SCENARIO: I am a listing agent representing a seller on the sale of real property. Given the increasing interest rates and decline in the sales prices of properties in the market, my seller has agreed to extend seller financing to the buyer. The loan will be in second position behind the primary financing. How do I protect my client?
RESPONSE: There is a significant potential risk to a seller in extending financing to a buyer. Sellers generally do not appreciate that risk, because they believe that there is adequate security in the property. They also falsely believe that if there is a default, they can simply foreclose on the loan and take back the property. Foreclosures are not that simple and by extending seller financing, sellers are at risk of losing all or a portion of the amount of the loan. When sellers lose money, agents are at risk of getting sued for failing to properly advise clients. Risks to the seller include:
BUYER DEFAULT: Risks of loss include the possibility of the buyer defaulting on the loan or defaulting on a loan which is senior to the seller’s loan. If that occurs, the seller will need to retain a creditor’s rights attorney to address potentially preserving the seller’s loan/equity. Sellers could lose their equity if the senior lender forecloses, and the seller is not able to buy out the senior loan at the foreclosure sale.
BUYER BANKRUPTCY: Buyers could also file for bankruptcy. In that case, sellers face retaining bankruptcy counsel and potentially, losing some or all their equity/loan.
If sellers are going to extend loans to buyers, it is strongly recommended that sellers consult with a qualified California real estate attorney regarding the risks. Ideally, the attorney will send an opinion letter to the seller outlining the potential risks of extending credit to the buyer. This recommendation should be made in writing and documented in the agent’s file.
RESIDENTIAL ONE TO FOUR PROPERTIES: If the property is residential, one to four units, California law requires that the parties prepare a Seller Financing Addendum and Disclosure (CAR form SFA on zipForms). It is strongly recommended that the seller complete this form with the assistance of their attorney and that the agents refrain from completing the form on behalf of the parties. Please note that if the buyer’s agent participates in preparing this form, the buyer’s agent is considered, under the law, to be an Arranger of Credit and can be liable for any losses. Moreover, the form includes a discussion of any senior financing or financing that a buyer may be assuming. Agents should not review the existing financing and complete this section. Sellers need to complete this section with the assistance of their attorneys.
Buyers should also consult with their own qualified California real estate attorney regarding the risks of either assuming the seller’s financing and/or borrowing from the seller.
Sellers’ agents should also encourage their sellers to treat the seller financing as if they were making a third-party loan, such as requesting a loan application and running a credit report.
NOTE AND DEED OF TRUST: These loans will require a promissory note and deed of trust. Many parties try to save money and request that the title company draft these documents. Title companies are not in the business of preparing promissory notes and deeds of trust and therefore, this practice is discouraged. It is recommended that the buyer and seller retain counsel and that attorneys prepare and negotiate the promissory note and deed of trust.
PRACTICE TIPS
BOTH AGENTS:
- Agents should refrain from completing the seller financing disclosure.
- Agents should never advise sellers that extending a loan to a buyer is risk-free.
- Agents should recommend that counsel prepare the promissory note and deed of trust. The promissory note and deed of trust should never be prepared by agents on behalf of their clients.
- Agents should advise their clients to consult with a qualified California real estate attorney regarding any senior financing and the risks thereof.
- If seller is proposing, or is asked by buyer to consider, an All-Inclusive Deed of Trust (AKA a “Wrap-Around Deed of Trust”) immediately consult with your broker or manager as these types of transactions are extremely complicated and have their own risks.
SELLERS’ AGENTS:
- Immediately recommend that your seller consult with a qualified California real estate attorney.
- Encourage your client to obtain an opinion letter from their attorney regarding the risks of seller financing.
- If the property is residential one to four units, the seller will need to complete a seller financing disclosure and addendum to the contract regarding the terms of that seller financing. Sellers are encouraged to consult with counsel to facilitate the completion of that disclosure and addendum.
BUYERS’ AGENTS:
- Buyer’s agents should refrain from handling the seller financing disclosure to avoid being the Arranger of Credit.
- Buyers’ agents should recommend that buyer consult with a qualified California real estate attorney regarding the terms of the seller financing and preparation of the promissory note and deed of trust.
WEEKLY PRACTICE TIP: DO NOT FORWARD TO CLIENTS. This Weekly Practice Tip is for the exclusive use of clients of Broker Risk Management and their agents. It may not be reproduced or distributed without the express written consent of Broker Risk Management. The advice and recommendations contained herein are not necessarily indicative of standards of care in the industry, but rather are intended to suggest good risk management practices.