Step 4: Exit Strategy – Before you close, you should know how you are going to exit the deal. Are you going to just buy it, fix it up and sell it? Are you going to do a 1031 exchange or a cash out refinance because your seller financing structure is going to end? In many cases, your creative financing deal has a time limit of 5 years or so. So you need a five year plan on how you are going to pay off the seller or you may lose the property, your down payment and and all the equity. So, having an exit strategy is crucial to success.
The master lease agreement is the most powerful technique for creative financing commercial real estate. We have used this technique on some of our best deals, with some of our most distressed sellers, and with some of the most unqualified buyers.
In commercial real estate, the term “Master Lease” refers to a creative financing arrangement that could technically be written up one of three ways in the paperwork; Lease with Option to Purchase, Subject To or Land Contract / Contract for Deed.
Lease with Option to Purchase: The property owner remains the title holder and the Buyer leases the property from the Seller while also acquiring the option to be able to purchase the property for a set price within a specified period of time. This is the most common version of how the paperwork of a Master Lease is drawn up.
Subject To: The property owner transfer title to the Buyer but the existing financing recorded against the property doesn’t change. Most commercial loan documents have a due on sale clause (and commercial lenders are more willing to enforce that clause if title transfers than with residential loans) so how this is normally structured is that if the property is titled in an LLC, the Sellers sells the LLC to the Buyer to navigate around the due on sale clause. The terms of the sale of that LLC are similar to the terms of a Lease with Option to Purchase because the purchase price is set along with a specified period of time to pay off the existing loans.
Wrap Around: Similar to a Subject To, with a Wrap Around, the existing liens remain on the title and but then a new lien is originated with its own financing terms and wraps around the existing financing. Title is transferred to the Buyer.
Land Contract / Contract for Deed: This is an agreement whereby the title transfers to the Buyer once the entire sales price has been paid. This way of writing up the deal is very helpful when establishing an installment sale for IRS tax purposes. Once again, the terms of this are similar to the other two, whereby the Buyer has a specified time to pay it off and a pre-arranged purchase price.
Therefore, since all four of these versions of a Master Lease are essentially the same in the end, I will teach the principles of the Master Lease as all four being one creative financing technique.
Our Protégé Dean purchased a large self storage facility using the Master Lease commercial creative financing technique. His deal is a good example of how to implement the Master Lease using the 4-step process.
Seller Motivation: We focused on determining what the Seller’s real motivation since the Seller tried to keep it close to his vest. We narrowed it down to two things; Either (1) the seller wanted out of the business but he didn’t want to pay capital gains right away, or (2) he didn’t want to work with an agent. With our seller’s motivation hunches in mind, we knew early on that we would need to use a creative financing technique.
Creative Terms: Dean negotiated a 3 year master lease agreement with a $2.5 Million Option Price for a 3 year term with a option/down payment of 10% (considerably less than the 25 or 30% a bank would require) of $250,000 and a monthly lease payment of $9,375 (the amount was determined based on a 5% interest only payment on the $2,250,000 balance).
Write Up Offer: Dean submitted his offer using our Master Lease Agreement contract that we give those in our Protégé Program. The win-win deal arrangement provided the Seller with $250,000 upfront along with $9,375 per month for the next three years, while still claim depreciation for their taxes and not have to deal with the property anymore. Meanwhile, Dean gets to increase the NOI by raising rents and making improvements, collect the increase in cash flow and benefit from the forced appreciation.
Exit Strategy: Dean can either cash out refinance within 3 years to get his original $250,000 down payment back along with paying off the $2,250,000 while still cash flowing; or Dean can capture capture the forced appreciation by selling at the end of 3 years.
Forced Appreciation: Recall that the value of a commercial property is determined based on the Net Operating Income (NOI). Forced Appreciation is accomplished by increasing the NOI. NOI is increased by reducing expenses and increasing the income. The day that Dean closed, the NOI was $73,603 a year, which is actually less than the $112,500 in payments due to the seller. However, Dean immediately raised rents where he could as well as reduced expenses so that he could at least break even with debt coverage within a few months. Then, he systematically increased NOI well above the debt coverage and by year three, the net operating income is estimated to be $285,542 per year.
To calculate the amount of Forced Appreciation, start with $2,500,000 as his original purchase price. Then, divide Dean’s 3 year ProForma NOI by the market cap rate of 7%.
$285,542 / 7% = $4 million
$4MM – $2.5MM = $1.5MM Forced Appreciation
Dean acquired a commercial property for only 10% down that he will create $1.5 million in equity in 3 years, or roughly $500,000 per year; all thanks to the Master Lease creative financing technique. Not only would this porperty not have qualified for traditional financing, even if it did, his cash on cash returns would have been much lower if he had to put 25% – 30% down.
For further study on the Master Lease Agreement, go here: https://www.commercialpropertyadvisors.com/master-lease-agreement/
Check out Dean’s video on how he purchased this large self-storage property using creative financing:
Real World Commercial Deal Without a Bank Loan
This creative financing technique is when the seller becomes your bank by originating a mortgage whereby the seller is the lender and you are the borrower. Another way to say this is the seller is holding the paper, hence the name “Seller Carry”. You may have also heard this called owner financing or seller financing. Why would a seller agree to be the bank and lend you the money to purchase their property? Here’s an example of what that might look like with a Seller Carry 1st technique.
Example: You meet with the seller, and he tells you he has no mortgage. This seller wants to sell, but he wants to maintain some of the income. So how do you do that? How do you create a win-win deal around the seller motivation? You use the Seller Carry 1st technique. Here’s a break down of an example deal.
This technique is ideal for a seller with no mortgage, but the property is distressed. It could be a property in a great location with a lot of potential but because it is distressed, a lender will see it as too risky. And it is also a great technique to combat high interest rates. If you can negotiate a 5% interest rate today, it’s a win for you. And lastly, it is ideal for a distressed seller, who needs someone to take over the property for personal reasons. With this technique, they can be the lender for you to get the deal done quickly and efficiently.
The Seller Carry 2nd mortgage is similar to Seller Carry 1st, only the seller holds a mortgage in the second position. This technique is useful when you don’t have all the down payment and is great to have in your toolbox of creative strategies. Most banks require you to have 25% down. If you don’t have the full 25%, the seller can loan the remaining amount to you as a second mortgage.
Example: You have found a life changing deal: great locations, lots of cashflow and a motivated seller. There’s one problem though, you don’t have enough money for the down payment.
Sale Leaseback is a commonly used creative financing commercial real estate technique. It’s an old technique with terrific benefits. This technique is used when you purchase a property from a professional, for example a dentist, and their practice is in the building. They sell the building to you, but remain the tenant and you lease it back to them. That’s why it’s called, sale lease back. The benefit for the dentist is it frees up their equity. They can use the cash to expand their practice or buy new equipment. With all their cash freed up, they can focus on their business. As the buyer you inherit an automatic and established tenant with a fixed rent, which will get you the best terms with a lender.
Seller equity participation is when the seller sells the property to you but some of the profits from the sale go to your down payment. So, at the close of escrow, the seller gets the profits but 25% of the purchase price will go back as the down payment into the property. This technique is ideal for sellers with a lot of equity.
There are two main benefits of this technique. First, as the buyer you have no down payment. Second, the seller who puts in the down payment becomes a limited partner with you. The seller gets the majority of the sale price plus a certain rate of interest on her money. Alternatively, she could get a certain interest in the property for as long as you own the property. This technique is a great way for a seller to maintain income and stay in the real estate game, even though she just sold everything to you.
That’s Creative Financing Commercial Real Estate. They are a must for today’s commercial real estate investor.
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