When Money is Tight, Wraparound Loans Get the Job Done
A good way to understand wraparound mortgages ("wraps") is to follow a little story. Once upon a time Ida Investor bought an office building. The cost of the office building was $1,400,000 and she put down $350,000 (25%) in cash. Hometown Bank made a $1,025,000 new first mortgage for ten years at 6.25% interest.
Ida Investor made a shrewd investment. The City of Hometown started to boom. The value of her office building skyrocketed, and just four years later Bobby Buyer offered to purchase the property was a whopping $2 million.
The problem was that commercial loans had dried up. Neither Hometown Bank, nor any of the other banks near Hometown, Montana, were making any new commercial loans.
Fortunately Ricky Realtor, Ida's real estate broker, had a solution. Bobby Buyer would give Ida Investor $400,000 in cash (20%) as a down payment.
Ida Investor would then carry back an all-inclusive mortgage (wraparound) in the amount of $1,600,000 at 7.25%.
Bobby Buyer would pay Ida Investor one payment every month, an amount sufficient to amortize a mortgage of $1,600,000 at 7.25% over 25 years. It would then be Ida Investor's responsibility to make the payment on the existing first mortgage, which had been paid down from $1,025,000 to just $1,000,000.
Since Ida Investor's existing first mortgage balloons in just six years, the all-inclusive mortgage (wraparound mortgage) would have a similar due date. These two mortgages would be coterminous; i.e., they have identical maturity dates.
Why bother with the wraparound structure? The reason is because Ida Investor really wanted all cash on the sale. She didn't want to carry back a garden-variety second mortgage at a lousy 7.25% interest. Bobby Buyer, however, would never agree to pay Ida Investor 9% interest on the second mortgage. He was way too stubborn.
The wraparound structure solved the problem. How? Remember, Ida Investor's old first mortgage had an interest rate of just 6.25%. The amount of the old money - wrapanese for the existing mortgage being wrapped - was $1,000,000.
The amount of the new money - wrapanese for the amount of the equity inside Ida Investor's new all-inclusive mortgage - is $600,000. Remember, the gross wrap was for $1,600,000 and the existing mortgage was $1,000,000. Therefore Ida Investor's equity in the wrap is $600,000.
Now let's get back to Ida Investor's return on her equity in the wrap. She's earning the wraparound interest rate of 7.25% on her $600,000 equity inside the wrap, which works out to be $43,500 per year in interest income.
But Ida is also earning 1% interest - the difference between 7.25% and 6.25% - on the existing $1,000,000 first mortgage that is being wrapped. This is an extra $10,000 per year in interest. If you add $10,000 to $43,500 you get $53,500 in annual interest income on Ida Investor's $600,000 equity in her wrap, or an annual interest return of almost 9%.
Look for more wraparound mortgages to be made on commercial properties in the coming years, as the banks remain tight-fisted about making commercial loans.
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