What is it? Wrap-around financing is a type of seller financing that is common for TIC sales. In wrap-around TIC financing, the owner of a given building will have a mortgage loan that pre-dates the formation of a TIC. The owner then sells the building to the TIC ownership group. The seller “lends” the funds to the TIC owners who then pay back their mortgage loan directly to the seller. The seller than uses a portion of the payments he/she receives to pay the original mortgage on the building.
A basic example:
In 2001, Juan buys a 3 unit building for $1M which he finances at 7% interest.
In 2006, Juan decided to convert the building to a TIC and take on two co-owners, Erica and Brian. The building is now valued at $1.4M and he sells two thirds of the ownership to Erica and Brian for $800k at 8% interest.
Juan acts as the lender in this sale and finances the $800k at 8% interest.
Juan, together with Erica and Brian, then assumes ownership of the building as TIC co-owners. Erica and Brian pay their monthly mortgage payments directly to Juan.
Juan takes their monthly mortgage payments on the loan for $800k at 8% interest and uses the proceeds to pay off his original mortgage of $1M at 7% interest. He pockets any difference.
- Seller can offset or even eliminate their own monthly mortgage payments by leveraging the mortgage payments due from their TIC co-owners mortgage payments.
- Seller can generate cash flow out of the property without secondary financing.
- Seller may be able to earn a markup on the interest rate in addition to leveraging the appreciation on the property.
- Seller may be able to defer capital gains taxes as this type of sale may be considered an installment sale. (Note: Check with a tax accountant for specifics).
Due on Sale
For a wrap-around to work, the original loan must not have a due on sale requirement. If it does, the seller must get permission from his/her lender. It is extremely unwise to enter into a wrap-around financing deal without knowing if the seller has a due on sale requirement. Even worse is to enter into a wraparound under a “don’t ask, don’t tell” verbal agreement.
Mortgage lenders will consider a wrap-around that circumvents their due on sale clause as a breach of contract. More than likely they will either call the loan or require an interest rate hike or an assumption fee. If the seller gets his/her loan called, this means the bank is asking for immediate payment. The fellow TIC co-owners would then be facing a costly dispute over who owns and owes what to whom. To reiterate, wrap-around financing is normally an equitable method of financing a TIC, just be sure to verify the due on sale provisions of the original loan.
In order to make future re-sale smooth, the TIC loan should be assumable and have no due on sale requirements. Without assumability, a seller may run into resistance from their fellow TIC owners in terms of who they sell their shares to and on what terms.