Creating a Seller’s Market: Exploring the Advantages and Disadvantages of Seller Financing
INTRODUCTION
Seller financing, also known as owner financing or seller carryback financing, is a unique and flexible real estate transaction method that allows the seller to act as the lender. In this arrangement, the seller enters an agreement with the buyer to loan a portion of the total purchase price, enabling the buyer to acquire the property without relying on traditional loan sources such as banks or insurance companies. The property’s title is typically conveyed to the buyer upon the sale, though any existing liens or encumbrances may apply. The seller might also maintain a security interest in the property as collateral for the financing extended to the buyer. However, the details of the transactions, such as title ownership, can differ based on the specific seller financing agreement employed. For instance, for a land contract, the seller maintains legal title to the property until the buyer fully pays off the purchase price. Once paid in full, the legal title is transferred to the buyer.
In this piece, Alliance Global Advisors highlights the typical situations in which seller financing is used, the advantages and disadvantages of parties involved in the transaction and its prevalence in the current market environment. We thank Dean Dulchinos, Head of Debt Portfolio Management at AEW Capital Management and others who contributed to this research.
WHY SELLER FINANCING
Generally, seller financing is most frequently employed by a seller who wishes to motivate a sale in what would otherwise be a challenging capital markets environment or situation, such as reducing exposure to a heavily out-of-favor property type. Given the seller’s motivation, it often affords the buyer (borrower) a negotiating power advantage, resulting in better borrower terms and a weaker lender position than traditional financing transactions. Examples of key terms that may be more borrower-friendly in seller financing include:
Lower Interest Rates
Lower or No Origination/Extension Fees
Higher Advance Rate/Loan-to-Value
More Limited Recourse/Guaranty Provisions
More Limited/Weaker Insurance Requirements
More Limited Covenant Structure and Cash Control Provisions
Additionally, seller financing may also be employed in more complicated transactions, such as bulk or portfolio sales or sales of distressed assets, to motivate market participants to bid or to substitute for transitional financing sources that may be reluctant to take on the added burden of complexity or asset risk inherent in the deal. While seller financing is often discussed from the perspective of a seller and buyer of an equity asset, it can also be used effectively as a financing structure for the sale of debt assets. The same advantages inherent in an equity sale are available in a loan sale, with financing taking the form of a loan-on-loan or a retained senior a-note interest in the underlying transaction.
Dulchinos shared an overview of the considerations from a seller’s (lender) and a borrower’s perspective.
Seller (Lender) Considerations:
The seller offering financing must retain a loan interest in the asset being sold, creating potential for tail risk (although at a lower basis) if the asset faces challenges going forward
In the most extreme case, this tail risk might include the need to foreclose on a defaulted loan and take back title to the asset, adding cost and further burdening seller resources
Often, the buyer in a seller financing trade has significant leverage to demand better than market financing terms and rates from the seller because the seller is in a distressed situation and must sell, leading to a weaker loan document structure and additional risk for the seller
Because the seller is continuing to hold an investment in the asset via its loan interest, it reduces the sale proceeds, and this results in opportunity cost in the form of more limited options for redeployment of capital and a lower yielding/below market retained debt investment
Another factor impacting some transactions is that under GAAP fair value standards, a seller offering a below-market rate loan may be required to mark the loan to market value, which would result in a loss on its balance sheet. Conversely, for the buyer holding its liabilities at fair value, it will potentially show as a gain due to the below-market financing
Buyer (Borrower) Considerations:
Because the seller may not be in the business of CRE lending, the loan options and structures available may be more limited. However, in challenging capital markets environments, often any loan is better than an unlevered capital structure
Similarly, a seller who is not regularly engaged in lending may be less aware of how to negotiate the lender position effectively, which might lead to delays in concluding closing documentation, elevated legal fees and the risk that any negative emotions wrapped up in the sale transaction may transfer to the loan transaction, further adding to the usual tensions inherent in closing a deal
If the seller is making a loan which is a closed-end vehicle with a limited life or has other non-traditional restrictions on its business, there may be limited flexibility to extend or renegotiate the loan should the buyer need additional time or capital to complete its business plan
A seller not regularly engaged in a lending business may lack the servicing capability to properly manage the loan, which could lead to delays, funds mismanagement and record-keeping gaps that might create problems further down the line for the borrower
SELLER FINANCING IN THE CURRENT MARKET ENVIRONMENT
According to MSCI Real Assets, in the first half of 2023, seller financing accounted for 1.9% of all commercial property lending, up from 0.5% in the same period of 2022, when mortgage rates were lower. For comparison, MSCI indicated it peaked at 4.6% of all commercial property lending during the Global Financial Crisis.
A Public Pension Fund Investor shared the last time seller financing was considered this extensively was between 2015 and 2019, when the retail sector faced performance challenges because of oversupply and e-commerce growth. However, for retail, there continued to be enough debt capital available from traditional sources and Investors saw that there wasn’t a need to utilize seller financing. Today, seller financing is almost a requirement to transact in the office sector, with the buyer pool mostly comprised of high-net-worth capital primarily interested in the income stream. The office buyers are requiring a positive leverage scenario in the transaction; accordingly, the seller must offer a below market interest rate to transact.
According to a Bloomberg article on the topic, examples of recent uses of seller financing include Capital One financing some of Fortress Investment Group’s purchase of around $1.0 billion of Capital One’s office loans and JP Morgan offering seller financing to find a buyer for the $350 million mortgage backed by Manhattan’s HSBC tower. General sentiment specific to OECFs is the consideration and use of seller financing is mostly isolated to the office sector as to some extent debt capital continues to be available for multifamily and industrial.
Dulchinos indicated, “By far, office assets are the most impacted by the current CRE credit shortage and are the asset class with the most focus on seller financing. A seller that needs liquidity or has limited capital to support an office asset may offer seller financing to create a market for its asset. It may potentially reduce its loss on disposition by offering financing that will support a higher price/levered return to the buyer than what may be possible with commercially available financing or on an unlevered basis.”
Given the current lack of Investor interest in acquiring office assets and the fundamental challenges much of the sector faces, seller financing offers Investors a portfolio management solution for reducing their allocation relative to benchmarks like NFI-ODCE as well as the ability to redeploy capital into higher conviction sectors with better long-term fundamentals and outlooks.
CONCLUSION
Seller financing, though not without its challenges, is a creative alternative to traditional financing. It offers a lifeline in times of capital market illiquidity and provides a means for transactions that might otherwise not occur, benefiting sellers and buyers. In today's landscape, especially in the office market, where Investor appetite and traditional lending sources fall short, seller financing is a tool to unlock opportunities and drive real estate deals forward.
If you are interested in learning more about seller financing or other industry topics, please connect with us.
ABOUT ALLIANCE GLOBAL ADVISORS
Alliance Global Advisors is a women-owned consulting firm focused on empowering the institutional investment community to elevate best practices. Advising clients with over $520 billion in assets under management, Alliance partners with organizations to provide an independent perspective and innovative approach to critical strategic initiatives. Our partnerships allow senior management teams to focus on what matters most: diligently managing client capital, creating value and delivering exceptional returns in a performance-driven market.
Disclaimer: This blog was originally published in November 2023 and will be updated periodically to reflect changes in the industry. The content may contain or cite personal and/or professional opinions that differ from the views of Alliance Global Advisors.