Executory Contracts

Definition and Overview

A land contract, also known as a contract for deed, is a creative financing method similar to seller financing. The key difference is that the legal title to the property is not transferred to the buyer until after all the terms of the contract have been met and the full balance of the loan has been paid off. As the buyer makes payments, they hold an "equitable title" to the property.

Legal Considerations and Compliance

Equitable Title: The buyer's equitable title prevents the owner from selling the property to someone else or placing a lien on it.
Memorandum of Land Contract: To protect the equitable title, it is recommended to file a "memorandum of land contract" with the city or county. This puts the public on notice of the buyer's interest in the property.

Benefits and Advantages

Win-Win Scenario: Like other creative financing methods, a land contract can create a win-win situation for both parties.
Little to No Money Down: It allows an investor to purchase a property with little to no money down.

In-Depth Definition

Executory Contract: An executory contract is a contract that has not yet been fully executed. In creative finance, it's a solution used in specific scenarios, such as holding the deed but not recording it with the county to avoid a due-on-sale clause being called, or because the deed is being sold again without the property ever being in the current holder's name. This allows for controlling the deed without legal ownership.

Contract for Deed: Also known as an agreement for sale, a contract for deed is a type of executory contract where the buyer is the owner of the property but does not receive the title until the lender (either a bank or the seller) is paid off in full.

Calculations/Formulas

The following general real estate investing rules can be applied to assess the viability of a deal structured with an executory contract:

The 2% Rule: This rule helps to quickly screen potential rental properties. It states that the monthly rent should be at least 2% of the purchase price. For example, if a property is purchased for $100,000, the monthly rent should be at least $2,000.
The 50% Rule: This rule helps to estimate the profitability of a rental property. It suggests that, on average, 50% of the income a property generates will be spent on operating expenses (excluding the mortgage payment). These expenses include taxes, insurance, utilities, repairs, and vacancy.
The 70% Rule: This rule is often used by house flippers and wholesalers to determine the maximum allowable offer (MAO) for a property. It states that an investor should pay no more than 70% of the after-repair value (ARV) of a property, minus the cost of repairs.

Mechanics of a Land Contract

A land contract is a seller-financed real estate transaction. The process typically involves the following steps:

Agreement: The buyer and seller enter into a written agreement, or land contract, that outlines the terms of the sale. This includes the purchase price, down payment, interest rate, payment schedule, and other key provisions.
Payments: The buyer makes regular payments directly to the seller over a specified period. These payments may include principal and interest, and can be structured in various ways, including a final "balloon" payment.
Title: In a traditional land contract, the seller retains legal title to the property until the loan is paid in full. The buyer, however, receives "equitable title," which gives them the right to occupy and use the property and to build equity.
Transfer of Ownership: Once the buyer has fulfilled all the terms of the contract and paid off the loan, the seller transfers the legal title to the buyer.

There are two main types of land contracts:

Straight Land Contract: The seller retains the legal title until the loan is fully paid.
Wrap-Around Land Contract: The seller continues to pay their existing mortgage on the property, while the buyer makes payments to the seller. In this case, the buyer may receive the warranty deed at the beginning of the contract.

Benefits for the Buyer

Easier to Obtain Financing: Land contracts are a viable option for buyers who may not qualify for a traditional mortgage due to credit issues or other reasons.
Opportunity to Purchase: This financing method opens up homeownership opportunities for a wider range of buyers.

Risks for the Buyer

Dependence on the Seller: In a wrap-around land contract, the buyer is at risk if the seller fails to make their mortgage payments. The buyer could lose the property even if they have been making their payments to the seller.
Contract Vagueness: Land contracts can be less standardized than traditional mortgages, so it is crucial to have a well-drafted agreement. It is highly recommended to seek legal advice to ensure the contract is fair and protects the buyer's interests.
Higher Interest Rates: Sellers often charge higher interest rates to compensate for the additional risk they are taking on.
Homeownership Gray Area: In a straight land contract, the buyer is in a legal gray area until the loan is paid in full. This can create complications in legal disputes or with insurance claims.
Forfeiture Clause: A significant risk for the buyer is the inclusion of a forfeiture clause, which allows the seller to cancel the contract and evict the buyer for a single missed payment.

Benefits for the Seller

Steady Income Stream: Seller financing can provide a consistent source of income for the seller.
Property Repossession: If the buyer defaults on the loan, the seller can typically repossess the property.

Risks for the Seller

Buyer Default: The primary risk for the seller is that the buyer may default on the loan, forcing the seller to go through the legal process of reclaiming the property.
Property Maintenance: The buyer may not properly maintain the property, which could result in a loss of value.

Common Mistakes to Avoid

Not Recording the Contract: Failing to record the land contract or a memorandum of the contract can leave the buyer vulnerable. If the contract is not on public record, the seller could potentially sell the property to someone else.
Ignoring State Laws: The laws governing land contracts vary from state to state. It is essential to understand and comply with all applicable state laws.
Not Having a Written Agreement: A verbal agreement is not legally binding. It is crucial to have a comprehensive written land contract that is signed by both parties.
Failing to Address Property Taxes and Insurance: The land contract should clearly state who is responsible for paying property taxes and insurance.

Real-world Application Scenarios

A buyer with poor credit: A buyer who cannot qualify for a traditional mortgage due to a low credit score can use a land contract to purchase a home. This gives them time to improve their credit while building equity in the property.
A seller who wants a steady income stream: A seller who owns a property free and clear can use a land contract to sell the property and receive a steady stream of income from the buyer's payments.
A family who wants to sell their home to a relative: A family can use a land contract to sell their home to a relative who may not qualify for a traditional mortgage. This allows them to keep the property in the family.

Executory Contracts: Land Contracts and Creative Financing