By Julia M. Wei, Esq.
With the tight capital lending market, seller carryback or seller financing is being revived as an option to get real estate sold.
The rewards are that these seller financed notes tend to charge slightly higher interest rates and the transaction is more likely to close since the seller can move more decisively than an institutional lender (bank) in this economic climate.
The risks to the seller in California relate primarily to California’s
anti-deficiency law, as stated in California Code of Civil Procedure 580(b), which prevents the seller (who is now the lender) from pursuing the borrower (buyer) for any deficiency. In a falling market, that’s a true downside.
As a real estate attorney, I see three kinds of seller financing:
1. Seller carries back the balance of the purchase price after buyer’s modest down payment. Seller is in 1st position.
2. Seller carries back the balance of the purchase price after buyer’s modest down payment and buyer’s institutional loan. Seller is in 2nd position.
3. Seller sells unimproved land, carries back the balance of the purchase price, and the later agrees to subordinate their loan to a major construction loan.
The first position seller carry back is the least risky, even in a down market because the lender can always foreclose, hold the property and wait to see if the economy improves. The seller has already pocketed the downpayment and perhaps some interest payments before the borrower defaulted.
However, the seller who carries back financing behind another loan has significant risk and this is perhaps the least desirable type of transaction. Imagine that you sell your house in San Jose for $500k and the buyer puts down $50k, gets a loan for $350k and then you carry back $100k behind that loan. . The borrower defaults and now, in order to take back the property, you will have to service a $350k senior loan obligation to the tune of $3k/mo, and pay the higher property taxes and insurance. Not exactly a good deal—especially in a falling market where the house may now only be worth $300k. The seller in that transaction actually received $400k for the sale price ($100k below market at the time of the sale) and is likely to simply walk away from the loan.
Once the senior lender forecloses, the seller carry back lender is wiped out and can NOT seek a deficiency against the borrower under C.C.P. Section 580b.
As lenders know, there are very few exceptions to the anti-deficiency protection of 580(b). Indeed, that is why lenders often request a separate guarantor for the loans because that is the ONLY circumstance in which a waiver of the 580b protection can be obtained. As the Supreme Court of California held in DeBerard, Ltd. v. Lim (1999) held, not even a subsequent waiver obtained during a forbearance agreement is enforceable against the borrower.
The other caselaw made exception to 580(b) is the purchase money subordination to a construction. Normally, this purchase money lender too would be wiped out too by the senior’s foreclosure, however, under the seminal case of Spengler v. Memel (1972) the California Supreme Court concluded that since the seller would end up with neither the land, nor the promissory note after the foreclosure sale, and since the seller had no way to know the true market value of the land since it was behind a construction loan that would ostensibly fund an improvement to increase the value of the land, 580(b) should not apply.
There you have it—the three likely scenarios of the seller financing. Instead of the normal caveat emptor of buyer beware, it is seller beware!