Brokerage Reminder: Carryback financing – the creditworthy buyer and mandated disclosures
This article series analyzes the seller’s use of carryback financing as a flexible financing arrangement to encourage prospective buyers to purchase the seller’s property in a recessionary market.
Part II of this series comments on the seller’s agent’s and carryback seller’s need to investigate and analyze a buyer’s creditworthiness and capacity to pay, and the proper structure for a carryback transaction purchase agreement.
For an introduction to the concept of seller carryback financing and a discussion of the tax benefits of carrying paper for the seller, and the flexible sale terms available to the buyer, see Part I of this article series. For comments on the yield limitations which contrast loans from credit sales, and the requirements a carryback seller is to meet to be eligible for exemption from mortgage loan originator licensing, see Part III of this article series.
The need for credit checks
Carryback sellers face the risk a buyer will default, no matter how wealthy, conscientious and qualified they might appear to be. On any default in payments on a trust deed note, the seller’s sole source of recovery is to resort to the property secured by the trust deed (unless the note is subordinated to a construction loan or additionally secured by property other than the property sold).
The Consumer Financial Protection Bureau (CFPB)’s ability-to-repay regulations require an owner who carries back more than one note secured by a one-to-four unit residential property in a 12-month period to investigate and document a buyer’s ability to repay the carryback debt according to the CFPB’s criteria. Part III of this article series digests the criteria for exemption from this requirement for sellers who carry back only one note per 12-month period. [15 United States Code §1602(cc)(2)(E)]
Even if the carryback seller is exempt from CFPB requirements, it’s in the seller’s best interest to ensure the buyer is creditworthy, meaning willing and able to pay as agreed. This determination must be made for the same reason a landlord must obtain reliable credit information on prospective tenants. Prudent mortgage lenders also abide by these same fundamentals when making a loan; propensity to pay and source of funds for payments.
Further, the carryback seller performs a background check on the buyer’s management of property they owned or occupied to be certain the buyer will maintain the property unimpaired as required by the carryback trust deed provisions. If the buyer is discovered to be unqualified to own and care for property, the seller may justifiably cancel the carryback transaction before closing since the buyer presents an unreasonable risk to the security for the carryback note.
The buyer needs to have the financial ability and credit history to pay the trust deed note carried back by the seller and any underlying the first trust deed loan before the seller approves and closes the sale. A default by the buyer on the first trust deed jeopardizes the seller’s security interest in the property under their second trust deed lien.
A seller’s agent has the duty in a carryback transaction to advise the seller about the need to obtain credit information on the buyer, as well as disclose any facts known or readily available to them about the buyer’s creditworthiness which might affect the seller’s interest.
The seller’s agent documents the buyer’s creditworthiness and ability to pay their debts by:
- analyzing an application for credit, along with credit reports and criminal background reports obtained on the buyer under authority granted in the application [See first tuesday Form 203 and 302];
- reviewing financial statements, both an operating statement (profit and loss report) and a balance sheet (net worth statement) and confirming bank balances [See first tuesday Forms 209-2 and 209-3];
- contacting the buyer’s creditors (vendors, landlords, lenders) for their experiences with the buyer’s payment history; and
- inspecting properties owned by the buyer to determine the level of care and maintenance the properties have received from the buyer.
Analyzing credit information
The right to obtain credit information also applies to private parties such as carryback sellers. Thus, the seller’s agent orders the buyer’s credit report. On receipt, the agent reviews it with the seller. In turn, the seller independently decides to either proceed with the transaction or cancel it under a further-approval contingency in the purchase agreement. [See first tuesday Form 150 §8.5]
Written disclosures itemizing the buyer’s credit information are mandated on all sales involving one-to-four unit residential properties when the seller carries back a portion of the sales price. [Calif. Civil Code §§2956 et seq.]
