Often note holders sell their property with an underlying lien. Instead of carrying back a second, the property is sold via a wrap note, or contract for deed (CFD); also called a land contract. Both the CFD and wrap note have their own issues with structure and legalities, but in this issue I addressing only the number crunching.
To refresh your memory, a wrap note is a form of financing where instead of taking back a second, the property seller will create a “wrap note” where the underlying note will remain in place, and the wrap note will “wrap around” the underlying lien. The property seller will now hold a wrap note instead of a first lien. When the property buyer makes the wrap note payment, the wrap note holder will take that payment and pay the underlying note. The remainder is the wrap holder’s profit.
If there is not enough equity between the wrap note and the underlying note, the wrap note holder will be disappointed in the final outcome of the note sale.
For example, a property has a value of $100,000 with an underlying lien of $70,000 at 5% with 20 years remaining and payments of $451.97. The property was sold for $100,000 with $10,000 down and the property seller carried a “wrap” note of $90,000 at 8% interest for 20 years with payments of $752.80. In this example the borrower would pay the wrap holder $752.80 a month on the wrap note, and the wrap holder would pay the underlying lien of $451.97.
The remainder of $300.83 is the profit the wrap holder receives. (The wrap holder actually enjoys a yield of 17.49%, but this is a topic for a different discussion.)
The wrap holder needs cash and wants to sell the wrap note. Let’s assume that the credit, property and note are acceptable to a Note Buyer. Let’s further assume the Note Buyer is requiring a 11% yield. How much would the wrap note be worth? Let’s look.
N = 240
I/YR = 11
PV = -72,932.04 (This Is the Amount the Note Buyer Will Pay for the Wrap Note)
PM = 752.80
FV = 0
But hang on. Remember there is an underlying lien of $70,000 that has to be addressed. All things being equal, Note Buyers will require the underlying lien to be paid off so they will have more protection by being in first position, as well as not having the risk of the due on sale clause being activated.
Under this scenario, subtracting the underlying lien of $70,000 from the $72,932.04 from amount paid for the wrap note, the note seller will receive the balance of $2,932.04. If the closing costs of selling the note are factored in, it is not uncommon for the wrap seller to be in a negative position. (Can you purchase a wrap note and leave the underlying in place? YES. This is an advanced technique for later discussion.)
As either a Note Buyer or note seller, you should be aware of how wraps are purchased and address the possibility the wrap seller will have to come to the closing table with cash.
There are many other Do’s and Don’ts when dealing in wraps which I discuss in my Advanced Note Class. However, I will address “wrap traps” that I have encountered twice in the last 30 days. Do Not Get Upside Down on the underlying lien with either the size of the loan, the length of the loan, or interest rate.
Two quick examples to avoid. First DO NOT construct your wrap note where the underlying lien is more than your wrap note, no matter how much down payment your receive. I just had to turn down a wrap sale where the wrap note was $168,000 and the underlying was $175,000. This is what I call “a bug looking for a windshield”.
Question: What is the wrap holder’s position if the borrower sells the property or pays off the $168,000? There is a $13,000 difference that is going to have to be paid by somebody?
The second trap to avoid is having the time period of the wrap note less than the underlying note. Using the above as an actual example, the underlying note had a balloon due in two years, while the wrap note was a straight amortization. See the problem?
A “time trap” which happens more frequently that makes selling the wrap a big problem is having the terms of the wrap note for 15 years while the underlying note has a 25 year term.
Under this scenario, the borrower will have paid off his wrap note in 15 years, but the underlying note still has 5 more years ago. The result is not favorable. The current property owner will have to make payments for 5 years more than contracted, or the wrap seller will have to make payments for 5 years, yet have no payments coming in. Not a good scenario, is it?
Wraps can be very lucrative and advantageous. Just be aware of how wraps work, whether you are buying, selling, and more importantly, if you plan to take back a wrap note as an exit strategy for selling real estate. Act out of knowledge; not ignorance or fear.
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