Passive Income Investing in Mortgage Notes | PREI 012
In this episode we talk to David Campbell, the founder and Hassle Free Cash Flow Investing. He started investing in real estate part-time while he was working as a full time high school band director with zero net worth. Within six years and before the age of 30, David had become a financially independent millionaire through the vehicle of part-time real estate investing. David has been involved with new home construction, land development, commercial real estate and has been focused as a professional mortgage note investor for over a decade.
You will learn:
- How to make money as the bank by acquiring an income producing mortgage note secured by quality real estate.
- Why now is the best time in the market cycle to acquire a mortgage note.
- How to buy a mortgage note to create a portfolio of tax-free and tax-deferred passive income for life.
- Why the most savvy investors are buying real estate outside of their IRA and buying mortgage notes inside their IRA but usually not the other way around.
Get your FREE copy of David’s white paper on Mortgage Note Investing by emailing him at [email protected]
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Passive Income Investing in Mortgage Notes
Today’s show is all about passive income and specifically, it’s about mortgage notes. I have a long interview here with a good friend, who is involved with mortgage note investing and he has been for over a decade. He’s very successful at it. He has a very large portfolio of notes, and he really understands the ins and outs of mortgage note investing and how to profit from it.
It’s my pleasure to welcome David Campbell to the show. David is a founder of Hassle-Free Cash Flow Investing. He started investing in real estate part-time while he was working as a full-time high school band director with zero net worth. Within six years and before the age of 30, David became financially independent. In fact, he became a millionaire through the vehicle of part-time real estate investing. David has been involved with new home construction, land development, commercial real estate and he has been focused as a professional mortgage note investor for over a decade. Welcome to the show, David.
Marco, it’s a pleasure to be here with you and your audience.
Thanks. It’s great having you here. Just give our audience a sense of geography. Where are you located?
I am in a suburb of San Francisco.
Today’s subject is about mortgage note investing. I need to be honest with our audience. I am not a big fan of “paper assets.” However, I do make an exception with mortgage notes. The reason is because it’s actually an IOU that is backed by a real tangible asset, which in this or my case, would be real estate. That’s the only thing I would invest in. I like mortgage notes for that reason. The other thing is, our show’s theme is passive real estate investing, so this fits right in with that model of passive real estate investing.
I think the best place to start for people who are not that familiar with what notes are or mortgage notes specifically is maybe you can explain what mortgage notes are and what they look like.
A mortgage note is shorthand. It’s a way of saying promissory note secured by a piece of property. That security instrument can be either a mortgage or a Deed of Trust. It depends on what state you’re doing business in or which security instrument you’re using. It’s a two-part instrument and they move together. The promise to pay which is called a promissory note, which states how big the loan is, and what the interest rate and the terms of the loan are. That security instrument which is the mortgage note or the Deed of Trust, that’s the thing that ties that note to the piece of property and what makes that promise to pay have much strength. It’s either the borrower pays you as agreed or you get to foreclose on that property, and ideally foreclose on that property for pennies on the dollar.
You are talking about two parts. One thing but made up of two parts. You’ve got a note, which is the promise to pay or a promissory note. Then that is piggybacked with another document which is the security instrument, and that’s either a mortgage or a Deed of Trust depending on what state you’re in, correct?
That’s correct. The difference between a mortgage and a Deed of Trust is that a Deed of Trust is what’s called a non-judicial foreclosure action. If someone doesn’t pay you, then you file a notice in the public record that it’s such and such a date. On the courthouse steps this property will be auctioned for sale. That’s it. As long as you comply with the timing and the noticing, then that sale goes through. A mortgage is different from a Deed of Trust in that you have to go to court to get the court to foreclose on the property for you.
Fundamentally they’re conceptually the same. It gives the right of a lender to force a borrower to sell the property for the benefit of the investor or lender. I have a slight preference for a Deed of Trust because it’s simpler. It’s usually faster and less expensive to foreclose on a Deed of Trust. That being said, the vast majority of mortgage notes if they’re written in a conservative fashion, they do not get foreclosed upon. The vast majority of the notes that we work with in our company are performing as agreed. It’s pretty seldom that we have to foreclose on a property.
That was the next thing I was going to ask you, but just for clarification. This is more of a side note, but the difference between a judicial state versus that with a Deed of Trust is a foreclosure in a state that goes through the judicial system can take literally years before it goes through the system. That’s the problem with states like Florida. There are such a backlog of foreclosures that there are still foreclosures in the pipeline that haven’t gone through the system because it’s held up in the court system. Whereas a Deed of Trust can take 90, 120 days to go through the system and complete a foreclosure from the time it’s filed, right?
