DAVID J. WILLIS ATTORNEY
Copyright ©2016. All rights reserved worldwide.
Wraparound Transactions in Texas
By David J. Willis, J.D., LL.M.
What is a wraparound transaction?
A wraparound transaction is a form of creative seller-financing that leaves the original loan and lien in place when a property is sold. The buyer usually makes a down payment, gets a warranty deed (title), and signs a new note to the seller (the “wraparound note”) for the balance of the sales price. This wrap 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 wrap 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 existing “wrapped deed of trust.” It is possible to wrap more than one prior note (e.g., an “80/20”).
Often the principal of the wrap note to the seller exceeds the amount of the payoff on the wrapped note. This is the seller’s profit. Alternatively, the buyer may make a cash payment to the seller for the seller’s equity, and the wrap note payment will then be structured to correspond closely to the amount of the payment on the wrapped note (referred to as a “mirror wrap”).
Specific wrap terms can vary, but the wraparound principle remains the same. Wraps may be done on both residential and commercial properties. Wrap paperwork begins with the earnest money contract which should include an addendum setting forth the terms of the wrap. At closing, details of the wrap should be contained in a comprehensive wraparound agreement.
Alternatively, if the parties are clear on terms and ready to move forward immediately, they can skip the contract phase and request that the attorney prepare wrap documents for immediate closing.
If and when the buyer gets a refinance loan, the 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 matures or is paid in order to receive the full sales proceeds.
Wraparound financing is sometimes referred to as subordinate lien financing.
Wrap documents should include (at minimum) the following:
(1) a wrap note signed by the buyer;
(2) a wrap deed of trust securing payment of the wrap note;
(3) a warranty deed with vendor’s lien conveying title to the buyer; and
(4) a wraparound agreement covering miscellaneous details.
A short-term note for part of the down payment may also be included.
The interest rate on the wrap note is often higher than that on the wrapped note since seller financing usually carries a rate slightly higher than market. The wrap note is often amortized over 15 or 30 years. In the past, most wrap notes were ballooned in 3 to 7 years, giving the investor a reasonably short time horizon for realizing a profit; however, Dodd-Frank now requires that the seller affirmatively determine that the buyer has the ability to repay before a balloon may be used.
Other Forms of Seller Financing
Wraps are a form of seller financing. There is no disputing it. Dodd-Frank and the SAFE Act apply.
Residential lease-options exceeding six months and contracts for deed were both restricted by changes to the Texas Property Code made in 2005. Because the Code now imposes severe penalties on sellers if strict, burdensome rules are not followed, investors have moved away from lease-options and contracts for deed. Only a few types of residential owner financing remain practicable:
traditional owner finance, used when residential property is paid for;
land trusts, which involve temporarily deeding the property into a trust until a credit-impaired buyer can obtain financing.
How is a wrap different from a contract for deed?
A wraparound is an “executed” (complete) transaction as opposed to an “executory” (incomplete or unfinished) transaction. The buyer gets a deed to the property at closing, not at some future time. Therefore, the executory contract rules contained in Prop. Code Sec. 5.061 et seq. 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” (often by a lawyer) as “security” for a period of time – for example until the buyer pays in the full down payment. The wrap paperwork then states that the buyer is only leasing until the deed is delivered out of escrow. This is generally a bad idea. A material item of the transaction – the most material item, in fact, the warranty deed – is undelivered. Since the deal is unfinished, it qualifies as an executory contract and is subject to the requirements and penalties of Prop. Code Sec. 5.061 et seq. Note that this statute has a nasty tie-in provision that makes violations of Sec. 5.061 also violations of the Deceptive Trade Practices – Consumer Protection Act (DTPA).
The practice outlined in the preceding paragraph is different from the “security deed” technique. A security deed is a deed back from the buyer to the seller that is intended to be filed by the seller only if the buyer defaults – i.e., in lieu of going through foreclosure. This can legally be done but it is risky since it is possible that a future court may disapprove of this avoidance of foreclosure procedures.
Remember, real estate investors are not the most beloved of persons in a courtroom. The common perception is that investors are greedy predators exploiting the unfortunate. Juries are often happy to award treble damages and attorney’s fees against investors, so caution is in order.
Isn’t a wrap the same thing as an assumption?
No. In an assumption, the buyer formally assumes the legal responsibility for paying the existing first-lien note. Sometimes this is done with the approval of the seller’s lender, paying an assumption fee, and signing onto the debt; sometimes the promise to assume the existing debt is made directly (and only) to the seller by means of an assumption deed. Either way, it is expressly stated that the buyer is taking on the legal obligation of paying the first-lien note. This is not the case in a wrap, which is a kind of “subject to” transaction. The first-lien note remains the exclusive responsibility of the seller.
In a wrap, therefore, the first-lien note and the deed of trust securing it remain undisturbed. A new note (the wrap note) secured by a new wrap deed of trust is created. In other words, there are two separate and independent sets of payment obligations: the seller remains obligated on the wrapped first-lien note until it is paid and released; and the buyer becomes obligated to the seller on a new wrap note and wrap deed of trust. 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. Even the State Bar of Texas, in its Real Estate Forms Manual, publishes suggested forms for wrap documents, although they are elementary in nature.
