Investing in Land Contracts

In this article, we will cover:

  • the basics of a land contract,

  • the characteristics that make a land contract unique when compared to other purchase agreements,

  • the benefits and risks for both the borrower and the investor, and

  • an example showing how an investor can profit by investing in land contracts.

Terminology:

  • buyer = borrower

  • seller = investor = lender

  • land contract = contract for deed (CFD)

  • rent-to-own = lease option

What is a land contract?

Also called a contract for deed, a land contract is a form of seller financing used primarily on lower-valued properties, often in rural areas. A land contract is a written, legal agreement used to purchase real estate. It is similar to a traditional mortgage; however, rather than borrowing money from a lender or bank to purchase real estate, the buyer makes payments to the seller, until the purchase price is paid in full.

The buyer and seller both execute the land contract covering agreed-upon terms of the sale. Upon satisfaction of the contract terms, including payment of the purchase price over a specified time period, the legal title of the property is transferred from the seller to the buyer.

When does the buyer become the owner of the property?

While the buyer is making payments to the seller, the buyer is considered to have an “equitable title” to the property. As an equitable title holder, the buyer has an interest in the property and the seller is precluded from selling it to a third party or subjecting it to a lien or encumbrance that would interfere with the buyer’s interest in the property.

The “legal title” to the property remains with the seller until the buyer makes the final payment. When the final payment is made, and all conditions of the land contract are met, the buyer becomes the owner of the property.

What happens if the buyer fails to make payments?

If the buyer defaults on the land contract, the seller can file a court action called a forfeiture. Forfeiture results in the buyer “forfeiting,” or giving up, all money paid to the seller for the property pursuant to the land contract as well as the equitable title. In other words, if the buyer fails to pay, the seller keeps all money received plus the real estate.

How is a land contract different than a traditional mortgage?

Many people are familiar with the traditional mortgage/note arrangement, which is most common when someone buys a house and borrows money from a bank. The buyer of the house is also the borrower. The borrower is immediately identified on the deed as the owner of the house, and the lender places a lien on the property.

With a land contract, however, the lender technically owns the property until the contract has been satisfied. As such, the deed will reflect that the seller/investor is the property owner until such time that the borrower has paid the debt in full.  

How is a land contract different than a rent-to-own agreement?

Both land contracts and rent-to-own agreements (also referred to as lease options) are types of seller financing. They can make it easier to buy or sell a home when typical mortgage financing is difficult to acquire, by eliminating the need to get approval from a traditional lender.

In a rent-to-own arrangement, the buyer has the option of buying the property at a predetermined price at the end of the contract period. With a land contract, however, the buyer agrees to purchase the property at the outset, sometimes with a balloon payment due to the seller at contract’s end.

For the buyer, a rent-to-own agreement carries less of an obligation at the end of the contract than a land contract does. In a rent-to-own arrangement, the buyer has the option--not the obligation--to buy the property at the end of the contract period. With a land contract, the buyer has already entered into a loan agreement for the full purchase price.

Another major difference between a rent-to-own arrangement and a land contract is that with a rent-to-own, the seller maintains control of--and responsibility for--the property. The seller/investor is responsible for: the maintenance of the property, any repairs, and the payment of property taxes and insurance. The seller is essentially a landlord. In contrast, with a land contract, the buyer is responsible for property maintenance, taxes, and insurance.

What are the benefits of a land contract for the borrower?

There may be a buyer interested in a property who, possibly because of poor credit history or inconsistent income, cannot obtain approval for a traditional mortgage. Instead, the parties can enter into a sale by land contract so the buyer makes monthly payments directly to the seller. Hence, the main advantage of a land contract for the borrower is that the threshold for qualifying is lower. As long as the seller is willing to oblige, this eliminates the need for appraisals, credit checks, income verification, etc., that a bank or lender may require for a traditional mortgage.

Further, a land contract is often viewed by the buyer as a way to lower the purchase price before obtaining a regular mortgage to buy the property outright. Sometimes, the terms of the contract will call for 5 to 10 years of regular payments, concluding with a balloon payment for the balance of the loan. The buyer will sometimes plan on taking out a mortgage to make the balloon payment, since they will have had several years to improve their credit and earnings to qualify, and the loan needed for the balloon payment will be smaller than what would have been needed to buy the home up front.

What are the benefits of a land contract for the investor?

When compared to investing in traditional notes, land contracts may offer the investor more upside and fewer costs if forced to take back full title to the property. Rather than undergoing a potentially expensive and lengthy foreclosure should the borrower default, taking the property back is more like an eviction process. Moreover, the investor typically keeps any equity in the property (property value minus debt owed). With a traditional mortgage/note, the investor is not normally entitled to this equity.

What are some potential risks with a land contract for the borrower?

A land contract doesn't have many of the protections for the buyer that come with a traditional mortgage. Because the seller retains the title until the land contract is fully paid off, the borrower may end up defaulting and forfeiting their interest in the property.

Although going through a bank or lender to obtain a traditional mortgage can involve some hurdles, it also provides some safeguards. Before granting a mortgage, a lender is going to insist on making sure that everything is in order: that the title is clear, there are no outstanding liens on the property, that the property appraises for the purchase, and that the deed is recorded after the sale.

Also, when you buy a home with a regular mortgage, you own the property at that point and have certain rights as a result. And if you fall behind on your payments, you can't be evicted from the property without the lender going through a lengthy, expensive foreclosure process.

What are some potential risks with a land contract for the investor?

As the legal owner of the property, the investor may subject themselves to a greater chance of law suits, fines, etc. Moreover, the investor is typically dealing with a higher-risk borrower, one with lower credit and more of a checkered pay history. This can present a higher chance of default.

Why are some states cracking down on land contracts?

Some states, such as Ohio, appear poised to attempt to limit the use of land contracts in the future. Due to predatory-lending practices of some hedge funds and institutional investors, lawmakers have felt the need to intervene. The consequences of this potential legislation have yet to be determined.

What is a hypothetical example of an investment in a land contract?

  • property value = $70k

  • ·original land contract amount = $50k

  • purchased principal balance of land contract = $35k

  • investor’s purchase price = $25k

  • interest rate = 9%

  • monthly payment = $402

Scenario #1:

The borrower continues to pay each month and the investor enjoys a relatively passive 15% yield.

Scenario #2:

The borrower fails to make monthly payments, thereby forfeiting the property to the investor. The investor takes back the property, lists for it sale “as is,” and sells it quickly for $60k.

After 12 months of owning the land contract, the investor makes a profit of approximately $30k ($60k sale, minus $25k for purchase price, minus $5k in servicing costs, taxes, fees).

The investor has doubled their money in 1 year. While this scenario is certainly not a passive one and is not common, it provides a return on investment that is very hard to find elsewhere. It is difficult to find this upside even by investing in traditional notes.  

Jamie BatemanComment