That’s correct. My favorite state to buy mortgage notes in is the state of Texas. The state of Texas is a Deed of Trust state. In Texas, you can foreclose on a property, and uncontested foreclosure is going to be about 120 twenty days and less than $1000.
Another thing I really like about owning mortgage notes in Texas is it’s a deficiency judgment state, which means that if you foreclose on a property and the foreclosure sale doesn’t create enough cash to satisfy everything that’s owed to the lender, then in Texas, you can also sue the borrower for the deficiency, the amount that they didn’t pay you. You can actually do the Deed of Trust foreclosure and then separately sue the borrower for the deficiency afterwards.
In our business, we’re focused on notes that are producing a high-interest rate, a higher yield, which usually means that the property is strong, the loan-to-value is strong, but the borrower is sometimes slightly weak. It’s usually a credit score deficiency. In our lending business, we’re primarily asset-based lenders, meaning we do underwrite the borrower to make sure they can afford the loan. In terms of collecting, we are primarily looking at the property and the equity in the property to collect upon. Even though we have the right to pursue a borrower for a deficiency, it usually doesn’t work out because the borrowers aren’t very collectable. But what that deficiency judgment ability means is the borrower knows that they should cooperate with a short sale or a deed in lieu for closure, or just sometimes Cash for Keys that they’ll walk away from the property in the loan if they get into nonpayment situation because they could be liable.
For example, in states where there is no deficiency judgment, some borrowers just get mad at the lender, and they trash the house on the way out because they know that the lender’s only recourse is getting the property back. In a recourse state, if the borrower trashes the property in the way out, it means the property is going to sell for less money, which means the deficiency judgment on that borrower is potentially significantly larger. You got a lot more leverage with borrowers in the state of Texas where this Deed of Trust and where there’s deficiency ability, a deficiency judgment.
There are different types of notes, and you’re talking about notes from an origination perspective meaning that you’re the one writing or creating or funding that note. That’s one side of the equation. There’s the other side where you could be an investor in a note. Explain notes from the perspective of the originator of that note or the holder of the note. Talk about the different lien positions because you can be in a first, second, third position with a note, then the difference between a performing versus a non-performing note. I know that’s a lot I’m throwing at you but if we can just chunk it down that would be great.
I’ll start with the simple and go to the more complex. A non-performing note is a note where the borrower is not paying as agreed. A lot of people invest in non-performing notes. It’s an existing note. It’s performing. Someone else originated it. The person who wants to buy that non-performing note, their goal is usually to foreclose on the property because they think that they can buy that note for less than the property is worth. Their goal is to go through the foreclosure process and to own the property. We call that loan-to-own. They don’t ever want to be a mortgage note investor. They want to be a real estate investor and get title to that property through the foreclosure process.
Our business does not deal in non-performing notes. We deal in performing notes. Oftentimes, when you go to a bank and you borrow money, or you go to a mortgage broker and they make a loan for you, pretty commonly, a month or two or three months later, you get a letter in the mail that says, “Don’t send your payment to us anymore because we’ve sold your mortgage to a different company.” That can happen two or three or four times, even at the beginning of a mortgage. The reason is there are people who are in the business of originating notes, and there are people that are in the business of holding notes for income. It’s the difference between someone who wants to have a job, that’s the loan originator or business in originating notes and that person who wants to be an income investor or to have bonds basically. Mortgage notes are different type of bond. It’s a promise to pay back by real estate.
Our company goes through the hassle and the complexity of creating the mortgage notes or finding existing notes where the lender wants to sell those notes to our clients. Sometimes our company will buy notes and resell them. Sometimes we just connect an existing note to an investor who wants the income stream. The reason someone wants to sell a note is either they want to rebalance their portfolio. Sometimes, someone, they sold the property with seller financing, and then their life changed, and they want to sell that note to get a lump sum of cash to do something with. Sometimes people really want to just turn their money quickly. They originate a loan. They make one-point or two points origination on that loan. They want to sell that as quickly as they can, so they can use that money to originate another loan and make one or two points.
There are a lot of different motivations in the mortgage business. What we work with our clients that want either through their self-corrected IRA or through this their personal checking account, they want to acquire an income stream that’s paying interest rates of 8% to 10%. That’s very well secured in the first position by real estate.
That brings to your next question about lien position. The note is just a promise to pay, and then the collateral is the Deed of Trust that’s secured against that real estate. The real estate, if it’s sold, the first person to get paid is the person who’s running the foreclosure auction. Then the next person who gets paid is any outstanding property taxes on the property. Then after that if there are any financial lien holders on the property, they get paid next. The lenders on the property get paid next. The very first lender in line to get money at the foreclosure sale is the first lien holder. That first lien holder from the foreclosure sale gets all of the net proceeds of sale until they’ve been paid back all their principal interest and any late fees and foreclosure fees that they’re owed. The next person that gets paid at that foreclosure sale would be a second lien holder, if any. Potentially, there could be a third lien holder on that property. Once all of the lien holders on that property get paid, any additional money from the foreclosure sale usually goes to the person who was foreclosed upon the property seller.
