SOC; it's hard work to avoid taking the easy way. - Posted by Brent_IL

Posted by Glen SoCal on July 31, 2003 at 01:08:01:

Thanks again, Brent for the advanced tutorial.


SOC; it’s hard work to avoid taking the easy way. - Posted by Brent_IL

Posted by Brent_IL on July 29, 2003 at 16:25:25:

IMNSHO, the most underrated article on this, or any other real estate site, is ?Subordination and Substitution of Collateral? by Attorney William Bronchick.

I?ve noticed a proliferation of posts asking about how to over-finance, asking how to find Hard Money lenders and cash investors, and asking about how to overcome the cash requirements of rehabs. If you are active, all of these challenges disappear by a proper application of subordination and SOC practices. Most financial flippers take over lien payments subject-to. Sellers who accept subject-to offers won?t blink an eye at a SOC clause.

It isn?t written in stone that post-sale participation by the seller is limited to junior mortgages or equity-shares. Couldn?t he accept a note containing a SOC clause AND an equity share agreement for the top part? Couldn?t we then move the note off the property to some form of illiquid collateral and use the real estate to borrow needed investment cash?

There are many seller?s who have 50% equity and will carry a no-payment or accumulating interest note for a few years if you put 20% down. Once the SOC-containing purchase contract is signed, why should your trustee burden the former owner with the knowledge that the note collateral was transferred at closing, and that you refinanced with a HM second to 70@ of contract value and used the $20K from the loan to make the down payment to him.

Prior to that same closing, it would have been just as easy to sell the house to a R/B on terms or to another for cash.

It just seems to me that most of us don?t take full advantage of the deals that we already have because we are stuck in a purchasing rut.

I agree! - Posted by Eric C

Posted by Eric C on July 29, 2003 at 22:44:03:

– at least about the “stuck in a rut” and the “SOC” parts. Bill’s article is probably good too.

And by far, the two clauses that have made me the most money in this business (about 30 years now) are those that call for the substition of collateral and the first right of refusal. Everyone should know how to use them.

Take Brent’s advice and educate yourself. It’ll do wonders for your pocketbook.

Take care,

Eric C

Interesting concepts - Posted by Chris(indiana)

Posted by Chris(indiana) on July 29, 2003 at 18:40:51:

I kind of understand what you are saying even though i have not heard of this SOC document before. I kind of get the drift of what it is. But when you said “move the note off the property to some form of illiquid collateral”. What is this illiquid collateral? Probably not experienced enough to understand all of this…but i am trying…

Go Purdue!

Re: Interesting concepts - Posted by Brent_IL

Posted by Brent_IL on July 30, 2003 at 16:36:06:

No one is born experienced enough to understand all of this. Trying to learn and eventually getting it right is the name of the game.

Not all collateral is created equal. Cash, or a cash-equivalent substitute, e.g., a T-bill, is the best collateral for a loan because its value is easily ascertainable, and if the collateral is forfeited, the cost of transforming it into useable money is miniscule. A 35-lb .9999 gold brick isn?t as good because it would have to be assayed to determine true value. If it had to be sold, there are selling costs involved that reduce the amount of cash the lender would recoup. Realty as collateral is technically worse, but there are modifying influences. A SFH has significant transaction costs to convert it to cash. That’s bad. The good things are that the market is enormous, valuation procedures well established, and people can perform actions that can change the collateral for the better. Soybeans are a big market. The market establishes the price. But no one trader or assemblage of traders can do much to change the collateral value of soybeans. That?s why, after cash, real estate is preferred collateral for bank loans.

Substitution-of-Collateral is used to switch the security for an obligation to a form of collateral that allows us to do something beyond the loan. Older RE agents refer to this as ?walking the loan,? or ?walking the paper.? Although my purchase contract refers to both, SOC is easier to get a seller to accept and is more useable and adaptable in real life. Basically, an SOC clause establishes your right to use further documentation to remove a lien from the subject property and place that lien on something else. It?s a very good idea to collect and have executed every document and irrevocable power-of-attorney that you could ever need prior to settlement and deposit them into a land trust or long escrow with appropriate instructions. It eliminates post-sale disagreements and having to chase down the sellers for signatures.

