DAVID J. WILLIS
Copyright © July 2010. All rights reserved.
What is a wraparound transaction?
A wraparound transaction or a “wrap” is a form of creative seller-financing that leaves the original loan and lien on the property in place when the property is sold. The buyer usually makes a down payment, gets a deed, and signs a new note to the seller (the “wraparound note”) for the balance of the sales price. This wraparound note, secured by a new deed of trust (the “wraparound deed of trust”), becomes a junior lien on the property, behind the existing first lien. The buyer makes monthly payments to the seller on the wraparound note and the seller in turn makes payments to the first-lien lender. The original lender’s note is referred to as the “wrapped note,” and it remains secured by the “wrapped deed of trust.” Note that is possible to wrap more than one prior note (e.g., an “80/20”).
Often the wraparound note to the seller exceeds the amount of the wrapped note payoff by the amount of the seller’s equity – this is the seller’s profit. Alternatively, the buyer may make a cash payment to the seller for the seller’s equity, and the wraparound note payment will then be structured to correspond closely to the amount of the payment on the wrapped note.
The interest rate on the wraparound note is often higher than that on the wrapped note, since seller financing usually carries a rate that is slightly higher than market. The wraparound note is usually amortized over 15 or 30 years but balloons in 3 to 7 years (i.e., the buyer has that 3 to 7 year period in which to refinance and pay off the wraparound note). Occasionally, however, the seller will intend to keep the wraparound note as income, and therefore no balloon will be included.
Specific terms can vary from transaction to transaction, but the wraparound principle remains the same. Wraparound paperwork begins with the earnest money contract which should set forth the terms of the wrap. A suggested form of the addendum is attached. At closing, details of the wrap should be contained in a comprehensive wraparound agreement.
When the buyer gets a refinance loan, the original, wrapped loan is paid and released, and the seller keeps any cash that exceeds the payoff amount of this first lien. The main difference between a wrap and a conventional sale is that the seller must wait until the wraparound note balloons in order to receive the full sales proceeds in cash.
Wraparound financing is sometimes referred to as subordinate lien financing.
Other Forms of Seller Financing
Seller financing, always popular in Texas, is a legitimate and effective way to sell real estate in an economy where conventional financing is scarce. Residential lease-options exceeding 6 months (formerly the favorite of investors) and contracts for deed were both restricted by changes to the Texas Property Code made in 2005. Because these changes impose severe penalties on sellers if strict, burdensome rules are not followed, sellers have moved away from lease-options and contracts for deed. Thus only a few types of owner financing remain practicable:
- the traditional owner finance, used when the property is paid for;
- the wraparound, which is addressed in this article; and
- the land trust, which involves deeding the property into a trust as a “parking place” of sorts until a credit-impaired buyer can obtain financing.
Those interested in traditional owner finance or land trusts should read the articles on these subjects available at LoneStarLandLaw.com.
How is a wrap different from a contract for deed?
A wraparound is an “executed” transaction as opposed to an “executory” (i.e., incomplete or unfinished) transaction. The buyer gets a deed to the property immediately, not at some future time. His indebtedness to the seller is evidenced by the wraparound note and is secured by a wraparound deed of trust. Therefore, the burdensome rules contained in Texas Property Code Sec. 5.061 et seq. that are applicable to executory contracts (contracts for deed, lease-options, and the like) do not apply. In the event of default by the buyer, the seller must foreclose in order to get the property back. This is usually not an undue hardship since Texas has one of the fastest non-judicial foreclosure statutes in the country.
What about doing a wrap but delaying delivery of the deed to the buyer?
Some wraparound arrangements provide that the deed to the buyer will be held “in escrow” (sometimes by a lawyer) as “security” for a period of time – for example until the buyer pays in the full down payment. The wrap paperwork usually states that the buyer is only leasing until the deed is delivered out of escrow. This is a bad idea. A material item of the transaction – the most material item, in fact, the deed – is undelivered. Since the deal is unfinished, it is “executory” and therefore subject to the requirements and severe penalties of Sec. 5.061 of the Property Code (which, incidentally, has a nasty “tie in” provision that makes violations of this section also violations of the Deceptive Trade Practices – Consumer Protection Act).
