Real Estate Notes

 “I’d rather have a mortgage payment than a rent check any day and not have the tenants, maintenance, contractors, townships, liability, etc.”

Whole mortgage notes is an alternative real estate investment opportunity that is plentifully available when the market is strong and wanes when the market is suffering.  Although they have some sensitivity to interest rates, residential whole mortgage notes are non-correlated with stocks or bonds and are therefore not affected by the performance of those two asset classes. Whole mortgage notes produce income from the underlying mortgages, and the investor also benefits from the “collateral gap” between the amount paid to purchase the note and its value when the note is paid off or refinanced, or if the home is sold. The mortgages are typically purchased from lenders at a discount.

How Note Buying Compares To Other Investments

The biggest differences are depreciation and appreciation. From a tax perspective, there are no depreciation advantages with notes. As for appreciation, the face of the note is the face of the note, but sometimes when purchased at a discount, there can be a “phantom appreciation” because note values directly correlate to property values. When real estate values go up the value of the notes go up. Another plus with purchasing a note is that you don’t need any credit, or have to “qualify” like you would have to do for a mortgage to purchase real property.

Many new note buyers are afraid of the “F” word, Foreclosure. If a tenant of a rental property doesn’t pay rent you have to take the tenant to court by filing for eviction. Not only do you lose rent, but you have to evict them, pay court costs, fix the property and re-rent the unit. Usually, without recourse since many tenants do not have assets. With a homeowner, if they miss any payments and there’s equity in the property, you can collect the missed payments, late fees, corporate advances and any attorney fees. By attaching these items onto the loan balance, per your loan documents, you will recover these fees at some point, as long as there’s enough equity. There’s also a significant difference between a homeowner’s mentality and a tenant’s mind set. The homeowner usually has more invested into the property like “pride of ownership” and “sweat equity”.

How Note Buying Compares To Other Investments

1. Collateral

With a note and mortgage you have a secured lien. Risk is relatively moderate, especially with equity to protect the mortgage. “It’s better to have a bad loan with equity, than a bad tenant “. Mortgage notes with a 30% – 40%  equity cushion are a safe and highly collateralized investment.

2. Control

Notes tend to be easier to manage than real property. As an investment, they also tend to be more passive. In effect a note turns tenants and toilets into mailbox money. Wells Fargo or Bank of America do not get calls about plumbing leaks. Location doesn’t tend to be as big of a factor when owning the note. It’s easier to own notes in areas that you might not want to buy and hold real estate, especially short term. There’s often less liability and responsibility with owning notes. With notes, not only do you tend to avoid dealing with tenants, contractors and townships, you also tend to avoid issues with vacancies and maintenance.

3. Profitability (Cash Flow without Tenants)

Notes and mortgages usually offer comparable returns to hard real estate investing after factoring in management and maintenance. Non-performing notes or notes bought at a discount can even exceed today’s private money mortgage yields that can range from 8%-18% plus discount points. So just like real estate, you make more money when you buy and you can make even MORE money when you rehab the note (just like rehabbing the property). And let’s not forget, there’s a lot less competition when you’re a “lien-lord” versus a landlord because other than large hedge funds there are fewer individuals working today in the note space. The reason there’s such a high probability of achieving superior returns with notes is that they can be purchased at a discount. When purchasing notes at a discount, you make your money when you buy. Your profit is derived from the banks’ inefficiencies. You don’t usually make money off the borrower’s equity.   

4. Opportunity and Creativity with Notes- Selling/Buying Partials

Another opportunity, one that is not well known is either buying or selling a partial. When an investor purchases all the remaining payments it is considered a full purchase. When an investor purchases just a portion of the remaining payments it is considered a partial purchase. In effect it is a 1st on a 1st. Once you have bought one cash flow, it’s easy to go to the performing payor and negotiate the next stream since the paperwork done on the initial deal is saved. Typically the buyer of the partial gets paid before the assignor gets theirs. If the collateral is sold or goes through foreclosure the remaining balance goes back to the partial note buyer then to the partial seller.

For example, a note has a balance of $100,000 at 10% interest payable in monthly installments of $878 with 360 months (or thirty years) of payments remaining. When the seller sells all 360 remaining payments of $878 to an investor it would be considered a full purchase.

If the investor only sold the first 132 monthly payments of $878 each for $69,900 to a partial investor, this considered a partial sale. Once the partial note buyer received the next 132 months of payments, the note would be reassigned to the investor and the investor would collect the remaining 228 payments (360 total payments less investor’s partial sale of 132 payments leaves 228 payments remaining to the investor). The back end –remaining payments could be placed in the investors Roth IRA.

One can maximize the return on investment by accelerating a settlement. It is not uncommon that a note/mortgage may be paid off early either with a refinance or property sale, the note’s paperwork would reflect the following. Assume an early payoff after 60 months. The unpaid balance (UPB) is $97,574. It is split between the investor and the partial note buyer investor. The partial investor receives $47,291 and investor receives $49,283. 