Mortgage notes are typically moved to another real property, but that isn?t always the case, nor is it always advisable. SOC can be used when we have unencumbered collateral to reduce our investment in a given property and increase our return on that investment at little cost. This is when we buy-and-hold. It is better used to do enable us to do more CRE deals. It?s best used when we make something from nothing. CRE deals always involve rearranging the collateral and the risk. Otherwise it is a standard buy-low/sell-higher, buy-low/fix-up/sell, or change of usage transaction. They?re all profitable, but they are all standard.

Somewhere around 1983, I learned from Ray Como about Transaction Engineering® and the concept of splitting the financial benefits of ownership from a SFH and selling them to multiple buyers. It was an epiphany. On this site, William Bronchick, J.D. called Ray his mentor. Mr. Como has several articles posted at www.dealmakerscafe The ideas will greatly increase your effectiveness in making deals. Substitution-of-Collateral is the tool that makes it all happen. Substitution-of-Collateral isn?t a technique; it is an art-form.

Here?s a quick and simple example.

Seller has a house for sale at $100,000. It?s worth $100,000. He owes $50,000. He will finance $30,000 if we put down 20% of the sales prices. He agreed to five $6,000 annual payments in arrears. We followed Ray?s teachings, so we pay zero or near-zero interest. The seller went along with this even though he is under no pressure to sell of any kind. He rationalized it as saving a real estate commission and saving his time.

Forget $20,000, after buying a course from Bronchick, we only have 20 cents left over. We gained all of the advantages of a land trust for the cost of recording a deed from the seller to his estate-planning trust and buying the beneficial interest using the forms from the course. Lost the forms? Real estate attorneys will draw up the agreements and get paid out of escrow. We inform the trustee that Substitution-of-Collateral will be invoked at settlement to transfer the collateral for the $30,000 purchase money mortgage to other security. At this point, the decision is unilateral. The seller might object, but he gave you that right, so he has no option.

We, on the other hand, have several options. Here are two.

  • We can sell the house prior to close for $90,000 cash. The closing agent pays off the $50,000 lien, gives the seller $20,000 down, pays attorney fees and settlement costs of $5,000, and hands a check to us for $15,000. This isn?t free money. It?s a loan. We have to use it to earn 40% so we can make the $6,000 annual payment. Can a journeyman creative real estate investor make 40% a year using Transaction Engineering® techniques like SOC? In our sleep.

  • We can equity-share with someone who will make mortgage payments and pay property expenses in return for 100% financing. We can strip out the tax benefits and sell the credits at a discount to get the $20,000 to pay the seller. We get a monthly cash flow and a future profit that we can use to make the cash to pay the $6,000 due for the next 5 years.

O.K., so what is the illiquid collateral that we are going to use? One of the purposes of extensive documentation is to establish how and if collateral will be valued. We don?t want to have to go to court or mediation for a ruling. My absolute favorite is Variable Appreciation Personal Offering Receipts, or perhaps Appreciating Investment Receipts, but I digress. What about buying some throw-away seconds with a face amount of $30,000 for $6,000? How about some corporate bonds that are rated BB? How about using any junior notes that you have accumulated by coming up with part of the down payment for your buyers from other deals that aren?t worth much because the property is up-side down?

The one I use most often is, ?Purchaser?s signature and personal guarantee.? It is one of the types of collateral specifically listed in the contract. I phrase my offer presentation so the sellers have to ask me for it. They do.

All of these non-liquid collaterals can be substituted for liquid real estate equity.

The possibilities are limited only by your imagination and lack of conviction these terms will be accepted.

Good luck.