Guest Article by Tracy Z. Rewey:
Want the security of real estate without the hassles of the 3 T’s (tenants, toilets, and trash)? Then it’s time to consider investing in real estate notes.
Be The Bank
When you own a promissory note, you are acting like the bank. You are the one receiving the payments. If something needs fixed the owner has to do it. And like the bank, you also have the right to take the property back in the event of non-payment. You can then sell the property for cash or take back another note.
A Note Investing Example
Seller financed mortgages and trust deeds are a staple of private note investors. The note is created when the owner of the property allows the purchaser to make payments over time rather than getting a traditional bank loan. While seller financing has always been around it has seen historical increases over the past 5 years.
The deals come in all shapes and sizes so we’ll look at one example of a well-seasoned transaction involving an owner-occupied 1971 mobile home with land in Texas.
The property sold with owner financing for $32,500 with 5% down. After collecting 95 monthly payments the note seller wanted to sell the remaining payments for cash today. The payer still owed a principal balance of $8,924.50 with 9% interest payable in 25 remaining installments of $392.88 per month.
With a slow payment history, delinquent taxes, and lapsed insurance, there were few interested investors. Satisfied with the equity position against the land value alone, my self-directed retirement account made a net offer of $2,531.
The seller, tired of the headaches and in need of cash, accepted the offer. The Note and Deed of Trust were endorsed and assigned to the Retirement Account Administrator for the benefit of (FBO) the individual retirement account.
By investing $2,531 for the right to receive the remaining payments the self-directed IRA was able to yield a return of over 180%.
The note eventually paid in full, however, if the buyer had stopped making payments the retirement account could have foreclosed and resold the property.
Tips for Investing In Real Estate Notes
After 25 years of buying and selling seller financed notes there have been both wins and losses. If you are just getting started these are my 17 tips for new note investors:
1. Learn From Others – There is no reason to reinvent the wheel. Learn and network with other investors to find the opportunity and minimize the risk.
2. Refer a Deal First – Before investing your own funds get some hands-on experience. Start by referring a deal to another note buyer and earn a referral fee. Once you understand the process then consider note investing for your own portfolio or with retirement funds.
3. Discover The Why – Get direct with the note holder to find out why the note is being sold. Does the seller need the money for another investment? Are their financial challenges? Is there a certain sum that will solve the seller’s needs or wants? Understanding the why will provide insights valuable to both deal structuring and due diligence.
4. Always Talk to The Payer – Go beyond the basic estoppel and actually talk to the person making the payments each month. You will be surprised the things you will learn. They might be in the process of refinancing (think early payoff), just lost their job (better rethink that ITV), or stopped making payments a year ago (funny the seller didn’t mention that). Better to know the good and the bad before writing that check.
5. Verify Everything – Some sellers lie. Sometimes it’s on purpose, sometimes it’s by omission, and other times they just don’t know the facts themselves. Make it a practice to verify everything.
6. Embrace The Boring – Due diligence can seem tedious and mundane. So can brushing and flossing every day. But we do it anyways. Why? Because it is essential to good health and preventing bad breath. Establish a checklist and follow routine due diligence procedures to ensure a healthy investment (and to avoid the deals that stink)!
7. Plan for The Worse – If the note stops paying you get to take the property back. Of course it takes time and money to initiate foreclosure and there is inevitably some fix-up or back taxes. There are no TARP funds for private investors. Be sure to keep the Investment-to-Value (ITV) at a level that allows you to get out whole at the end of the day.
8. Partials Are Your Friend – You don’t need to buy all the payments remaining on a note. Partial note purchases can be both the safest and most profitable transactions.
9. Master The Time Value of Money – Learn how to run a financial calculator. Understand the 5 keys to cash flow calculations and how to structure deals to increase yield and ROI.
10. Encourage Early Payoffs – When you buy notes at a discount an early payoff can mean increased yields. Take a solid 10% return and turn it into a 20% return by incentivizing the payer. We’ve used discounted payoffs, lower interest rates, and even a TV to encourage the payer to accelerate the amortization.
11. Originals Count – Get the original promissory note. Have the original note endorsed at closing and keep it in a safe place. If the seller is not the original note holder be sure there are endorsements that follow the chain of title. You will want this if you ever need to enforce your lien position or prove holder in due course status.
12. Seek Professional Help – Get title insurance and use the closing services of an attorney or qualified escrow agent. Seek advice from competent legal, tax, and financial advisors.
13. Use Solid Servicing Procedures – Track the payments each month including interest and principal applications. Act quickly to start collection efforts when payments are missed. Check to be sure real estate taxes and property insurance are paid when due. Use the services of a servicing professional whenever possible. It’s easy to get busy and let too much time pass before taking action.
14. Understand When Laws Apply – There are laws that may or may not apply to note transactions. It can depend on how the note was created, the state, and/or the number transacted each year. Do your homework on the Dodd Frank Act, Safe Act, RESPA, Fair Credit Act, SEC, and others to determine whether or not they apply and how to comply when necessary.
15. Spread The Risk – It is better to buy five notes for $50,000 each than one for $250,000. In addition to spreading the risk among several deals, smaller balance notes often provide greater opportunities for increased yields.
16. Know When To Fold – Once upon a time I bought a mortgage note without proof of property insurance on the collateral. It had been in place then lapsed the day of closing. Rather than pull funds or delay closing we finalized the deal. The house burned down over the weekend. While “Burn to Learn” makes for an entertaining story I should have played that hand differently.
17. Be Creative – To find value where others overlook you need to get a little creative. You can buy a 4% face rate note and still yield double digits. The seller that won’t take a discount might consider a split funding or 50/50 partial. Realize that most seller financed notes fall outside of some conventional lender’s strict guidelines. You will need to think outside the box to minimize risk, secure a good return, and still create a win-win situation with the seller.
Tracy Z. Rewey is the author of How to Calculate Cash Flows and co-owner of Diversified Investment Services, Inc. She has handled millions of dollars in owner-financed real estate notes and alternative cash flow purchases since 1988, becoming a well-known industry expert. Visit www.noteinvestor.com to receive a free eBook on the 5 Ways to Cash In on Notes.