5. Volume

The typical note buyer can manage more loans than properties. Loan counselors can handle as many as 15-25 loans per month. How many properties a month can a real estate investor handle? 25/month is unlikely.

Loan Servicers are more affordable than real estate property managers. Property managers can be anywhere from 8-10% of gross rents, sometimes lower if given a large number of units and they often charge one month’s rent to find a tenant. Loan Servicers, on the other hand, have a one-time set up charge of $25-$170 or so, and monthly fees can range from $15 – $35/month. There can be similar monthly cash flow on a performing note, as there is on a typical rental property. Many times, real estate investors leave a substantial amount of money in a property, in the form of sweat equity, (70-80% LTV).

6. Versatility (anything you can do with a house, you can do with a note)

You can do almost anything with a note that you can do with real property.

· You can flip or wholesale a note. 

·  You can rehab a note. (turn a non-performing note into a performing asset.)

·  You can refinance the borrower.

·  You can sell the full note or you can recoup your original investment by selling a partial.

·  You can borrow against the note, since it’s an asset, also known as a “Collateral Assignment” or “Hypothecation”.

Some Other Benefits Through Investing With Notes

· Increase your IRA or retirement account returns by using these funds to invest in notes.

· Increase your cash flow from equity in real property.

· You can borrow against the equity in a property and invest in a note to increase your return from that same property.

· Increase your return on investment (ROI) on equity when selling real estate by offering terms. For example: “Holding Paper” or “Owner Financing”, Carrying a second mortgage, often allows the seller to achieve a higher selling price.

· Better financing and leverage when buying real estate through the use of Notes and Seller Financing. You can get a higher return (ROI) on a rental property if the seller assists the buyer with financing.

· Private Notes used for “Rehab Loans”, are usually more affordable than a hard money lender.

  The real estate market in 2007 and 2008 was devastated in the likes that we haven’t seen in many, many years. Market conditions have placed a huge burden upon lenders as they find themselves saddled with a massive inventory of non-performing loans(notes). Under normal circumstances, the lender will try to work the problem out directly with the borrower. If that proves unsuccessful, the lender then begins the foreclosure process in order to recover the collateral.

In today’s market, there are simply too many non-performing loans for the lenders to effectively resolve them relying on the same old processes. Lenders are not as adept at quickly adapting to market forces resulting in trillions of dollars in non-performing notes waiting for resolution and it is growing much faster than the lenders can handle.

The growing trend for resolution is the direct sale of the non-performing note where the lender simply decides to let someone else deal with the problem. The bank realizes what’s on their balance sheet is not only non-performing, but has not yet gone through the foreclosure process to wash out the liens and other clouds on the title that keep the property from re-structuring towards a performing asset again. Often, non-performing notes involve a lot of work and expense. Over the life to the process it could reach as high as $50,000/property. This is due in part to the high cost of foreclosure which typically can run has high as $25,000, not to mention the cost to manage the REO, possible fix up and other related selling costs. The bank realizes this and prices the asset very aggressively to sell.  It is cheaper for the lender to sell the non-performing notes, these “toxic” assets, in pools to hedge funds with a discount to a buyer (like hedge funds). This process allows the lender to quickly recover its capital without the time and expense of foreclosure and subsequent marketing and sale of the property.

The hedge funds in turn will sell the notes as a one off to individual investors that are either interested in the note, or interested in acquiring the underlying collateral. The hedge funds will rent out or lease option the properties with values exceeding $125,000 for and hold them for 3 years.

However, most of these notes are in the $125,000 range. Upon purchase, the note buyer “steps into the shoes” of the lender and assumes all rights and remedies that the lender had under the loan documents. This is accomplished primarily by the assignment to the borrower of the loan documents; including the note, the mortgage and security agreement and, if applicable, the guaranty.

However, while the buyer obtains all of the benefits held by the lender, it is equally important to remember that he also obtains all of the burdens. This includes the risk that the loan documentation history may be flawed, that the borrower may refuse to cooperate in either a modification or a foreclosure alternative and the risk that pursuing foreclosure may take much longer than expected. In other words, just like the lender, the borrower now holds a note that is not performing and which will require resolution

When buying a non-performing note, the buyer must determine:

· The buyer should conduct due diligence on the loan documents

· Identify all the Stakeholders

· The borrower’s financial condition.

· Are they open to a loan modification?

· Are they motivated and have the means to fight a foreclosure?

· Or will they file a bankruptcy to delay the process.

In addition to the above and like any other real estate investment, one must determine the appropriate exit strategy. In other words, just like the lender, the borrower now holds a note that is not performing and which will require resolution. Those options include the following: 

· Acquisition Phase–Buy or broker the deal

· Modification Phase

· Property Based Solution

· Paper Based Solutions

For many buyers, non-performing notes are attractive investments because they typically trade at a large discount off of the secured property’s perceived value. In fact, it is not uncommon to see non-performing notes trade at a discount of up to 80% or more off of the unpaid balance. It should be remembered, however, that this discount is a reflection of the note’s distressed condition and/or the condition of the asset.