People occasionally worry that a wrap transaction may cause the first-lien lender to accelerate the wrapped note pursuant to the due-on-sale clause contained in the wrapped deed of trust. It is possible but unlikely.
Are there recent laws affecting wraparounds?
Yes. Recent laws include the Texas Secure and Fair Enforcement for Mortgage Licensing Act of 2009 (the SAFE Act or “T-SAFE as implemented in Texas) and the federal Mortgage Reform and Anti-Predatory Lending Act (the Dodd-Frank law). Even though the SAFE Act and Dodd-Frank impose limits and conditions on owner finance, such transactions (including wraps) continue to be legal.
The SAFE Act
The SAFE Act imposes a licensing requirement (a residential mortgage loan origination license or “RMLO”) on certain types of owner financing extended by persons who are regularly engaged in selling owner-financed residences. A seller is required to be licensed if the property is not the seller’s homestead and/or if the sale is not to a family member. So, if the property is a rental house being sold to a non-family member, then the seller is required to have an RMLO license from the Texas Department of Savings and Mortgage Lending (TDSML). Obtaining the license requires training, a background check, and an exam. Note that the licensing rule applies only to residential wraps.
There is relief 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 minimis exemption” of Finance Code Sec. 156.202(a)(3).
The Mortgage Reform and Anti-Predatory Lending Act (aka the Dodd-Frank Law)
Title XIV of the Dodd-Frank law pertains to residential loans and lending practices. Dodd-Frank overlaps the SAFE Act in its regulatory effect and legislative intent. It requires that a seller/lender in a residential owner-financed transaction determine at the time credit is extended that the buyer/borrower has the ability to repay the loan (the ATR rule). The seller is generally obligated to investigate the 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. This law provides for a de minimis 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 (no balloon) unless the sale is a one-time event within twelve months by a private, non-builder seller (which excludes most investors); the seller must determine that the buyer has the ability to repay the loan (and this must be supported by verifications and documentation), but with the same exception as with balloon notes; and the note must have a fixed rate or, if adjustable, may adjust only after five or more years and be subject to reasonable annual and lifetime limitations on interest rate increases. See CFPB reg. sec. 1026.36(a)(4).
Dodd-Frank also provides that the note must have a fixed rate or, if adjustable, may adjust only after five or more years and be subject to reasonable annual and lifetime limitations on interest rate increases.
Dodd-Frank is a hugely complex law and is still undergoing interpretation and rule-making by the Consumer Finance Protection Board. Their rules are a challenge to understand, even for the most intelligent investor or attorney.
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. Read our article on The Dodd-Frank Law in Texas for more details.
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 is valued at $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 $25,000 equity. In the usual case, 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. The wrap note will likely bear a higher than market rate of interest. It will secured by a wrap deed of trust that enables the seller to conduct a traditional foreclosure if the buyer defaults on the wrap note.
Is this a device to get sub-prime buyers into homes?
Perhaps, but prudent investors will require the buyer/borrower to have a substantial down payment. The seller/lender should evaluate and approve the buyer’s qualifications just as any other lender would. In fact, Dodd-Frank generally requires this. The wrap should be viewed as a legitimate 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. See Land Trusts in Texas.
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, but this requires more complex documentation since a trust agreement will also have to be prepared.
Are wraps just for homes?
No. Both residential and commercial wraps are possible. Commercial liens are more likely, however, to contain provisions that expressly prohibit any transfer of title without prior lender consent. In all cases, but especially in commercial cases, one should carefully review the deed of trust securing existing loans before proceeding with a wrap.
Why would a seller do a wrap?
The wrap seller can unload property at full market price (or even higher) – property which might otherwise have to be discounted or sit idly on the market. The seller gets at least some cash today (the buyer’s down payment) which either goes into the seller’s pocket or is used to reduce principal on the wrapped note (or a combination of both – this is negotiable). The seller is then out from under the payment burden, although the seller must continue to remain involved by forwarding payments to the first lienholder. 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 title 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, but availability is limited. Some title companies are more inclined to insure wraps than others. Certain underwriters are not comfortable with the wraparound process, for reasons of their own. It may be necessary to “shop” title companies until a wrap-friendly title company is found.
If a title company is issuing insurance, then closing will be held at the title company. However, most wraps are closed without title insurance in a lawyer’s office based on an informal title search or a title report. After all, while title insurance is customary in Texas, it is not required. A title report may suffice for an investor.
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 due-on-sale. The due-on-sale clause merely gives the lender an option to take action if it chooses. Look closely at paragraph 18 of the FNMA deed of trust: it says that a lender may (not must) accelerate. This is not prohibitory language.
Isn’t there some kind of notice requirement before doing a wrap transaction?