Remember, real estate investors are not the most beloved of persons in a courtroom. The common perception is that investors are predators. Juries are usually happy to award treble damages and attorney’s fees against them.
Conclusion? It is better to give the buyer a deed and then rely on Texas’ expedited foreclosure process in the event of default.
Isn’t a wrap the same thing as an assumption?
No. In an assumption, the buyer directly assumes the legal responsibility for paying the existing first-lien note. Sometimes this is done with the approval of the seller’s lender and paying an assumption fee, sometimes not; but the assumption documents expressly state that the buyer is taking on the legal obligation of paying the first-lien note. This is not the case in a wraparound transaction, where the first-lien note remains the exclusive responsibility of the seller.
In a wrap, the first-lien note is undisturbed. Instead, a new wraparound note from buyer to seller is created. In other words, there are two separate and independent sets of payment obligations – the buyer becomes obligated to the seller on the new wraparound note, which is secured by a wraparound deed of trust; and the seller remains obligated on the first-lien note (which is “wrapped”) until it is paid and released. These obligations coexist.
How can I be sure a wrap is legitimate?
Wrap transactions are legitimate, primarily, because there is nothing that says they are not. There are numerous Texas cases in which wraparound transactions have been upheld. The State Bar of Texas, in its Real Estate Manual, even publishes suggested forms for wrap documents, although use of these forms is not recommended because of their very basic nature.
People occasionally worry that a wrap transaction will cause the first-lien lender to accelerate the existing note pursuant to the “due on sale” clause. More on that below.
Are there new laws affecting wraparounds?
Yes, and these laws affect all forms of owner financed transactions. These laws are the Texas Secure and Fair Enforcement for Mortgage Licensing Act of 2009 (the SAFE Act) and the federal Mortgage Reform and Anti-Predatory Lending Act (the Dodd-Frank Bill). The SAFE Act and Dodd-Frank impose certain limits and conditions on owner finance, but such transactions (including wraps) continue to be legal.
The Safe Act
The SAFE Act places a licensing requirement on certain types of owner financing extended by persons regularly engaged in selling owner-financed residences. Since wraparounds are a form of owner finance, the Act applies; however, the seller is required to be licensed only if the property is not the seller’s homestead and/or the sale is not to a family member. So, if the subject property is an investment rental house being sold to a non-family member, then the answer would be “yes” – the seller is required to have a residential mortgage loan origination license from the Texas Department of Savings and Mortgage Lending. Obtaining the license requires training, a background check, and an exam. Note that the licensing rule applies only to residential wraps.
But there is relief here for sellers who are not in the business of regularly selling owner-financed residential properties: the Commissioner of the TDSML has ruled that the SAFE Act will not be applied to persons who make five or fewer owner-financed loans in a year, thus preserving the so-called “de minimus exemption” under Finance Code Sec. 156.202(a)(3).
The Dodd-Frank Bill (aka the Mortgage Reform and Anti-Predatory Lending Act)
Dodd-Frank overlaps the SAFE Act in its regulatory effect. It requires that a seller/lender in an residential owner financed transaction (such as a wrap) to determine at the time credit is extended that the buyer/borrower has the ability to repay the loan. Seller is obligated to investigate Buyer’s credit history, current and expected income, current obligations, debt-to-income ratio, employment status, and the like in order to make this determination. Unlike the SAFE Act, this law provides for a de minimus exception for persons doing not more than three owner financed transactions per year (so long as the seller/lender is not in the building business) – but the loan must be fully amortizing (i.e., there is no balloon); the seller must determine that the buyer has the ability to repay the loan; and the owner financed note must have a fixed rate or, if adjustable, must adjust only after five or more years and be subject to reasonable annual and lifetime limitations on interest rate increases.
The intent of Dodd-Frank is essentially to put an end to the practice of making of loans to people who cannot afford to pay them back.
What if there is more than one existing lien?
It is not uncommon to wrap more than one note and lien (e.g., a first and second lien). The prior liens may even be to different lenders. The principle is the same – the buyer pays the seller on the wraparound note, and the seller then pays both prior notes. The lien securing the wraparound note is subordinate to both of the prior liens.
Can you give an example of a wrap?