That would be remaining equity?
Correct. What happens often in a foreclosure sale is the lender show up to the foreclosure sale. Let’s say it was $120,000 property and the lender is owed $75,000 that would be 75% loan-to-value. The lender shows up to the foreclosure sale and there are no bidders. Then the trustee who’s running the foreclosure sale says, “We open the bid in the amount of the outstanding indebtedness in favor of the first lien holder.” If there are no other bidders, then that first lienholder can basically purchase the property for the amount of their lien and they own the property now. If there are multiple bidders at the property auction, which would usually happen in a low loan-to-value loan situation. If the loan is only 20%-30% loan-to-value in the properties in the major metro, you can be pretty sure that someone is going to show up to that foreclosure auction and just pay you off as a lender.
If you’re a lender in the high loan-to-value situation, you’re in a rural place, it’s possible no one’s going to bid on that loan, and you’re going to wind up owning that property as the lender. That really brings you back to the fundamental principles of lending. If you want to be happy if you get repaid because the interest rate is high enough to be a good rental fee on your money, and then you have to be happy, sometimes happier, if you don’t get repaid because there’s enough equity in that property to cover the time and the hassle and expense of going through a foreclosure and reselling that property.
Oftentimes, people make more money through the foreclosure process than they would as a lender. I personally want all of my borrowers to succeed. When we make loans and we buy existing notes that are performing, I really do want the borrowers to succeed. But if they don’t succeed, I am not going to skip a beat in foreclosing because they made a promise to pay and if they don’t meet that contractual obligation to pay, then it’s the lender’s right and responsibility to foreclose on the asset to protect their investment.
It’s my understanding that a very small percentage of these notes are actually foreclosed on, you don’t actually go through the entire foreclosure process and take title to a property other than maybe in a few cases.
That’s correct. It really depends on how well those loans are underwritten at the very beginning. Specifically, when we underwrite our notes, number one, the most important thing to us is the value of the asset, the condition of the asset and the loan size relative to that asset. As a company like to be 75% loan-to-value or less, a smaller loan-to-value is better for a lender because it gives you more security, more protective equity both from a non-performing borrower and from a potential decrease in property values. If you’re at 75% loan-to-value and the property value decreases, you haven’t lost anything as a lender. It has to decrease beyond the borrower’s entire down payment into a negative equity situation before you, as a lender, are significantly exposed to loss.
The other thing that we look at is we want to be compliant with the Frank-Dodd Act. Generally, I want to give you some very big rules of thumb but this is not legal advice. There are a lot of rules around lending, so you’ve got to do your own due diligence, have your team support you on doing due diligence. Generally, if you’re doing a business-to-business transaction, meaning an investor is loaning to an investor, so it’s not a consumer loan, but the borrower is using the money for investment purposes and the property itself is held for investment.
The compliance of the regulations around those types of loans is a lot less. What you’ll find is most hard money lenders they won’t lend to consumers because the legal compliance is too high when you’re lending to consumers. Our business primarily works with investors, but we also do buy notes or broker notes that are originated to consumers.
We don’t want to do the direct lending to the consumer, but we work with other mortgage brokers or loan originators. Registered mortgage loan originators are LMO, who create the paper for owner-occupants and then once it’s created, we’ll go buy that paper. The person who holds that license that is LMO licensed, they handle all of the compliance with the Frank-Dodd Act to make sure that the property disclosures were done adequately and that the loan documents are compliant and that the loan size is compliant and the interest rate is compliant.
In some states, if you are loaning to an investor on property that’s held for investment and it’s done with a licensed real estate broker, there’s really no limit on the interest rate that you can charge to that investor. But you take that same property and you make it owner-occupied, and there is, then you are faced with usury compliance and Frank-Dodd noncompliance to make that loan enough a reasonable rate. The way that we help our clients get high yields on mortgage paper for owner occupants is really the difference between the interest rate on the note and the yield on the note. You might have a note where the interest rate says 8% or 9%, and that’s what the borrower promised that pay. It’s their principal back plus 8% or 9% per year.