All disclosures are to be made in good faith by the buyers, brokers and agents to meet the objective of the credit investigation. [CC §2961; see first tuesday Forms 302, 209-2 and 209-3]
Even the existing trust deed lender has the right to obtain credit information from the buyer on a change of ownership. The lender, like a carryback seller, needs to make an informed decision as to whether the risk of default in the payments or care and management of the property will increase under the new ownership, a situation called impairment of the security. [Santa Clara Savings and Loan Association v. Pereira (1985) 164 CA3d 1089]
Neither a carryback seller nor a private lender typically has the resources of institutional lenders to personally investigate and assess a buyer’s creditworthiness and management capabilities prior to making a loan. Thus, a broker or an agent who assists private lenders and carryback sellers is obligated to help them, or advise that someone else needs to help them, determine the buyer’s ability to operate the property and their propensity and resources to make payments on a carryback note. [Dawn Investment Co., Inc. v. Superior Court of Los Angeles (1982) 30 C3d 695 (Disclosure: the legal editor of this publication was an amicus for this case.)]
Financial statements for income and worth
Two financial aspects of a buyer’s ability to perform on the carryback note need to be investigated by the seller and their agent:
- the ability of the property’s income to cover the expenses, and carry the debt service if it is income-producing; and
- the ability of the buyer to personally service any negative cash flow resulting from the debt burden or lack of rental income or the buyer’s use of property.
To investigate the ability of income property to carry its debt service, the property’s income and expenses are analyzed using the Annual Property Operating Data Sheet (APOD). [See first tuesday Form 352 and the first tuesday Income Property Brokerage (IPB) suite of forms]
If the property’s income is unable to support its operating expenses and debt service, the seller needs to look for other abilities of the buyer to carry the negative cash flow brought on by payment of the carryback note.
The buyer’s personal capacity to pay is investigated by a review of the financial statements delivered by the buyer itemizing their:
- income/expenses (profit and loss statement); and
- net worth (balance sheet).
Evaluating credit information
Once a seller’s agent has obtained a buyer’s credit application and financial statements, the data must be evaluated by the agent and seller.
The buyer’s representations of employment, cash deposits and loans with existing lenders is best verified by requesting confirmation, as is done by any mortgage lender or mortgage loan broker originating a loan. [See first tuesday Form 210 through 214]
Formulas for determining a buyer’s ability to pay for any negative cash flow generated by the purchase of the real estate are structured as costs of ownership-to-income ratios, referred to as a debt-to-income (DTI) ratio. [See first tuesday Form 230]
Institutional lenders generally set the ratio of home loan payment to gross income at around 33%. Further, institutional lenders typically set the ratio of total installments on all debt to gross income at around 40%. However, when applying ratios as guidelines to determine a buyer’s creditworthiness, each buyer needs to be treated individually. Depending on other financial factors, a buyer who does not meet the DTI ratio does not necessarily impose an increased credit risk.
Also, the seller and their agent may apply an arbitrary ratio or formula for the buyer’s installment payment burden, such as a three-to-one income-to-note/rent payment ratio, as the only basis of determining the buyer’s creditworthiness, as long as the ratio is uniformly applied to all transactions. [Harris v. Capital Growth Investors XIV (1991) 52 C3d 1142]
In addition, requiring employment to be a qualification for prospective buyers unfairly discriminates against people who receive income from:
- retirement pay;
- family support; or
- private subsidies.
Thus, the carryback seller reviews all credit information supplied by the buyer and looks for a reason why the buyer does or does not qualify as a good credit risk for the amount of debt and the payments to be made.
Only after all credit information has been reviewed and creditworthiness has not been established can the seller reasonably cancel the carryback transaction – or renegotiate it – due to the buyer’s lack of credit.
The creditworthiness contingency
Initially, a carryback disclosure statement is to be attached to any purchase agreement containing provisions for a carryback note. The carryback disclosure statement is mandated on the sale of one-to-four residential units. However, a prudent seller’s agent will also require a disclosure statement in carryback transactions on all types of property be part of the offer/counteroffer negotiations. [CC §§2956 et seq.; see first tuesday Form 300]
Both the carryback disclosure statement and the purchase agreement include a credit approval contingency. The further-approval contingency provision calls for the buyer to hand the seller a completed credit application. [See first tuesday Form 302]
The buyer’s agent preparing a carryback offer should consider having the buyer fill out the credit application on commencement of negotiations and attach it to the buyer’s purchase agreement as an addendum. Early disclosure helps the seller determine the buyer’s sincerity and good-faith willingness to cooperate in a fully transparent credit analysis process.