Consider the example of 123 Oak Street which has a market value of $100,000 but has been slow to move. There is a first lien in the amount of $50,000 to Apple Bank and a second lien in the amount of $25,000 to Orange Bank which, taken together, result in a $25,000 equity. In the usual case (conventional financing), a purchaser should be able to make a down payment and obtain third-party institutional financing so that the seller receives $25,000 at closing and goes merrily on his way. But what if the buyer is unable to get traditional financing? The solution is a seller-financed wrap note that may be in a premium amount, say $110,000, which is subordinate to the notes due Apple and Orange Banks. As is customary with owner financing, the wraparound note will bear a higher than market rate of interest. It is secured by a wraparound deed of trust that enables the seller to conduct a traditional foreclosure if the buyer defaults on the wraparound note.
Is this a device to get sub-prime buyers into homes?
Not really. The buyer should have a substantial down payment. The seller should evaluate and approve the buyer’s qualifications, just as any other lender would. The wraparound is a device to sell property to reasonably qualified buyers who have money to put down and can afford the monthly payments. For less qualified buyers, a land trust may be the better option (Our article Land Trusts in Texas, also on this site, may be useful reading).
Can wraps be used in conjunction with land trusts?
Yes. There may be circumstances where it may be a good idea to first transfer the property into a land trust and then do a wrap.
Are wraps just for homes?
No. Both residential and commercial wraps are possible. Commercial liens are more likely, however, to contain provisions that may prohibit a wrap. In commercial cases, one must carefully review the deed of trust securing the existing lien before proceeding with a wrap.
Why would a seller do a wrap?
The seller can unload property at full market price – property which would otherwise have to be discounted or be slow to move because buyers are finding it difficult to get traditional financing. The seller gets some cash today (the buyer’s down payment) which either goes in the seller’s pocket or is used to reduce principal on the wrapped note (or a combination of both). The seller is then out from under the payments. The seller also gets the benefit of any spread between the interest rate on the wrapped note and wraparound note.
Why would a buyer do a wrap?
That is an easy question. The buyer does not have to apply and qualify for a new loan, at least not immediately. The buyer gets a warranty deed to the property and immediate possession, without lengthy delays, expensive loan fees, and closing costs.
Why would a broker encourage a wrap transaction?
Aside from meeting objectives of the broker’s client, the buyer’s down payment supplies cash for the broker’s commission to be fully paid at closing, just as with any other transaction.
Is title insurance available?
Yes. A wrap does not interfere with the insurability of title in the name of the buyer, therefore an owner’s policy of title insurance is available. A wraparound lien is a valid lien, therefore a mortgagee’s policy is available. However, some title companies are more inclined to insure wraps than others. Some title companies are not comfortable with the wraparound process, for reasons of their own. It may be necessary to “shop” title companies until a wrap-friendly closer is found.
If a title company is issuing insurance, then closing will be held at the title company. However, many if not most wraparounds are closed without title insurance, on the basis of an informal title search or a title report, in a lawyer’s office. After all, while title insurance is customary in Texas, it is not required.
Note that this office is not a “fee office” for a title company and does not offer title insurance. With all due respect to other attorneys that do this, we consider it a conflict of interest and confine ourselves to aggressively representing the buyer or seller.
Isn’t a wrap a breach of contract with the lender? What about the due-on-sale clause?
A wrap transaction is neither a breach of contract nor a “violation” of the due-on-sale clause. If you look carefully at the typical lender’s residential loan documents, you will see that they usually do not prohibit a transfer of property without the lender’s consent. They generally state that if the borrower transfers the property without the lender’s permission then the lender may, if it so chooses, declare the loan due. Look at paragraph 18 of the Fannie Mae/Freddie Mac Uniform Deed of Trust:
If all or any part of the Property or any interest in the Property is sold or transferred (or if Borrower is not a natural person and a beneficial interest in Borrower is sold or transferred) without Lender’s prior written consent, Lender may require immediate payment in full of all sums secured by this Security Instrument.
This is not prohibitory language. It says the lender may accelerate the note if it wants to. When an investor transfers the property without consent from the lender, the investor makes it possible for the lender, if the lender so chooses, to accelerate. It is not a breach of the deed of trust. It is not fraud. As attorney Bill Bronchick puts it, “There is no due on sale jail.”
How often does a lender declare an otherwise performing loan due? They may not like the fact that the property has been sold to someone else, but – so long as payments continue on a timely basis – the risk that a lender will do anything about it is small.