If you buy that note at a slight discount, meaning you only paid $0.95 to $0.99 to buy a $100 dollar lien or one dollar lien, then that purchasing that property or person that note I should say to discount gives the investor a higher yield. When we look for notes to buy or sell, most of the notes that we resell to our clients are slightly discounted, and that discount helps make what otherwise could have looked like a mediocre investment become an awesome investment. Because the discount gives the buyer investor that marginal investor better security because they have less money invested in that note, so their loan-to-value is now lower. Second, it makes their yield higher. Third, it makes it attractive if a borrower pays you off early. Because as a mortgage note investor, you really don’t want to get paid off, because when you get paid off, you’ve got vacancy on your money. You’ve got to go through the time and hassle of finding another mortgage note. But when you buy a note at a slight discount, you’re getting the interest rate that you’ve been agreed to, but then if they pay you off early, you get to realize the time value of that discount being paid all at once. It’s like getting points. You can get points on the frontend of the loan, which makes your yield higher when they pay you off.
If someone stops paying you on a note, then your cashflow stops, so you’ve lost that passive income. These are performing notes when you buy them, how often do you actually see situations where a performing note becomes a non-performing note?
You can look at industry-wide numbers but you really have to drill down to what type of note are you investing in, and the big things are, “What’s the borrower strength? What’s the borrower’s credit? What’s their debt-to-income ratio? What’s the borrower’s occupation and what’s their liquidity look like?” More importantly to me as I said earlier, with the asset equity and if a property has a lot of equity in it, there is no business reason for that property to go to foreclosure. The reason is if the property has got equity in it, the borrowers simply sell it. If they’ve got equity and they can’t afford their payment, they sell it, even if they call one of those, “We buy ugly houses for cash in two days” kind of people, it’s usually better than going through your foreclosure.
Where does the investor get all this information, though? You’ve mentioned a bunch of things such as the stability of the borrower, their credit, etc. But is that information piggybacked on top of the mortgage note? Where do you get that information from?
In our company, we collect a significant loan file with each loan. It’s not uncommon for our loan files to be 100-200 pages thick of documentation. The documentation is a lot of it designed for compliance so that if a borrower ever says, “I was taken advantage of. This isn’t a high-cost loan that I couldn’t afford. Poor me. The big bad lender took advantage of me.” What we’ve got in the loan file is all the documentation that says, “No, Mr. Borrower, according to you, under penalty of perjury, you said you could afford this loan. Here are all of the income documents that support your statement that this was affordable at the time that you borrowed the money.” That’s primarily why we collect that information.
Secondarily, we collect that information to help our investors make a very prudent decision so they can get a feel for who that borrower is. The third reason we collect that information is it’s a road map to the borrower’s assets. It’s a roadmap to collecting from the borrower. If the note ever does go non-performing, there are a lot of clues in that borrower applications that will help you find the borrower. For example, you know where they work. You know where they’ve lived in the past. You know where they bank. You know if they’ve got other assets, they’ve told you where those assets are. It’s easier to find them, do a skip trace to find the borrower. Secondarily, if you foreclose and you want to pursue a deficiency judgment, then you know whether the borrower has got assets to go collect against or wage garnishment, for example, you know where the borrower works.
When it comes to evaluating a mortgage note, is everything that you just listed off the same thing that a typical or average investor investing in notes on their own would have to go through as well? Those are the same things that they should be looking at?
Correct. When you’re originating a loan yourself, you’re going to want to put all of that information together hopefully with a licensed broker to help you avoid the pitfalls. One huge part of the due diligence that we didn’t talk about yet is the title commitment on the property and the title insurance on that particular mortgage note investment. The purpose of the title insurance is to protect the lenders lien interest in the property. Because you can write on a mortgage note document first position lien and you file it with the county and if you are the fifth person to file your lien in order of chronology, it doesn’t matter that it happens to say first positional lien, you are actually fifth because you’re the fifth person to show up with your recording stamp.
The point of the title insurance is to point out number one, to make sure that the legal description matches. That you actually do have a lien on the property that you think you do. Number two, to make sure that the borrower really owns the property that they are using as collateral. The third is to make sure that your lien order is correct that there are no other liens on the property. Also you want to check that preliminary title commitment for any other easements on the property. If there’s something of public record that might make you think that the property value would be different than it appears on the surface because of easements or other encumbrances on the property.
You’re answering this question from the perspective of a loan originator, but what if you’re a passive real estate investor looking to just simply buy a note. Is the evaluation process the same thing as what you just described they should be looking for the same types of things?
Correct. When you’re a loan originator, you’ve got to collect the documents. You need to know what to ask for. When you’re buying an existing mortgage note, usually that entire package is already put together for you and someone can spoon-feed it to you and say, “Here you go, it’s in a neat little bundle and here’s usually a summary.” Someone’s usually read all of the original documents but the summary of that note together. As a starting point, you read the summary and say, “It looks really good.” Then it should have all of those primary source of documents available to you to make sure that that summary information is correct.
