With interest rates up significantly, some sellers may propose a construction called a “wrap” in which you leave the existing mortgage intact as part of the deal. But does that work? In this Mobile Home Park Mastery podcast we’re going to review the good and bad aspects of this deal construction and discuss methods to mitigate the risk.
Episode 280: Navigating Wrap Notes Transcript
With interest rates at a 40% or high, it can look appealing to do what's called a wrap note when buying a mobile home park. This is Frank Rolfe, the Mobile Home Park Mastery podcast. What is a wrap note and how does that work? Well, let's assume that the mom-and-pop seller already has a mortgage on the mobile home park at a low rate. You really don't wanna replace that loan, right? Because if you do, you'll have to pay a higher interest rate. So mom and pop may propose to you, "Here, let's do this instead. We'll leave my existing mortgage in place, we won't tell the lender, I'll go ahead and then wrap an additional mortgage over that one in the form of a second position, and then you just give me the down payment." So, does that work? Can you effectively circumvent traditional interest rate fluctuations by doing the wrap note construction? Well, people have done it for a long time. I've seen mobile home parks bought and sold using wrap notes for at least 25 years now.
But there are some issues you have to be aware of. There are two big risks when you do a wrap mortgage. First, you might get caught by the lender, and if the lender catches you, what could happen? Well, the lender might call that note due in full. Now, people would say, "Why would a lender do that? Why would a lender on a perfectly fine performing mortgage suddenly say, 'Wait a minute, you lied to me, you violated your loan covenants, I wanna go ahead and get that loan paid off here at the bank.'" Because sometimes bankers do get upset when you violate the terms of the loan. So just because you're current on the loan, just because your park meets the current occupancy and all those items, it doesn't mean they're still going to take it very well when you have effectively lied to them. The second problem, what you have when you do a wrap note is the property is still not titled into your name, it's titled in the name of the old mom and pop. So what happens if you do your wrap note construction and then years later you wanna have the park in your name, and mom and pop says, "Nah, I don't wanna do it anymore." Or mom and pop are incapacitated or mom and pop die? So there are some risks to doing the wrap note.
So how do you mitigate those various risks of doing a wrap construction? Well, the first thing you can do is you can go to the bank or you can at least read the loan document to see whether a wrap note is legal or not, because in some cases, if you read the loan documents, in fact, it does allow for a wrap construction. So that would be step one. See if it is illegal, and perhaps it isn't. Number two, why don't you just go to the bank and legally and properly assume the loan? We've done that many times. If you go to mom-and-pop's bank and bear in mind mom and pop, the bank has this loan on this mobile home park, and is probably performing well, and it has for years, and they're perfectly happy with the collateral, and they know all about the collateral and its season and it's been performing well, that's a much better loan for the bank, that if you were to pay off that loan, and they have to go out and find somebody else to loan money to. Now, they're making a loan with a stranger on some strange concept, probably not anywhere near as good on paper as a mobile home park. So would behoove the bank often to go ahead and let you assume the existing loan, because that existing loan is deemed by the bank to be safer and therefore on a risk-adjusted basis more, I'm forgetting the word here, more positive, more profitable for the bank.
So that's another option you have, just go to the bank and say, "Hey, I'm buying this mobile home park, that's got an existing mortgage, and I wanna go ahead and improve on it and make it an even better property and make it more profitable and raise the rent and fill it up and all that. Do you wanna let me assume it?" And often the answer would be yes. Number three, just put a smaller amount down. Some people, when they do the wrap construction, they still end up with a 20% or 30% down payment on this overall hunk of debt and equity. But since we're talking a unique loan product where we're going to assume an existing note and then add a second, perhaps what would make it a little better for everyone would be if you put a smaller amount down, that helps protect you in the event that the bank should come forward and suddenly call the note due in full. Because effectively, if the whole thing went down the drain, you've got less money at risk, of course, and that's better for you as a buyer. Now, it's not necessarily better for mom and pop as the seller, except bear in mind, they are getting interest on the principal that remains that you didn't put down as a down payment, so you're not taking away from them, you're not cheating them over that, so that's another thing you can do to kind of mitigate your risk.
