How To Set The Interest Rate On A Seller-carry Note

Every loan must bear interest, and when you borrow from a bank that number is typically non-negotiable. However, with seller financing the interest rate is subject to negotiation. In this Self-Storage University podcast we’re going to explore strategies for determining the correct interest rate on seller-carry debt.

What is The Self Storage University Podcast?

Welcome to the Self-Storage University Podcast, where you will learn the correct way to identify, evaluate, negotiate, perform due diligence on, renegotiate, finance, turn-around and operate self-storage facilities. And your host is a partner in one of the largest real estate portfolios in the U.S. with nearly $1 billion of holdings, Frank Rolfe.

With most deals, you only negotiate the price. But when you have seller financing, you also negotiate the terms of that note. This is Frank Rolfe, the Self Storage University Podcast. We're gonna talk about some concepts behind how do you set the interest rate on a seller finance note. Now, we all know, or anyone knows who's ever gone and borrowed from a bank, the banks have very particular ideas on what the interest rate will be. It's relatively inflexible. It's pretty much already set when you walk in the room. So, if you're gonna borrow money from that bank, by gosh, you're gonna pay blank percent interest. And that isn't really something you can debate. It's not an initial offer waiting for your counter offer. It's just a fact of life. It's like going and renting a car from Hertz at the airport. If you have a change on the contract, then they're not gonna rent a car to you. They make no changes or amendments to their standard terms.

But when you go and you borrow money from the seller with a seller finance note on that self-storage facility, now we have a whole different game going on. Because, you see, there's no rules of order. There's no law and order. There's no bank regulators who set interest rates on seller notes. It's 100% flexible, 100% negotiable. So, how do you figure out then what the correct interest rate on that note would be? Well, the first thing you'd wanna know is, what are the banks charging? You can't really come up with this seller interest amount until you truly know what the going rate is in the marketplace. And if you say, "Well, the marketplace rate right now for bank financing is 6%." Okay, well that's the number we need to know. You may have to call a few banks to try and find out, or maybe call a loan broker and find out from them, but you've gotta know what the banks are charging. That's step number one.

Number two, what are the current CD rates? Because if you paid mom-and-pop in cash, they're not a lender; they're not gonna go out and be able to loan that money out, but they could go down to A. G. Edwards and put it in a CD. So what are CDs paying? What is that amount? And while you're at that, also look at how long the longer term CDs are paying, not just the one-year CD. What's a five-year CD paid? That's another item you're gonna want to consider. And then another one is gonna be, what interest rate do you need to hit your budgets? Because often when you're buying a deal with seller financing, that interest rate is a mighty important part of the puzzle as to how much cash flow and cash-on-cash return you have. And you're certainly not buying that self-storage property with the goal of just helping out mom-and-pop. No, you're buying it to try and make money. So, therefore, where do you need to set the interest rate to make the money that you are targeting? Sometimes there's a trade off because you can pay mom-and-pop more for the storage facility if they carry at a below-market interest rate or better terms. So, how is that going? What does that look like? What do you need to have as the rate to be able to make sense of what you're paying?

Also, you need to understand the inverse formula in the interest rate to the purchase price. Because if the seller has a certain number set in their mind, you need to know and understand what that means as far as what the interest rate would be to make that attractive, to make it compelling. And it also may be, you can also get there with a non-interest rate issue of a smaller amount of down payment. There's an old rule in commercial real estate that almost anything looks attractive if it's zeroed down non-recourse, because in that case you've got a situation where you have no risk. You could always just give the property back with no financial penalty at all. But again, not all sellers are willing to do that. So then the key question is, okay, what did this interest rate need to be on the note of the down payment to make this still very compelling to me?

Also, don't forget that if you buy something with seller financing at an abnormally low interest rate, you've gotta have enough time on that loan to push your NOI up so you can catch up to what current banks are charging when that note comes due. That's another part of the interest rate. If we're gonna go with a very, very below-market rate, then we've got to, to protect ourselves, have a situation where we have plenty of time to increase rents and decrease costs so that when you go to the higher interest rate that the bank would probably be at, that you then can clear the trees. And then finally, what's your personal opinion on the direction of interest rates? Do you see them going up more? Do you see them staying flat? Do you see them going down?

This year, many people projected rates would decline. Many people started off in January of 2024, anticipating five or six interest rate reductions by the Fed. But so far, we haven't had any. And now people are saying, "Well, we might get one by the end of the year." Man, that's a far cry from what they thought back in January. So, what are your personal beliefs on that? Because if you think rates will be dropping, then you are gonna want mom-and-pop to have a lower interest rate than if you think rates are gonna go up in which you may think that their interest rate they desire is still a bargain. The bottom line is, you then take all of that data: What the banks are charging, what the CD rates are, what you need to hit your budget, where you think interest rates are going, where you think that the note terms need to be to make the deal compelling. And from that, we'll spring forth what the rate would be.

But even then, you're not done, right? You haven't fully negotiated the rate. So, when you figure out what you think the rate needs to be to make your deal work, you would never offer that rate. You would go far, far lower than that number, allowing mom-and-pop the ability to counter that number so that in all negotiations, you typically triangulate to the final number. To get there, you gotta start low. They'll counter high, and then hopefully you end up meeting in the middle. But also, don't forget that very few deals are gonna die because you're unable to hit your exact interest rate amount. The actual payment differential, if you were hoping to get a 5% seller note and you can't get any lower than a five and a half, it may still well not kill your deal. So, it's not truly the end of the earth if you're unable to triangulate your way to the exact number that you needed. You may be able to modify your own assumptions going in on occupancy and cost to maybe make up for that shortfall.

So, the bottom line to it all is, that negotiating that seller note and that interest is an important part of the process. And anytime you go and buy a storage deal from mom-and-pop where they will carry the paper, you have not one negotiation, but two. This is Frank Rolfe, the Self-Storage University Podcast. Hope you enjoyed this. Talk to you again soon.