Here’s a tangent question. I think I know what you’re going to say but I’m just curious. When you get this bundle or this packet because you’re evaluating a note because you’re thinking of investing in notes and you’re flipping through all this stuff, and there’s 100-200 pages in there, what is the one most important factor, or thing to look for that trumps everything else?
I am usually going right to the value of the property relative to the loan size. The LTV, that’s number one to me. Number two is the title commitment. I’m going to go write to that title policy and see that the lien position that I have really is correct.
I don’t really underwrite the borrowers. In the types of loans that we’re doing which are portfolio type loans. These aren’t borrowers that are going to go to Wells Fargo and get a loan, because if their credit was perfect, they wouldn’t be paying 9%-10% for a loan. They’d be getting 4% from Fannie Mae. I called that three-legged stool to evaluating a loan. One is the borrower’s capacity to repay. The second is the assets, LTV itself. The third is the asset quality, like what is the collateral for the loan?
For example, we really love having single family homes as collateral for a loan because they’re very liquid. They’re easy to sell. They’re easy to evaluate. If you foreclose on them, they’re pretty easy to fix up turn and get back to the marketplace, even if the marketplace is in a huge economic crash. People are always going to need a place to live. At some price, someone’s going to want to buy or rent that property from you. If the collateral is land or a commercial building, those assets are harder to liquidate. There are fewer buyers in the market for those assets. We really focus on single-family homes. We also want single-family homes to have a minimum asset value of $75,000. The reason is it eliminates junk homes from our portfolio. We don’t want a junk home as collateral and the markets where we’re primarily lending which is Dallas and Fort Worth Texas. $75,000 is a decent home. That’s not a junk, whereas in San Francisco $75,000 is a garage with termites infested and a hole. That $75,000 is a little arbitrary based on the market. What I’m really trying to do is saying I want a reasonable piece of collateral for my loan that if I have to foreclose, it’s worth the cost of foreclosure.
Let me just tell you a quick story. I had a client who bought a mortgage note on a $20,000 home in a rough part of Florida. The borrower didn’t pay and they had to foreclose on that asset and after spending a couple of thousand dollars in attorney’s fees plus the property back taxes on it had already gone up to a couple of thousand dollars. After taking possession of the property and getting it cleaned up and paying the resale broker on the deal, all her equity was gone. If a $20,000 property and a $1500 loan, they only have 75% loan-to-value but they only have $5,000 of protective equity and that $5,000 was gone in a hurry just through foreclosure costs, legal costs, the resale costs, the fix up costs, etc. Our clients make sure that if they do foreclose, they’ve got plenty of not only LTV, but actual gross dollars of protective equity to cover the transaction costs.
I talk a lot about the foreclosure process because the performing part of a note is simple. You get an ACH deposit in your account every month, and that’s it. When you file your taxes at the end of the year your loan servicer, because all of our notes that we originate are professionally serviced by a professional and insured bonded mortgage loan servicing company, you basically get an ACH check in your savings account, checking account each month and at the end of the year you get 10.99 for the interest that you received for the year. It’s that simple. It really is that simple to be a mortgage note investor in a performing note.
All of the complexity is thinking through “What happens if I don’t get paid? I want to be happy if I don’t get repaid.” I run into investors all the time and say, “David, you’d be so proud of me, I made a loan to a company that’s paying me 12%.” I’ll say, “What’s the collateral for your loan?” They say, “Nothing. They promised me to pay me and look it’s 12%.” I’ll say, “It’s not worth the paper that it’s written on. Good luck. It is to a company.” Who cares what the company’s assets are unless you have a direct lien on the assets of the company. You’re really an unsecured creditor. That’s a very weak position to be in to try to collect that debt. You definitely want to be secured and you want to be secured in first position. I can’t say that enough.
A lot of investors get sucked into “I found the second mortgage lien that I could buy, and it’s only $10,000, and it’s 14% interest.” No. You don’t want to buy a second mortgage lien. Like you, I own lots of second mortgage liens, but I’ve been doing this for over a decade. I’ve got a very substantial portfolio. At any time if that first mortgage lien goes non-performing, the second lender has to be able to write a check to pay off that first mortgage lien. Then you have a first lien, because you never want a second lien. If you buy one, you just have to be prepared to become the first lender if it goes non-performing. Most investors don’t have that financial wherewithal to just at a moment’s notice write a check to pay off the first lien.
I agree. We used to work together when you were building new construction homes over the last two years. I think it was two years ago down in Dallas and Fort Worth. They were great investment properties. Investors were very happy. But you’ve made a shift. You’ve had made a comment to me before that mortgage notes have become your favorite investment in this market cycle. Can you just take 30 seconds and explain why this has become your favorite type of investment right now?
