How many months of reserve a wrap seller should hold before writing the note

Question

A theme that shows up in nearly every wraparound mortgage failure story is the same. The buyer stops paying, and the seller still owes the underlying lender, on time, every month, for however long it takes to get the property back. A wrap that turns into funding someone else's mortgage out of pocket for a year stops looking like passive income and starts looking like a second job. So the real question is sizing the reserve. Say the underlying payment including escrow is 1,150. What reserve should a seller hold at closing before writing the note? The short-reserve argument is that the down payment plus a few months covers the realistic gap, since most buyers who miss a payment cure within sixty days, and money sitting in a reserve account earns nothing while the spread is the whole point of the deal. The long-reserve argument is that the timeline is not set by the buyer, it is set by the process, and foreclosure or forfeiture timelines vary enormously by state, with judicial states sometimes running past a year. A three month reserve in a twelve month state is really a plan to sell something under pressure. A middle position worth considering sizes the reserve in months of the underlying payment rather than as a flat number, using the state's typical timeline plus a quarter to account for the property coming back in worse shape than it left. The right number is state-specific, but sizing it to the actual foreclosure or forfeiture timeline, not to an assumed best case, is the discipline that tends to separate wraps that survive a default from ones that do not.

tylerbrooks9 · Answer

Twelve. Holding twelve and doing fewer deals outlasts holding three and chasing volume. The unexciting version of this structure is the one that lasts.

devon_pierce · Answer

The reserve is not only the mortgage payment. If a buyer stops paying, they have usually also stopped paying anything else, so add property taxes if they are not escrowed, and add whatever it costs to make the place rentable again if it comes back. At 1,150 a month the twelve month payment total is 13,800, and the realistic all-in reserve is closer to 20,000.

raj_mehta14 · Answer

Worth pinning down the escrow mechanics while sizing the reserve. If the underlying loan escrows taxes and insurance, and the wrap buyer was supposed to be reimbursing that inside their payment, does the seller's escrow account keep functioning normally through a default, or does something break there as well?

Rena Expert · Answer

Vellum, the escrow keeps functioning as long as the underlying loan is paid, because the escrow belongs to that loan and the lender collects it inside the monthly payment. The seller is the borrower of record, so the lender bills the seller and the seller's failure to pay is what breaks it, regardless of whether the wrap buyer paid the seller. That's the mechanism, and it's the reason the reserve has to be sized against the full underlying payment including escrow rather than principal and interest alone.

The thing that does break in a default is the annual escrow analysis. Taxes and insurance reprice, the lender adjusts the escrow portion, and the underlying payment goes up while the wrap note payment stays fixed at whatever was written. That erodes the spread over time and it erodes it faster on properties in markets with rising assessments. Sellers who price a wrap off today's underlying payment and never revisit it find the spread thinner in year five than it was at closing. Some wrap notes address this with a tax and insurance adjustment provision, and whether such a provision is enforceable and how it has to be disclosed depends on the state and on whether the buyer is an owner-occupant, so that's a question for an attorney licensed where the property sits.

On marlow's actual question, the variable that determines the answer is the timeline to regain possession in that state, which ranges from a couple of months to well over a year. Confirm your state's process with a local attorney before choosing a number, because the reserve is only meaningful relative to how long you'd be funding the underlying payment alone.

nicole_adeyemi · Answer

Escrow creep is the piece almost nobody prices. On carried land it is common to see taxes move 40 percent over eight years in a single county while the note payment stays fixed for the whole term. Same shape of problem here.

paulgrant17 · Answer

Voted for sizing to the state timeline. Also worth doing what a landlord does, which is screening the buyer as hard as a tenant. If you're going to be their lender for five years you should know their income, their reserves, and their payment history at least as well as you'd know a tenant's.

ehernandez74 · Answer

Wren, the wrinkle is that once you start pulling credit and evaluating ability to repay on an owner-occupant, you are in territory where licensing and disclosure requirements can attach depending on the state and how many notes you write in a year. Screening is still the right instinct. It just needs to be done in a way somebody licensed has signed off on.

kevin_lombard · Answer

So the reserve isn't really a reserve, it's the cost of the risk you took, sitting in an account with your name on it. That reframing helped me more than the number did.

How many months of reserve a wrap seller should hold before writing the note

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