Last year around this time I wrote an article called “Subject to transactions on the rise” … and since that time mortgage interest rates have unfortunately continued to climb. As a direct result, subject-to as a strategy has exploded. Most deals that penciled a year ago just don’t work in today’s market. Values are still high, yet rates are the highest in ~40 years. But if you could keep the seller’s low rate in place, things still look great on paper. That means everything will work out perfectly, right?
My characterization “on the rise” was way understated. Many, many investors are trying to use the strategy. Plus it has become the shiny new thing REI gurus are teaching. Unfortunately, the gurus seem to be focused on sharing the strategy with inexperienced buyers as a way to get rich without having much cash. As a result, some of these inexperienced buyers are facing the potential problems I outlined in that post.
As promised, I’m circling back to discuss the main risks I identified with subject-to. Hopefully it will help you in your investing, or in dealing with a property you own.
I think subject-to is a great short-term strategy, even for new investors. It goes like this… buy subject-to existing financing, promptly take care of the improvements, and then resell at a higher profit than if you had to finance the acquisition. But that’s not how it’s being taught.
The first major risk I identified with subject-to was undercapitalization and buyer default. It’s just common sense that the buyer could default on payments, especially if the buyer intends to hold the subject property long-term as a rental. The longer the hold, the higher the risk. And if the buyer is undercapitalized – having little to no cash to respond if something were to go wrong, such is often the case for the new investors I referenced above – that’s where it can become a big problem.
If you’re an experienced landlord, you’ve learned to plan for and deal with tenant default. However, if you’re a new investor, tenant default may not be something you’ve adequately accounted for in your numbers. Evictions take time. Eviction attorneys are expensive. Clever tenants can hinder and delay the eviction process, especially in jurisdictions that are “tenant-friendly”. If a tenant defaults and eviction becomes the only solution, when the subject-to purchaser finally does regain possession of the property, it could be damaged. And after making any required repairs, finding a new tenant may not be quick and easy. Try finding a new tenant in the dead of winter! Of course through all of this, the mortgage payments still must be made. A single tenant default can create tens of thousands of dollars in unforeseen expenses and carrying costs with no rent coming in.
Even without tenant problems, the need to make large capital expenditures can materialize. Major systems and appliances fail. Roofs need replacement. The undercapitalized and unprepared subject-to purchaser may not be able to continue to pay the mortgage as well as the necessary expenses. Of course this can lead to default on the mortgage. If so, the seller’s credit will take a hit and the lender will eventually pursue foreclosure. It’s a potential disaster for all involved. And that’s before the lawsuits fly.
As a seller, how can you reduce the chance of your subject to deal going down this path? Don’t sell to someone who doesn’t have the financial ability to prevent it. Do your research on the buyer’s finances. Don’t sell subject-to to a buyer that doesn’t have significant cash reserves or at a minimum quick access to private money. And sell on a wrap or with a junior lien that can be foreclosed. Research the cost of foreclosure as a worst case scenario and factor that into your analysis.
As a buyer, how can you prevent the above? Don’t overpay for the property just to obtain the low interest rate. Have sufficient cash reserves or access to funding. And perhaps most importantly, know when to accept the loss, exit properly before the seller is damaged, and move on to the next investment.