Isn’t there some kind of notice requirement before doing a wrap transaction?
Yes. Property Code Sec. 5.016 (effective January 1, 2008) requires (1) 7 days notice to the buyer before closing that an existing loan is and remains in place; (2) giving the buyer this same 7 day period in which to rescind the contract to purchase; and (3) also that the 7 day notice be sent to the lender. These notices are the obligation of the seller and must be in the form prescribed by the statute. Actual lender consent, however, is not required. These notices, sent to the loan servicer, generally produce no response.
Note, however, that Property Code Sec. 5.016(c)10 provides an exception “where the purchaser obtains a title insurance policy insuring the transfer of title to the real property.” Thus if you are able to get a title company to insure your wrap, you can dispense with the 7 day notice.
This is a law that “has no teeth” to speak of. For now, it has not had a significant restraining effect on owner financed transactions.
What kind of down payment should the seller get on a wrap?
This is an underwriting issue. The seller is the lender and, like any lender, should carefully consider the risks inherent in the transaction as well as the creditworthiness of the borrower before determining the amount of the down payment as well as other issues such as what interest rate to charge. Any down payment that is less than 10% falls within the risky category.
There is also an issue of financing the down payment, i.e., the buyer pays part of it at closing and the balance within a short period – say 90 to 180 days. The wrap paperwork can certainly be drafted to accommodate this but, again, it is an underwriting issue for the seller.
What if both notes are due on the first of the month?
The timing of payments is an issue, and it should be addressed in the wraparound agreement. It is a good idea to schedule payments on the wraparound note 7 to 10 days before payments are due on the wrapped note, so as to allow time for the seller to collect payments from the buyer and forward them on to the wrapped lender.
What about casualty insurance on the property?
Sellers in wrap transactions usually want to cancel their casualty insurance policy. Wrong. The wrapped lender, who usually collects an escrow for taxes and insurance, or at the very least is named as an additional insured on the seller’s policy, will be notified of the change. The seller will then get a default letter from the wrapped lender who will “force place” another policy (usually much more expensive) at the seller’s expense. The existing policy should therefore be left in place.
Another issue: collecting on the seller’s insurance policy can be problematic after a wrap transaction since title to the property has changed hands. Even if the seller agrees to make a claim on behalf of the buyer, the insurer may refuse to pay it, asserting that the seller no longer has an “insurable interest.” Worse, this could potentially be construed as insurance fraud. Therefore the buyer should procure his own casualty and contents insurance. It is unfortunate that this results in two policies being in place, but there is no way around it. A wraparound can be a mutually beneficial way to structure a transaction, but it is not a perfect device.
If there is no escrow being collected by the wrapped lender, then the wraparound note should always provide for one to be collected from the buyer.
Insurance issues should be thoroughly addressed in the wraparound agreement.
What about “double wraps?”
So long as the wraparound deed of trust permits it, a wrapped loan can be wrapped and wrapped again. This permits an investor to purchase property on a wrap and then sell it the same way (at a higher price and interest rate, of course), collecting a down payment (the investor’s “front end” profit) from the new buyer in the process. This new buyer commits to go through credit repair and obtain a new loan from a third-party lender before the expiration of a “balloon period,” which is usually 3 to 7 years. When this new loan is closed and funded, all wrapped loans get paid and released. The investor then gets his “back end” profit.
An additional, advanced trick: some investors include a “substitution of collateral” clause in their wraparound notes that allows the property to be freed from the wraparound lien so long as property of reasonably equivalent value is substituted in its place.
What if the buyer defaults on the wrap note?
The seller receives a wraparound deed of trust that enables the seller to foreclose if the buyer defaults in paying the wraparound note. He can also seek and obtain a deficiency judgment if the sales price at foreclosure is insufficient to discharge the wrap note plus accrued interest and fees. The seller thus has the same ability to enforce his note and lien as does any other lender.
As mentioned above, Texas is fortunate to have an expedited non-judicial foreclosure process. Property Code Sec. 51.002 requires that a homeowner be given at least a 20 day notice of default and intent to accelerate the note if the default is not timely cured. If the deed of trust is on a FNMA form, then a 30 day notice and opportunity to cure is required.
