IC Elesson: Why You Need to Know Notes
After this past weekend’s No Excuses Retirement Wealth Summit (an event you REALLY should have attended…ask anyone…) I got to thinking about the fact that there were, in my estimation, 5 multi-millionaires in that room, and they all had one (well, another) thing in common. Know what it was? They were super-comfortable with, and commonly used, NOTES.
I don’t think that it’s a coincidence, either. Notes are REALLY useful things to know about, wherever you happen to be in your real estate career…and later on, when you have more money than you know what to do with, they’re a relatively easy way to deploy large amounts of money without adding a bunch of hands-on work to your life. And that’s kind of the point, right? More passive income?
Here, let me explain more.
Notes are, of course, debt instruments. They’re a document that says, “Borrower A owes Creditor B this much money, at this rate of interest, with payments of this much, with a final payment due on this date”.
Here in the real estate world, “Note” usually means “Mortgage note”, which is to say that there’s a second document attached to the note that’s a security instrument. That document is the mortgage (or deed of trust, if you’re from that part of the world), and IT says “Furthermore, if Borrower A doesn’t pay said amount as agreed, Creditor B gets to auction off property C in order to get his money back”.
If you deal in real estate, you’re eventually going to deal in notes, because you’re eventually going to borrow some money from SOMEONE (a bank, a private lender) or you’re going to take a property off of someone hands and promise to pay them (in the case of owner financing) or pay their bank (in the case of a subject to deal) over time. All of those activities are going to involve notes, so ya better get used to the idea.
Notes have a lot of advantages that people who don’t deal in them don’t think about. For instance:
- Notes, like real estate, are sellable and tradable, but in many ways, they’re MORE liquid. A note is a payment stream that generates a certain rate of return on the money that the noteholder has invested in it. As such, there’s a market out there of people who want to buy notes, just like there’s a market of people who want to buy real estate for income. And, just as there are people who want distressed properties that they can fix up and get a higher return on (or sell for a profit) and people who want ‘turn key’ properties at a lower rate of return, there are also people who want distressed (non-paying or only kinda paying) notes at high rates of return and notes with great, long-term payment histories at lower rates of return. But while most people would be uncomfortable buying a piece of property all the way across the country, they wouldn’t be uncomfortable buying a NOTE on a piece of property across the country.
It’s been my observation that notes (depending, of course, on the quality and the yield of the note) are actually easier to sell, more quickly and to a nationwide market, than houses.
- It’s hard to sell part of a property and easy to sell part of a note. These note guys are always talking about “selling partials” on notes, either to raise money for another investment they want to make, or to get back the money they paid for a discounted note.
Here’s how that works: let’s imagine that I have a note with a $35,000 face value at 9% that has more 100 payments due from the borrower of $500 each. I need $20,000 to go, I don’t know, close a house. I can sell the next 48-ish payments of that loan to someone else for $20,000 cash. What the buyer is purchasing for his $20,000 is the right to collect $24,000 worth of payments over the next 4 years. The cool part is, when those 48 (really 47 and some change) payments are over, the payments start coming to me again, and I get the remaining 52 $500 payments.
It’s kind of hard to do that with a house, and when you do, you’re typically giving up part of the control and profit PERMANENTLY, not temporarily, as with a partial note.
- Created or bought correctly, notes are actually LESS risky in some ways than real estate. Years ago, I asked a private lender why he made loans instead of buying properties. After all, the downside of a note is that it typically becomes LESS valuable as time passes; the amount owed drops each month until it reaches zero. On the other hand, the piece of real estate that secures it could, conceivably, get MORE valuable every month, as the tenant pays off the note and appreciation (and inflation) carry the value of the property up.
His answer was this: “No matter what happens with the PROPERTY, my money is still due. My borrower can lose money or make money, but if he keeps his promises to me, I ALWAYS make money”.
In other words, some of the things that can go wrong with a property that are (more or less) out of your control, like the neighborhood declining or the rehab costing more than you thought or your tenant discovering crack and doing $25K in damage in 2 months, is YOUR problem, not your lenders’. You still owe the money, and if you don’t pay it, the lender will take your property, and if that doesn’t pay him back, he can usually come after you personally for any balance.
That doesn’t mean that notes are risk-less. Borrowers can declare bankruptcy, or be uncollectable, and there are lots of things you need to evaluate about the note and the security before jumping in. But, ya know what? He had a good point about the whole “I’m getting paid even if you don’t” thing.
So, at some point, you should maybe stop being the person who OWES money and start being the person who GETS money on a note, and that’s what all these millionaires were doing. Now, I know what you’re thinking: “ME, being able to loan money to other people?? That’s a long time off in the future. Right now, I need my money for MY deals and MY lifestyle.”