Number one, it’s simple. It’s hassle-free. Number two, it’s safe. When you are a buyer of real estate in a seller’s market, you’re paying a market cycle premium for that asset. If there is a correction in that market, then you’re experiencing that loss. If you’re a mortgage note investor, then if there is a downward price movement in the market, you don’t necessarily experience a loss on your investment. I’m just looking at overall market cycles. Right now, money is still on sale, so if you want to go buy investment property, you can borrow cheap money to go do it and your interest rate is significantly lower than the cap rate on the property, that’s a great long-term investment. Even though it’s a seller’s market of real estate, it’s still a buyer’s market of debt. It still could make a lot of sense to buying cashflow income-producing property.
What I’m looking at a lot of the properties that we’re holding mortgages on, I think they’re great investments for income for mortgage notes because we’re only in for $0.75 on the dollar. Every single month, as that borrower makes a principal and an interest payment, that principal payment that they make to me, it lowers my risk in the investment. I’m just looking at the macroeconomy right now, and personally I want to get to a lower risk position. I could say, “I could go buy that property and make a six and a half, seven cap or I could be the lender on that property with significantly less risk, significantly less hassle and I’m going to get a 10% yield, which is basically a ten cap if I were free and clear ownership of that property.” Obviously, ten is better than seven and less hassle is better than more hassle. I’m really going to a more hassle free approach, less risk approach, easier cashflow.
Also, what I’m noting in the marketplace is so many of our clients have very significant IRAs. They’ve got the majority of their net worth invested in the stock market. I think the real estate market right now in 2015, I don’t think it’s at the top. I think there’s a little bit more room for that real estate market to run before we get to a correction in the market.
In the stock market, I disagree. I think that we’re at a market top. I think that the next move for the market is a significant down correction before we see any appreciable gain in the stock market. For our clients who are in equities, once the equities reach a market point, you sell equities and you buy bonds. But you can’t go buy up municipal bonds and treasury bonds because the yield doesn’t outpace inflation.
No. That’s a losing proposition right now.
It is. The strategy that I see for the majority of our clients is not really how do they change their real estate investing strategy, but how do they change their IRA investing or stock investing strategy? The answer is you sell your equities, you sell stocks and you buy bonds. You can’t buy conventional bonds because the yield is low, so you have to buy mortgage bonds which are mortgage notes. Mortgage note is the same as a bond. I actually like mortgage notes better because a bond isn’t usually backed by anything except for the company’s promise.
Let’s say you bought a Greek bond. “The Federal Government of Greece promises to pay the bearer of this bond.” That didn’t work out so well. You can’t walk up to the Greek Parliament Building and say, “I own this building now because you didn’t pay back my bond.” A bond is still an unsecured debt in terms of the way traditional investors think of bonds. When I think of bonds, I want to own the bond that’s collateralized, that is secured by something real. If the borrower doesn’t pay, I get that real thing, that tangible thing that someone can live in or rent for me or I could sell the profit.
I just recorded an episode that went live this morning on investing using your retirement accounts, 401Ks, IRAs, and self-directed retirement accounts. This is a perfect investment vehicle to plug into those IRAs and 401Ks because it’s tax sheltered. There are no tax benefits like depreciation that you get from a note. You’re not losing anything whether it’s inside or outside of your self-directed retirement account. Therefore, it makes a perfect investment to hold inside these retirement accounts and I know you like that particular strategy.
I do. Currently the only thing I own in my self-directed IRA is mortgage notes. I don’t have any plans to change that strategy. Because as that mortgage note income goes to my self-directed IRA, it’s tax deferred or in case of my Roth IRA, it’s tax free forever, so I’m a huge fan of notes on my IRA. If it’s outside of my IRA because I do own notes outside of my IRA, then that money is taxed as interest income which is at my ordinary income tax rate from a federal and state income tax perspective. I don’t pay self-employment tax on that interest income, but it is taxed at a relatively high rate outside my IRA.
Another great reason why I like mortgage note investing in this time of the market cycle is investors recently had a significant appreciation on their real estate assets. Maybe smart investors bought property in 2010, 2011, 2012. Now, here we are several years later and they’ve seen a significant capital increase in the price of their properties. They’ve got equity that they could harvest at today’s incredibly low 30-year fixed interest rates. What do you do when you harvest that equity? They were smart and they bought when prices are low, and then they pull the equity out when prices are high, but what do they do with that? A lot of investors are thinking, “Maybe I just double down and buy more properties.” I think a great play is if you’ve got a significantly appreciated property, you can’t 1031 exchange into a note because it’s not a light kind asset to sell real estate and buy a note. But what you can do is go to with cash-out refinance on your property, use a third tier fixed mortgages and say 4.5%, 5% of today’s rates. Then go buy a mortgage note with a fixed interest rate of 10%, and you’ve got the perfect arbitrage play. You borrowed it at 5%. You invested it at 10%. Your income in significantly increases your money out, and it’s a recipe for awesome cashflow or awesome arbitrage.