Also another thing you could do is, you can start paying the mortgage out of an account that you control, but in the name of the park, and you would do that so that the bank doesn't see that the payment is coming from somebody other than the park. So even though the name on the checking account and the number may be different than what it had been in the past, most people would look at that and that wouldn't trigger much. But the problem is, if you send your payment to mom and pop every month and you rely on them to pay the mortgage, how do you know that they did? You don't. So what could happen is, you could be paying your payments like clockwork every month, and without you having any idea, mom and pop did not pay the mortgage, and you're never even gonna know about that till they call the loan due, because all those warning letters, everything, that it all go to mom and pop. So by you paying the mortgage, at least you know monthly that it is in fact getting paid, and that gives you a little greater piece of mind.
Another thing you can do to mitigate your risk, you simply to get that park ready to refinance at the drop of a hat. So how do you do that? How do you think like a banker, how do you make your park easier to get a loan? Well, we all know the basics, number one, get good, solid financials, whatever software you choose, whether it could be Rent Manager or some other, you know, banks today, they wanna see good computerized records, they don't wanna see things written with a purple crayon on a sheet of paper, so having good solid financials definitely improves your odds if you have to go out and get a loan. Your chances of getting a loan, if you have good, solid, computerized records, are far greater than things that are generated by hand. Also get that park fixed up and looking good. So how do you do that? Well, you improve the entrance, you streetscape, you take those abandoned homes in there and you repair and renovate them to get them sold, so aesthetically make it better. Number three, maximize how much money it makes. We all know that basically the value of a mobile home park is based upon income, so let's maximize that income. Let's all the vacant units, whether it be mobile homes or apartments, or maybe mom and pops old stick built home, let's get all those occupied.
Let's raise the rent up to market levels, even if that means a significant increase, we live in a time of 10% inflation, roughly, no reason you should hold back on raising that rent aggressively. Let's cut costs where possible, let's fix water and sewer leaks and items like that, and get all that done, because all those things will help you get a loan later on. Finally, go ahead and get that park ready mentally in the form of that package. Don't let it fester where you say, "Well, I may need to get a loan at the drop of a hat, if the bank should suddenly call the mortgage, and then I guess I'll start working on my package." You wanna have a very well-crafted plan B. You need to all the time look at your financials, you need to have good photographs of your park ready to go at the drop of the hat, parks look much better during the summer months than they do during the winter months, when all the leaves fall off the trees. So start gathering all the things you need, keep them in a nice spot, maybe your plan B folder, so that you can jump out and immediately get a loan when you need to.
Now, how do you fix the name on the title issue though? Well, you know, that's a little harder, because unless you buy that park with the construction, where were you buying it through a title company with a loan on it, then you're not going to be able to achieve that. Now, you can mitigate that with a lower down payment, so that helps. But the big question when you look at these wrap note constructions that people do is, is it really worth doing it, or should you just get a traditional loan, the good old fashion way, right on the front end? Because that's the only way to care all the problems I've discussed. If you looked at that deal and say, "Well, I'm gonna do a wrap construction because, hey, I'm gonna get an interest rate that's a point or two less that I can get on a loan right now." Is that really smart? Is that really the best thing you can do? Is that really protecting your investment? Or are you perhaps taking out a little too much risk, going out a little too far on a limb just to hedge that interest rate a little bit? You know, you can always refinance that loan later. So if you get a loan right now and you say, "Well, I don't like this rate, and I like it better when it was lower." And in fact, we hit that recession in 2023 and the rate starts to decline, there won't be anything to hold you back to go ahead and get that refinanced, but that way you don't have these various other concerns.
The bottom line to it all is that wrap mortgages have been done for a long time. There are certain instances where they may be an attractive option. There are some instances where in fact there may be no problem in doing them at all, they may be fully allowable under the lenders' agreements. However, even in those cases, you do have risk as far as the title, so just be careful, use some good common sense, and you should be fine with those wrap mortgages. This is Frank Rolfe, the Mobile Home Park Mastery podcast. I hope you enjoyed this. Talk to you again soon.