Land Contracts versus Rentals

7 Feb

No ice cream anecdotes today – I’m all bizness….

I received an email from a real estate agent I worked with about a year ago, when I was still living in Chicago.  The subject read:  Money Man deal.  The body…. 174k  7.5%  amort 5yr  10k balloon 3-4k down.  That jibberish was the whole email.   I remember being irritated with the brevity and lack of detail.   It was a foreign language to me, so I told him to pound sand cause I didn’t know what that meant and I sure wasn’t nobody’s money man!   As it turns out that deal was not only illegal but also financially terrible.  It did however, open me up to the idea of selling notes.  Though it wasn’t until six months down the road that I got wise to the beauty of the land contract.

From Wikipedia:  A ‘land contract’ (sometimes known as a “contract for deed” or an “installment sale agreement”) is a contract between a seller and buyer of real property in which the seller provides financing to buy the property for an agreed-upon purchase price and the buyer repays the loan in installments. Under a land contract, the seller retains the legal title to the property, while permitting the buyer to take possession of it for most purposes other than legal ownership. The sale price is typically paid in periodic installments, often with a balloon payment at the end to make the timelength of payments shorter than a corresponding fully amortized loan without a final balloon payment. When the full purchase price has been paid including any interest, the seller is obligated to convey legal title to the property to the buyer. An initial down payment from the buyer to the seller is usually also required by a land contract.

You probably didn’t read that.  Here’s what you need to know.  The best way to think about a land contract is that you are essentially “the bank” giving a note/loan (like a mortgage).  You set the rules, down payment, interest, and the purchase price (amount of note).  Unlike a mortgage, you have title interest in the property rather than a lien, giving you more rights on a default.  The buyer is required to maintain the property, pay property taxes, and property insurance –  just like a mortgage.  So you don’t have to manage the property, all you have to do is make sure your payments come in.  If the land contractee fails to make these payments, you take the property back.  After X number of years and payments, they own the house (like a mortgage).  You can charge up to 11% interest on land contracts in the state of Michigan.

Now land contracts tend to get a bad rap because in the last decade people used them to sell houses to people that couldn’t get a loan at a time when all you needed was a pulse to get money from a bank.  So the absolute worst financial candidates were getting these land contracts and no shock, some of them defaulted, trashed the house, didn’t pay taxes etc.  You can’t make it around the block without some old-timer in a cowboy hat giving you a land contract horror story.  But times have changed!

I will use an example of a  land contract deal that I hope to close on next week.  This guy bought his house for 130,000 in 2005,  it’s now worth around 40k.  Either by choice or by inability to pay, the house was foreclosed by the bank.  The house went to auction and the bank bought the house back for $28,000.  Now under Michigan law, the owner has 6 months to redeem the property (buy it back for the price it sold at auction).  This right is transferable.  He obviously doesn’t have 28k in cash or he wouldn’t be in his situation and he really wants to stay in his house, so the deal got brought to me.  I will redeem his house for him under the agreement that I will land contract it to him.  We negotiate the terms.  We agreed upon 5k down, 10% interest, 60k note amortized over 5 years.  So my initial investment is 23k (28k-5k down payment) plus closing costs  (commission and interest to the bank) puts me around 28k  total, maybe a little less.  After 5 years and 60 payments, he will have paid me $76, 500.  So my ROI (if I did it right) is 34.6%.   If he defaults, you can quickly see that i am getting the home a great discount and because it’s essentially his home, I see him fighting like hell to keep it, so the chance of default is pretty low in my estimation.  He gets a little higher payment than he used to have, but he owns the house outright in 5 years and gets to a keep his home he otherwise would not be able to keep.  Definitely a win/win.  These deals that were once pretty lousy are now much better because of the changed market conditions.  Specifically, the difficulty in getting a loan and the drastic housing value collapse.

Now every land contract does not have a ridiculous ROI like the one above, the negotiation depends on a lot of factors.  However, they are usually quite a bit higher than the ROI of a rental in my area – and a LOT LESS work. There are two problems however.  I want to be in this business for life and if I have all land contracts after 5-10 years – whenever these notes get paid off – I’m left with a pile of cash and no passive income.  My fear is that the market condition will change and reinvesting the money won’t be as easy, especially if the housing market improves drastically.  Also, you can’t refinance the money out like you could in a rental.  At the current >5% interest rates, this is a problem.  You can refinance money out of an income property out at 70%.  So if you make 15% ROI on a rental and refinance it out and repeat – your ROI keeps going up on that same amount of money.  My plan right now is to resist the urge to snap up every good land contract and get a 50/50 split of rentals : land contracts.  In the future when I get a little more seasoned, I might start hedging one way or the other, but I think it’s safest to see how everything goes first before going all in on just one of the other.

Some tips – don’t set up a balloon – nobody can get financed or save enough to pay it by the end.  Escrow the taxes and insurance – too big of a  risk to let them handle it.  Add it to their payments.  Definitely get title insurance – I had some clown with like 50k in back taxes try to get me to buy his house so he could stick me the bill.   A lot of these deals come through short sales where you land contract it back to the owner.  Sometimes the banks make you sign an arms length transaction waiver to prevent this type of circumvention, sometimes they don’t.

caveat – I am just starting out and don’t want to sound like an authority or law expert.  These are all my original ideas and its possible I’m out to lunch so do your own due diligence.

5 Responses to “Land Contracts versus Rentals”

  1. Nick VanNewkirk February 8, 2012 at 1:06 am #

    Very interesting Justin. This seems like a market inefficiency right now. I feel like you should take as much advantage of it as possible. Do you have any recommended reading materials for learning more about land contracts in relation to post housing crisis meltdown times?

  2. justinsadauskas February 8, 2012 at 1:59 am #

    I haven’t done any reading – if you were to pick up something, I’d focus on learning about distressed assets and how the banks are doing things and why. Probably the best stuff you will find online. The market is so inefficient right now – I’ve been close to just buying a house off the MLS and selling it for a 20% markup without doing anything. Banks are all over the place and so are buyers and sellers. It’s pretty wild out there.

  3. Jordan Greenberg February 9, 2012 at 3:43 pm #

    You wrote earlier that only 15% of the houses are rented. Can you clarify that? Do you mean there are vacant properties or just not many of the properties are rentals? If there are vacancies, are you putting time into scouting specific neighborhoods to make sure you don’t run into an issue with finding a renter?

    • justinsadauskas February 9, 2012 at 4:09 pm #

      15% of homes in the area are rentals – 85% are lived in by the owner. This number is good because when supply for rentals is low, price increases. If this number were higher, the rental market would be more unstable.

      Yes, I definitely scout areas before I buy. This is really important. I find it takes a lot longer than you would think to learn an area. Thats part of the reason I stick to my one zip code. I would like to learn a few more areas but it takes time when you are not native to an area. It would be much easier if I grew up there since you’d know what each neighborhood represented.

  4. Jay P February 22, 2012 at 5:43 am #

    as the owner of a land contract, you still have to go through the same hoops the banks do to “foreclose” on someone.

    people used to make a killing doing this to people who may have paid 9 years out of a 10 year note. after they defaulted, the people lost all of those payments, as well as the house, and the owners reaped the benefit. i believe laws have changed to rectify that situation for the purchasers.

    nice work though.

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