Non-performing notes do have great investment potential. However, a buyer should not assume that a non-performing note is a guaranteed shortcut to acquiring the underlying asset. The prudent buyer will conduct thorough due diligence, not just on the underlying property, but upon the borrower, the lender and the status of the loan documents. The buyer must understand why the property is distressed and what additional expenditures in time and capital will be necessary to either bring the loan back to a performing condition, or to recover the underlying asset. When a buyer understands these issues, he will be able to assess whether the discount being offered is sufficient enough to justify the risk.

Hardly any other asset can offer such aggressive pricing and strong rewards for investors. As the housing correction continues to take place for the next several years, more and more opportunities will be available for investors who are well-positioned and willing to take on risk for big rewards. It is the perfect option to control real estate with an option and not have any of the downsides associated with property ownership for pennies on the dollar. An incredible once-in-a-lifetime market condition.

Definitions vary a bit, but re-performers (also known as “scratch-and-dent” loans) are generally considered loans in which the borrower missed at least one payment and has since gotten back to “current” status either to the original contract or to a new and permanent loan modification. Modifications are more common, which is the type of re-performer that needs a special approach. Many times the borrower may have lost their job or had personal/medical issues. They are re-employed or have regained their health. They were a good risk and can become a good risk again. They still have an emotional attachment to their home. They do not want to move and just need a helping hand. This is in contrast to a non-performing loan, in which the borrower has not made payments for over 90 days and has not resumed repayment of the loan.

To begin assessing how to maximize the value of a re-performer, it is important to understand certain key characteristics of the loan (essentially the quality of the modification itself), the property and of course, the borrower. Assessing the risk involved with a particular note is to understand what the history has been between the borrower and the lender; or more specifically, between the borrower and the special servicer who is the entity that attempts to resolve non-performing loans on behalf of a lender. Managing modified loans, lenders and investors can do many things to increase their odds of having successful experiences with borrowers who have had a second chance after defaulting on their original home mortgage. Some lenders perform this function in-house; others source it to third parties. Either way, the history between the borrower and the special servicer can provide you with valuable insight into what to expect with the borrower.

It is crucial to understand how the loan, the borrower and the property all relates to each other. How much emotional equity does the borrower have in the property?  Is the property maintained? Does the family have children and want to stay in the same school system? It is the inescapable loan-level uniqueness and complexity that makes it difficult to use one formula to manage all re-performers. Study the modification itself to identify critical items. Is it a HAMP loan? If so, how much will the payment increase and when? Changes in interest rates can have meaningful effects on payment amounts. These changes can be even more dangerous if a borrower’s employment or income situation is worsening or if local home prices in the same area are decreasing. The odds of the borrower defaulting again on a HAMP loan run as high as 65%. The odds of a borrower defaulting on a note that has been modified the payment, interest rate and/or principle to meet the current needs of the borrower are about 10%.

Maintaining a single point of contact for the borrower even when it is re-performing can pay dividends (literally). Recognizing this, the servicer should be able to customize how it positions its people, process and model for re-performers in order to improve performance.  Therefore a vital aspect of managing re-performers is ensuring that there is perfect alignment of interests between the note owner and the servicer so that any potential conflicts are minimized or eliminated.

If you own a note, how is it serviced?

What are the headaches? How do I get paid?

Think of it as a passive income stream with a relatively high rate of return. The loan servicer is the point of contact for the borrower. The borrower pays the servicer the monthly payments. The servicer pays you a monthly check.

RE-PERFORMERS PAY DIVIDENDS

Given the number of modifications that have been done since 2008 and the lack of yield across the credit spectrum today, the opportunities and risks associated with the re-performing loan market deserves some attention. Once the current payment history is seasoned for 6-12 months, the re-performing note is as viable as a normal performing note with no late payments, but can be purchased at 60-70% of UPB (unpaid principal balance) verses 85% of UPB.

In this example, the investor bought a $100,000 re-performing note with 360 payments remaining for $70,000 and at maturity will receive $100,000 plus the interest. This result in a much higher ROI than just the interest rate of the note due to the 30% discount at acquisition.

Return on investment is the key to most people. Loans normally have a life cycle every 7 years. The borrower usually moves or refinances. The sooner the note is cashed out, the higher the yield for the investor. If the holding time is shortened, then the return on investment becomes greater. If the loan is paid off in 7 years, the investors yield will be significantly higher than the above rate of return.

A goal could be to create a portfolio of as many discounted notes at the best price we can get them and collect the cash flow and hope some homeowners are going to sell or refinance early before maturity. Some investments are going to settle, they’re going to close, so you’re not always going to have exactly the formula that you want. But you’re always going to get nice results. So understand that re-performers pay dividends, because you have many options for them.