The default notice must be followed by a second letter stating that since the default was not cured, the note is accelerated and the property is being posted for foreclosure. This second notice must be given at least 21 days before the first Tuesday of the month in which the foreclosure will be held. So, a Texas foreclosure takes a minimum of 41 days – 51 days if a FNMA deed of trust is involved – although one should avoid cutting it that close.
There are two distinct advantages of the foreclosure process: first, foreclosure cuts off any other subordinate liens that may be have been placed against the property while the buyer owned it (e.g., mechanic’s liens); and second, there are no effective defenses to the foreclosure process except to block it with a temporary restraining order. For that, the buyer needs money and an attorney. They usually have neither. A companion article on this site entitled Foreclosures in Texas is suggested reading.
After foreclosure, the former buyer/owner may still refuse to leave, making an eviction (“forcible detainer” or “FED”) necessary. In order to accomplish this, the owner must give a 3 day notice to vacate, file an FED petition in justice court, get it served, get it heard by the Justice of the Peace, and then wait 5 days for a final judgment and a writ of possession. One must then wait until the constable posts a 48 hour notice on the door and then forcibly removes occupants who are otherwise unwilling to leave. Elapsed time? At least 3 weeks, although an appeal to county court can lengthen this process significantly. For more details, see the companion article on this site, Evictions in Texas.
What if the seller defaults by not paying the wrapped lender?
The wraparound agreement provides that if the seller fails to make payments to the wrapped lender the buyer may do so and receive credit against the wrapped note. The buyer should have the power to occasionally request documentary proof from the seller that the wrapped note is current.
Two related situations are of interest: What happens if the seller (1) files bankruptcy and seeks the discharge of the wrapped debt; or (2) dies leaving the wrapped debt unpaid? In either case, the buyer could be forced to refinance the debt on short notice – which may be difficult. In the case of bankruptcy, the seller should agree in the wraparound agreement to execute a reaffirmation agreement on the wrapped debt (i.e., rather than seeking to discharge it in the bankruptcy). As for the premature death of the seller, the buyer should check to see if the seller has or can add term life protection (payoff insurance). If not, the buyer should consider protecting himself by obtaining a term life insurance policy on the seller in the amount of the balance on the wrapped debt.
What about the interest deduction?
The seller continues to be able to deduct interest paid on the wrapped loan. Nothing has changed there. As to interest on the wraparound note, interest received by the seller must be reported as income, and interest paid by the buyer is deductible. More details should be obtained from your tax advisor. Beyond these basics, this office does not give tax advice.
Is there a lot of difficult paperwork?
A properly drafted wraparound transaction will include a warranty deed, a wraparound deed of trust, a wrap note, and a wraparound agreement to address the details. These are sophisticated documents that are highly customized for the particular transaction. Only a qualified and experienced real estate attorney experienced in preparing wrap documents should be used to draft these papers. There are no “forms” available from any source, including the Texas State Bar, that are adequate to the task. Also, because there is no TREC or TAR standard wrap addendum, the TREC earnest money contract should include an attorney-prepared wrap addendum. A sample of such an addendum is attached to this article.
What are the disadvantages of a wrap?
Obviously, the seller has to wait until the wraparound note balloons in order to receive the full proceeds of the sale (The seller needs to weigh this against the fact that today’s sale is at full market value, not a discount). Also, the wrapped loan is frozen in place and cannot be refinanced for the duration of the wrap. The seller has to collect and remit payments, which requires his ongoing involvement. If the wraparound borrower defaults, the seller must foreclose, which is not usually a problem with Texas’ expedited non-judicial foreclosure laws. In the unlikely event a loan is accelerated, the buyer may have to secure traditional financing. The wraparound agreement should specify the amount of time in which this must be done. The parties may also be carrying duplicate casualty insurance policies.
What about cost?
Our office charges $750 for residential wrap documents, $950 plus for commercial, not including recording fees which are usually about $90. Closing in our conference room is complementary. There are none of the usual title company charges, but a la carte items from third parties are extra (An example would be a title report, which is good idea).
Attached to this article is a client checklist that provides the attorney with necessary basic information to begin drafting the wraparound documents.
Information in this article is proved for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is expressly retained in writing to do so.
Copyright © 2010 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his web site, http://www.LoneStarLandLaw.com