It’s good strategy. We’ve talked about interest rates quite a bit here. How do you determine the interest rate of a note investor? What factors play in that allow the marketplace to determine that rate?
Interest rates are a reflection of supply and demand. Right now in the economy, the general demand for borrowing is generally weak. When borrowing is weak, there is less demand on the money. Prices fall to stimulate borrowers that exist. Also in the general real estate lending environment, the supply of capital is abundant. Lenders have a tremendous amount of cash and the federal funds rate is extremely low to stimulate investors or lenders to get that cash out into the marketplace.
Across the economy right now, interest rates are historically low. You can go get your 30-year fixed mortgage under 5% because there are not a lot of borrowers. The abundance of cash is high. We’ve got that supply and demand thing working. When someone doesn’t fit the conventional bank formula, their credit is weak or their debt-to-income ratio is weak, maybe their down payment is a gift from a family member. That’s a very common thing for us is where someone as a resident alien, they’ve got their green cards. They’re living here legally. They’re working here legally, but they don’t have a Social Security number. Therefore, they can’t get money from Fannie Mae and Freddie Mac. They can’t go to Wells Fargo if you don’t have a social. But they still have the right to live and work here and the right to own property here.
In fact, right now, the largest purchasers of property in the United States are Chinese. Not even just Chinese immigrants but people who are living in China. They are coming to buy commercial property up like crazy. Clearly, foreigners have a right to buy property here. They can’t finance it. They can’t finance a single-family home with cheap financing from the bank because the banks don’t have any loan programs for that type of borrower. The reason is most lenders like Wells Fargo, Bank of America, they are relying on the guarantee of Fannie Mae and Freddie Mac or FHA to back up their investment in a mortgage loan. If Fannie Mae and Freddie Mac and FHA are not going to repurchase or insure the loan then the lenders are not going to do it. They’ve got too many other opportunities to lend money that’s insured by the government that they’re not willing to lend it uninsured to a noncitizen. That leaves a huge gap in the marketplace.
One of the reasons we’re in the Dallas-Fort Worth market is there are a gigantic immigration Latino borrowers into Dallas-Fort Worth. That lending market is under-served. There have been in the past but there are currently no major institutions lending to immigrant borrowers in Dallas-Fort Worth market. Those borrowers have great jobs, great debt income ratio, and they usually have a mattress full of cash that they show up to the closing and they can put a huge down payment on a property. But they need a lender. They need someone to bridge that gap. We are all the time working with immigrant buyers to help them become homeowners. It’s awesome because they’re happy. They just feel like they’ve won the American dream lottery and they get to write home and say, “I moved to America and now I own a home in the major metro in America.”
Also the reason it works in Dallas-Fort Worth for us is even if we’re lending that money out at 9.5%, 10% interest rate, if someone has a 25% down payment, the cost to own, and the cost to rent are identical, even at 10% interest rate. The person who’s looking at buying this home, they’re not really focused on rate. They’re focused on payment. “I could own this home for $1000 a month or I can rent this home for $1000 a month.” The only difference is whether they have a downpayment in the property and we’re able to sell. Sell or finance properties in Dallas-Fort Worth to people on payment. In their head, they don’t really care what the rate is because they can own a home and it’s the same price.
We buy everything on payment. Cars, you name it. Your model there, your story is a great example of the free enterprise system at work. If it’s let loose to work as opposed to subsidizing everything through government programs where it just skews the market and makes it artificially inflated or purposely deflated. I love that model. Now, in terms of determining the market value of a note, are the facts the same that are driving the interest rates drive the market value?
Yeah, pretty much. It makes it really simple. The borrower has to be happy to be repaid or happy to not to get repaid. Some lenders want a huge assurance that they’re never going to have to go through foreclosure. Most of the notes that we’re helping our clients into are 75% loan-to-value in the collateral is a Class B, blue-collar home built between 1960 and 1985. That’s in borrower great income but either zero credit. That’s most common is that borrowers have no credit score at all, or they have weak credit. Either they’ve moved from California to Texas. That’s a big part of our business as people who did a short sale. Their job moved from Orange County to Dallas and they did a short sale on their home, and now they can’t buy a home. They can’t get a conventional mortgage. We can bridge that gap for them with high-interest rate loans. Then they just hold that high-interest rate loan for a couple of years until their credit heals and they refinance.