Yes. Prop. Code Sec. 5.016 requires that the seller (1) give seven days notice to the buyer before closing that an existing loan that will remain in place; (2) inform the buyer that buyer has this same seven days in which to rescind the earnest money contract without penalty; and also (3) provide a seven-day notice to the lender. These notices are all the obligation of the seller and must be in the form prescribed by the statute. Actual lender consent, however, is not required, which makes this a rather odd law. Lender notices, most often sent to the loan servicer, generally produce no response.
Note that the buyer’s opportunity to cancel is an exclusively pre-closing remedy. There is no right of rescission after closing has occurred.
Prop. Code Sec. 5.016(c)10 provides an exception to the notice requirement when “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 seven-day notices.
This is a law that has no teeth to speak of. As a consequence, it is widely disregarded. 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?
Down payments are an underwriting issue. In the case of a wrap, the seller is also 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 and what interest rate to charge. Dodd-Frank requires such due diligence in most cases. It is likely that a down payment less than 10% likely falls within the risky category.
Can part of the down payment be financed? Yes. There is no prohibition against it. Typically, the buyer would pay part of the down payment at closing and then promise to pay the balance within a short period – say 90 to 180 days – utilizing a second wrap note. Again, this is an underwriting issue for the seller but it is a common enough practice.
What if both notes are due on the first of the month?
The timing of payments is an issue and should be addressed in the wraparound agreement. It is a good idea to schedule payments on the wrap note seven to ten days before payments are due on the wrapped note, so as to allow time for the seller to collect payments from the buyer and then forward them on to the wrapped lender in a timely manner.
What about casualty insurance on the property?
This is a problematic area. Sellers in wrap transactions want to cancel their casualty insurance policy. This is inadvisable. The wrapped lender, which usually collects an escrow for taxes and insurance or at the very least is named as an additional insured, will be notified of the cancellation. The seller will then get a default letter from the wrapped lender who will “force place” another policy (usually more expensive) at the seller’s expense. The existing policy should therefore be left in place and the buyer should obtain his own policy. This is an inherent imperfection in the wrap process.
There is also an issue relating to insurable interest. What happens if there is a loss? Collecting on the seller’s insurance policy can be problematic after a wrap 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 owns it. Worse, this could potentially be construed as insurance fraud. Therefore the buyer should procure his own casualty and contents insurance and claims should be made pursuant to the buyer’s policy. It is unfortunate that this results in two policies, but there may be no reliable way around it. Insurance issues should be thoroughly addressed in the wraparound agreement.
If there is no escrow being collected by the wrapped lender, then it is in the seller’s best interest to collect one from the buyer.
What about "double wraps?"
So long as the wrap deed of trust permits it, a wrapped loan can be wrapped and wrapped again – although the documentation can become prolific. 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. Usually, this new buyer commits to go through credit repair with the goal (not the requirement) of paying off the wrap note early. The investor then gets his back-end profit.
An additional, advanced trick: some investor/buyers include a “substitution of collateral” clause in their wrap notes that allows the property to be freed from the wrap lien so long as property of reasonably equivalent value is substituted in its place. If the buyer is an investor with multiple properties this could be a useful option.
What if the buyer defaults on the wrap note?
Let’s review: the seller receives a wrap deed of trust that enables the seller to foreclose if the buyer defaults in paying the wrap note. The seller 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. Accordingly, the seller has the same ability to enforce the wrap note and lien as does any other lender.
Texas is fortunate to have an expedited non-judicial foreclosure process. Prop. 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 (unusual for a wrap) 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 when it comes to the notices. It is prudent to allow a cushion.
What if the seller defaults by not paying the wrapped lender?
The wrap 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 challenging. In the case of seller bankruptcy, the seller should agree in the wrap agreement to execute a reaffirmation agreement on the wrapped debt (i.e., rather than surrendering the property to the lender seeking or otherwise seeking to avoid the debt). 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 wrap note, interest received by the seller must be reported as income, and interest paid by the buyer is deductible.
What are the disadvantages of a wrap?
Obviously, the seller has to wait until the wrap note matures in order to receive the full proceeds of the sale. 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 ongoing involvement. If the wrap borrower defaults, the seller must foreclose. In the unlikely event a loan is accelerated, the buyer may have to secure traditional financing, so 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. Wraps are useful devices, but they are not perfect.
Going Forward with a Wrap
A properly drafted wraparound transaction will include at least four documents – a warranty deed, a wraparound deed of trust, a wrap note, and a wraparound agreement to address the details. There may also be a down-payment note involved. These are sophisticated documents that should be highly customized for the specific transaction. Only a qualified and experienced real estate attorney experienced in preparing wrap documents should be used to draft this paperwork. There are no forms available from any source that are adequate to the task. Also, because there is no TREC or TAR promulgated wrap addendum, the TREC earnest money contract should include an attorney-prepared custom addendum. Accordingly, attorney fees for wrap documentation may be somewhat more expensive than for the average closing.
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 © 2016 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 website, http://www.LoneStarLandLaw.com