The credit contingency allows the carryback seller to terminate the purchase agreement by a written Notice of Cancellation if they have grounds to disapprove of the buyer’s creditworthiness. [See first tuesday Form 150 §10.5]
However, the credit contingency does not give the carryback seller the unrestricted right to withdraw from a binding and otherwise enforceable purchase agreement.
Thus, the seller needs good reason to disapprove the buyer’s credit in order to cancel the transaction. Without good reason, the seller who cancels by wrongfully using the credit contingency as a back door provision to escape performance breaches the purchase agreement in bad faith. [Lyon v. Giannoni (1959) 168 CA2d 336]
One-to-four unit carryback transactions
All brokered transactions for the purchase of one-to-four unit residential property involving seller carryback financing are controlled by statute. For one-to-four unit residential properties, a written carryback disclosure statement is required to be presented to both a buyer and seller for their review and signatures. [CC §§2956 et seq.]
Even the use of a masked security device, such as a land sales contract, lease-option or unexecuted purchase agreement with interim occupancy, requires written carryback disclosure statements.
The written disclosure statements inform the buyer and seller about the extent of the risks presented by failing to use grant deeds, notes and trust deeds to evidence an installment sale when the buyer takes possession. [See first tuesday Forms 300, 300-1 and 300-2]
On the sale of a one-to-four unit residential property, any credit extended by the seller to accommodate the buyer’s deferred payment of the purchase price requires a written carryback disclosure statement when the carryback arrangements include:
- interest or other finance charges;
- five or more installments running beyond one year;
- an installment land sales contract;
- a purchase lease-option or a lease-option sale;
- credit (note) to adjust equities in an exchange of properties; or
- an all-inclusive note and trust deed (AITD). [CC §2957]
Carryback disclosure statements are not mandated in carryback transactions creating straight notes which do not bear interest or include finance charges. However, carryback disclosures are to be included as a matter of good brokerage practice since the risks and issues for the buyer and seller under a straight note are similar and the duty owed the client is the same.
Offer includes disclosures
The best policy for a buyer’s agent is to eliminate the need for further approval of the statutory carryback disclosures by preparing and attaching a carryback disclosure statement as an addendum to the purchase agreement. If the disclosure statement is not attached, a prudent seller’s agent will include it as an addendum to a counteroffer to eliminate the disclosure contingency. [CC §2956]
If neither the buyer’s or seller’s agent prepares and includes the disclosures as an addendum to the offers or counteroffers, then, as a minimum requirement, the buyer’s agent is responsible for preparing the disclosures and obtaining both the buyer’s and seller’s signature prior to closing the carryback sales escrow. [CC §2959]
Under the statutory contingency for failure to timely make disclosures, if the buyer discovers a reasonable basis for disapproving the financing arrangements when the buyer receives the carryback disclosures after entering into the purchase agreement, the buyer may cancel the transaction and terminate their obligation to purchase the property. [CC §2959]
However, the buyer may not arbitrarily cancel the sale when they are presented with the carryback disclosure statement for their acknowledgment and approval during escrow. Similar to the conduct of the seller, the buyer needs to act in good faith to cancel by showing the carryback disclosures are inconsistent with their reasonable expectations when they entered into the purchase agreement. [CC §2961]
After closing, the only legal remedy available to the buyer or seller for inadequate or nonexistent financial disclosures is to pursue both brokers involved for any money losses actually incurred as a result of the nondisclosure. If a broker or their agent fails to make the mandated carryback disclosures, they are liable to the buyer for the buyer’s losses resulting from the non-disclosure. [CC §2965]
For a discussion on the tax benefits of carrying paper for the seller and the flexible sale terms available to the buyer, see Part I of this article series. For comments on the yield limitations which contrast loans from credit sales, and the requirements a carryback seller is to meet to be eligible for exemption from mortgage loan originator licensing, see Part III of this article series.