The idea is if the borrower is A+, a borrower. I am going to give you an example. Our typical note is 75% loan-to-value blue-collar worker, blue-collar home, and slightly older property. The pricing on that note is going to be in the 9%-10% range. Let’s look at a different example we’ve got a loan a 50% loan-to-value. The property is ten years old. It’s a doctor who’s got an 800 FICO score making multiple six figures. He was Fannie Mae and Freddie Mac out. He had more than ten properties so he couldn’t get a conventional bank loan, but everything about him is great. There’s 50% equity, the borrower personally guaranteed. He has a great job, great debt-income ratio and the story behind why he needs private loan makes sense. He would get it from a bank except he’s got ten loans. That doesn’t make it a risk to me just because he’s got ten loans. Anyway, that note might trade for 5.5%, 6%. That pricing on that note varies. Maybe it’s a second position lien on a property up to 90% loan-to-value. Maybe that second position lien is going to get a yield of 18%-25%.
The higher risk note will carry a higher rate of return naturally.
Back in 2009, at the peak of the housing market implosion, if you want to call it that, there were about 15 million homes underwater. Banks were swimming in notes that were on upside down properties performing and non-performing. Today, the numbers come down to somewhere around 7.5 million. There are still a lot of these notes in the system, but the problem is that investors can’t just call up Wells Fargo or Citibank and say, “I’d like to buy a couple of notes.” They sell them in tranches of $50 million plus or minus. That’s a problem for a small time real estate investor looking to buy notes. How do they source real estate notes? Where do you go to find these notes to invest in and what are the sources or how do you narrow this world down?
One obvious answer is that companies like ours that aggregate notes for resale is a pretty easy source right. For example, our typical note size is going to be between about 60 and $100,000 which is very bite size. We also work with investors on owning note fractions. Maybe on a $100,000 note, they only have $20,000. $20,000 is not enough to buy an entire mortgage note of any quality, but they could own 20% of a$100,000 note and they would still be in the first position. They would just be a co-owner of other investors in a first position note.
If you’re looking for notes for sale to be an aggregator of notes for sale like our business model, where do we find notes is a great example. The hard way to do it is to put up advertising like Craigslist and go on websites that are bulletin boards for people that might be having Seller Finance notes for sale. That’s the hard way to do it. An easier way is connect with a hard money loan broker like myself and we can connect borrowers and lenders together.
The other way is to build what I call a “duplicatable business model.” Through the power of my network, I’ve taught a couple of our clients and have found other people in the industry who already have this business model of people who fix and flip house. Those people are always in demand for borrowing hard money. There’s always this source of people borrowing when you connect to those people fixing and flipping houses. The other thing is that if someone who fixes and flips a house, if they know they can sell that note when they flipped it, then they can offer it for sale to cash buyers. They can offer for sale to the conventionally financed borrowers. They can also offer seller financing. Even if they have no intention of holding that note forever, if you’re going to fix and flip a home or if you’ve got any property for sale, you can offer that home with seller financing. Then after you’ve closed, then you resell that seller financing note to a company like mine or to a client of ours and then you’ve got cash.
Is there anything I didn’t ask you that maybe I should have?
We do have a free report to help investors get a lot more information about this. We’ve got a couple of videos on how to be a private lender, as well as an awesome white paper that’s got tons of meat in it. It’s all meat with a lot of vocabulary to help you understand the different complexities of evaluating notes, doing due diligence on notes, and creating notes and understanding the note documents, etc. You can get a copy of that free white paper by sending an email to [email protected].
If someone has a note for sale or they want to buy a note, I’d be happy to just give you a quick consultation. If you’ve got an existing note you’re trying to evaluate, I’ll be happy to look at it and tell you my thoughts. If you want to create a note, maybe you want to sell a home on seller financing and you want someone to help you put those together so that you can get the highest sales price for your note possible, I would be happy to advice you on that as well.
David, I appreciate your time. This has been invaluable, lots of great information. I think we’ve gone very deep in some of these subjects, so hopefully it wasn’t too confusing for investors. I think with a little bit of research, due diligence, maybe a conversation with you or your report, they can work their way through the weeds and figure out how simple note investing can actually be, because at the end of the day it’s really an IOU where you’re getting monthly passive income, and that’s really what it’s all about. I want to thank you for being on the show, and I appreciate it. We’ll talk to you again soon.
Thank you very much, Marco. I really enjoyed being on your show.
It was a long episode but it was very content rich and that was a lot of information about mortgage note investing. It’s an interesting subject. I actually think it’s a great alternative to holding a portfolio of income generating properties. It’s an alternative and is something to consider.
That’ll wrap it up for this week. Download a free report The Ultimate Guide To Passive Real Estate Investing. Remember to subscribe. If you want more information to be sure to get a hold of David for that free report. I’m sure between that report and the videos, it will simplify the note investing for you. Please remember to leave us a rating review on iTunes. It really helps us out. Thanks for listening. We’ll see you on the next episode.