. Then how do you educate on what I just said? Well do just that. Tell them about the options. Give them something in writing comparing the options. A lot of times when they won't consider seller financing, they don't fully understand it. And they don't understand the benefits. And they don't understand them until they're too late when they go down to A. G. Edwards and they can't get any money for their money. So help them not do that. Show them in advance of how that works.

Another way to do it is to give two options when you give the initial offer to buy the storage facility. Give them a cash price and give them a terms price. The cash price in this case might be, I'll give you $800,000 in cash. Or if you'll carry the financing, I'll give you $900,000. Now, why would I do that? Well, it's because the seller financing is so incredibly attractive I can pay more because the interest rate would typically be lower. The cost of closing will be lower. Everything works my way. And if you run the numbers, you'll soon see that's exactly accurate. So seller financing saves me a ton of money. Therefore, I'm willing to pay a higher price if they will do it. Now, that's how you get the offer on the front end. Right?

What makes a seller capable of carrying seller financing? They have to basically have no debt. If they have debt, they can't do seller financing. They have to extinguish their mortgage. Now there's one option to this called the wrap mortgage. It's a risky construction. You leave that first lien in place with mom and pop at their bank. And then they take a second lien position for the rest of the amount that's financed. Now what's wrong with that? If the first lien, for any reason should come up due and payable, if they don't have the money and you don't have the money, you're all going to lose the storage facility and your money is gone. So a wrap to me is a little risky, but that does give you one more way to do it if they have a little bit of debt. But if they have a lot of debt, they're not going to be able to do it.

So often when we're looking at seller finance deals, we ask them on the front end, could you carry the financing? If they say "I can't," then that may mean they can't because they have a loan, but if they say, "I don't want to," then it's very possible you could change that opinion completely.

Now, here are some other important things you need to know about seller financing that most people do not. Number one: let's go over some of the important terms of the seller note. Now, one thing about the seller note that I find very important is what's called the cure period. It's true in all bank notes that bank notes typically have this written into them and a lot of sellers do not. In the event the seller does not get your payment, you have so many days to appeal to them and say, "Hey here. I'm sorry you didn't get it. And I'm going to go ahead and now give it to you." And they can't default the note. In some states, if you do not have that language, they in fact can default the note and what will then happen is they can call it due and payable and that's not going to work for you. So I like the idea of a cure period.

I also like the length of the note to be at least five years or greater, because here's how it works. I have to go out looking for a new loan, typically about a year or two before it expires. If you have a short three year seller financed window, then what's going to happen is I have to go out and get a new note after only about a year. That's not enough time. If you can get it, go for 10 years. If you can't get 10, try for seven. But I don't think I'd do a seller note less than five years because that's not really going to work for you.

And on the concept of how long should the seller note be, let's also explore the very necessity of why you want to have longer term debt and some of the traps you can fall into with seller notes. Bear in mind when you have longer term debt, you have greater security. But none of us know where America's going. This year it hasn't been going well at all. And we also don't know when there might be a lending crisis. If you have longer term debt, you can pick and choose when to refi based on the right part of the cycle, when the people are doing loans at low interest rates. When you have a short note, you're stuck with wherever things are at that one moment. And that's not typically always exactly where you want to be. You want to have a little more room to maneuver and you need that room to maneuver by having that longer term loan so you can do it.

But let's talk about some things that can happen that go wrong if you don't have the right seller note. And this is the number one way I've seen people lose self storage facilities over time, and that is they either over lever or they pick a timeframe they can't meet. So let's go over each one.

Over leverage means that you do an amount down that is not in any way in line with traditional banking. Let's say the banks are requiring 20% down, but mom and pop lets you get away with 5% down. That's all fine and good until your note comes due. Where are you going to come up with the rest of the money? If you bought the thing for a million dollars, with $50,000 down, and the banks, you know, are going to require 200,000 down, when mom and pop's note comes up, how are you going to pay it off? And the answer is you can't. There's no way you can make that happen because you just can't find anyone out there with that money. You don't have the money to do it.

And that leads me to the concept of term default. The worst thing you can do in the world of buying a self storage facility and using seller financing is to get into a position where you cannot replace the debt. A, because you can't find anyone who will do it, and B, you can't find that person in time. You don't want to enter into what's called a term default. When you have a term default, what it means is you couldn't get the loan replaced fast enough. And so therefore it expired and they take the property away from you.

You've always got to make sure you have plenty of safety cushion on when that loan is ending and what the amount is and how much down you have to have. I see people frequently go in and overextend themselves in every way possible. Either a note that's way, way too short. I've had calls from people who entered into seller notes that were only one year in length. What good did that do? They felt like it got them off the ground. Well, it sure did. It's like flying a plane that only has an ounce of gasoline in it. Didn't get very far off the ground before you got into trouble. So you typically want to have a long term and you want to match traditional lender terms.

Now what are traditional lender terms you might say. Well, let me give you a shortcut. If you call a place called Security Mortgage Group, 585-423-0230, they can give you some ideas on what the lending parameters are on a self storage facility. Then that's kind of sort of where you're going to need to be when you ultimately refinance. Now, yes, you can go with a lower amount down because the goal is you're going to increase the occupancy and the rent such that the value increases, such that now your loan to value will still work. If I buy that deal for $800,000 and I increase the value to a million, that perceived equity will count towards the down payment and I am fine.

But if you get something with a very short term where you don't have the chance to improve things that significantly, how in the world are you going to refinance the deal in the end? And if you don't have the capital what's going to happen? Well, they're going to take it away from you. Your clock is going to expire. You could not get the replacement loan and then you were in trouble. So always remember to think like a lender. Don't back yourself into a corner. Do things based where you know what the projection, the typical amount down, that you can hit that. Make sure to give yourself plenty of timing. And always understand that the seller wants to carry deep down in their heart. They want to get the most money possible. We're all greedy. So as a result, don't be ashamed to offer seller financing because really it's in their best interest.

This is Frank Rolfe with the Self Storage University podcast, hoping you enjoyed this exploration of seller carry. It's The best stuff on earth. Hope you find some and we'll talk to you again soon.