But, as with most real estate-related assets, it’s not actually necessary that you have a lot of cash in order to make money from notes.
I’m not here to try to teach you the note business—it’s not my primary strategy, and there are a lot of folks out there with great education and a lot more experience than I have in the topic. In fact, I’ll recommend one at the bottom of this page.
But I would like to give you a few quick ideas of some strategies where you can use notes to make money without having a lot of money.
- Buy a property with someone else’s money, sell it at a higher price and payments on a “wrap”. I’ve done this many times over the years, usually with cheap distressed properties that I then sell, as-is, to investors who wants to fix them. Here’s the basic strategy:
I find a junker house, typically in a rental area. EITHER the seller is willing to carry financing, OR I find a private lender who wants to invest a small amount of money in a fully amortizing 5 year loan. In my market, this property would be a $50,000-$60,000 house that I’m buying for $10,000-$20,000 because of the condition and because I’m magic.
So I borrow, let’s say, $20,000 at, let’s say 6% interest from a private lender. I have no money in the deal at all. I sell it for $29,900 with $6,000 down, and I carry financing for the buyer for the balance—$23,000—at 10% interest.
If you’re asking, “Wait, how can you sell the property without paying off your lender?” then you’re forgetting: I’m magic. And also, my lender doesn’t want to be paid off, he wants his 6% interest. And also, there’s a clause in my note with my lender that says I don’t have to pay him off as long as 1. The security (property) remains security for his loan and 2. I agree to stay responsible for making his payments, and don’t try to pass that responsibility on to my buyer.
So the result is that there is a total of $43,000 in notes due on this property—but the $23,000 owed to me is a “wrap mortgage”, which means that it INCLUDES the underlying $20,000 mortgage, which means that it says that I’m responsible for aking the payments on it. And what I’m collecting is 10% interest on the $3,000 difference between what I’m owed and what I owe, and…wait for it…4% on my lender’s $20,000. All with no investment (except my knowledge and magic) on my part.
- Flip notes. Just as you can find an undervalued property, put it under contract, and sell the contract to someone who wants to pay more, you can do it with both performing and non-performing notes, too.
- Buy and reperform defaulted notes. One of my students, who spoke at last weekend’s Retirement Wealth Summit, found not one but TWO defaulted seller-held notes in the last 6 months. He paid $500 for one and $1200 for the other; the borrowers owe him over $30,000 between the 2 notes. If he can get the borrowers paying (that’s usually done by cutting their payments, often by extending the loan), he’ll get an umpteen jillion percent return. If he can’t, he’ll spend another few thousand dollars foreclosing, and probably get the properties (worth more than the loan balances, even as-is) at the courthouse steps. Either way, he’ll have well under $10k in both of these deals.
- Not to blow your mind, but…here’s a little strategy I learned recently but have yet to try. Let’s say that you know a nice, experienced, solid investor who’s looking for a $100,000 loan to do a rehab. You only have $1,000. But your rich uncle Joe has $99,000 that he’d love to get out there at 10% interest, if only he could find the right deal.
Remember that wrap thing we talked about earlier?
What’s to stop you from telling the investor that you’ll get him the money, but that he’s going to have to agree to 2 mortgages, one for $99,000 at 10% to uncle Joe, and one at $100,000 at 15% with you?
Wait, you say…why would the investor do that?? Well, because his goal isn’t to dither about how it happens, it’s to close his rehab so he can make some money. He was willing to pay for a $100,000 hard money loan, and that’s what he got.
But what about Uncle Joe? Why would he be willing to let me make money on his money? Easy—he doesn’t want to manage the loan. By manage it, I mean find the borrower, review the deal, make sure the paperwork and closing are done correctly, make sure the rehab is progressing (and that the rehab funds are being released on schedule), chase payments if they’re late, etc.
So, in conclusion, notes are something that you might want to start getting comfortable with, even if you don’t feel like you’re ‘there’ yet. Rich people do them. Maybe you should, too.
A great place to get more of a start on learning these? The 2017 OREIA National Summit, November 9-12 in Cincinnati. It’s 4 days with 800 colleagues and 17 expert presenters, including a couple related to what we just talked about:
Strategy #1 (buy houses cheap and “note them out” at higher prices) is the specialty of Larry Goins, who just signed on to the event this week. He’s got a whole system for finding people who want these deals, and of course the deals themselves.
Strategy #2 and 3 will be covered at the event by Scott Carson, who’s nationally known for his defaulted note expertise, but a first-time speaker at OREIA.
For the next couple of weeks, you can sign up at a deeply discounted price ($157 for all 2 days, $197 if you’re bringing a spouse or partner) at www.OREIAConvention.com. I hope you decide to make the trip—it’ll be the highlight of your year.