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Note Investing Segments
On this episode, I would dive in a little bit into some of the note investing segments or some of the different assets that note investors dive into. There’s a variety of them because there’s so much great stuff in the note space. There are different little niches that are attractive and affordable and a great place to park some money in the long run if you know exactly what you’re doing. I’m not going to talk about markets because that’s a whole another show about which states are good, which states are bad, which are attractive, what’s hot and what’s cold. That’s a whole different episode that we’ll dive into, but a great topic for later.
This topic is about the different types of notes that investors chase. There are the first liens, there are second liens, there are residential, there are commercial, there are partials, there are owner financed notes, there are performing or nonperforming. What I thought I’d do is I dive in a little bit and talk a little bit about each note designed to be an educational piece on all the different notes subjects or different segments. I still highly recommend that you look into those different segments and educate yourself depending on what your risks and what you’re looking to do. I’m going to be honest and give you the pros and cons of each one. I’m going to start with the nonperforming notes. I’m not talking about what we do here at We Close Notes, my parent company, that’s the big kahuna when it comes to what we do as far as education and workshops and things like that.
Non-Performing First Liens
You can always find out what different types of education we have by going to WeCloseNotes.com. With nonperforming first liens, the big thing you’re going to find is stuff at a discount. Living here in Austin, Texas for the last several years has been overpriced for the most part. For me to find deals and stuff that makes sense as a yield play, I had to look at other markets. That’s one of the biggest things. There’s a lot of inventory out there across the country. That’s the first thing. The second thing I love about the nonperforming first lien notes is that you have multiple ways to make money. There are nine different exit strategies from wholesaling to reinstating to allowing the borrower and take over the property, selling up the note off, making a short sale, doing a Cash for Keys and foreclosure. You can also try to get them to reinstate. There’s a variety of different exit strategies that are involved there or get it reperforming. That’s where you make your money either getting it reperforming or some exit strategy that refers to you taking the property back or selling the property off.
Nonperforming notes, you’re going to have it happen. You’re going to have it go down the foreclosure somewhere between 30% and 40% depending on how precise you are on your due diligence and what you do as far as your due diligence and borrower stocking beside the asset itself. The third thing I like about assets besides the fact we find stuff all across the country with a lot of exit strategies is the pricing point. We still find stuff cheaper than what most people are going out and targeting. If you’re buying nonperforming, you shouldn’t be paying above 65%. You should be paying below that. I prefer 50% of either the lesser of the asset’s value or percent of UPB. UPB stands for Unpaid Principal Balance. If you’re buying an asset where the balance is less than the value, that’s a cheaper amount. It’s some basic numbers. For a $100,000 house, if the mortgage is $80,000 and you paid $0.50 of value, then you’re paying $50,000 which is above the 50% of the UPB.
If the UPB is $120,000 and you’re paying 50% of the UPB, that’s paying $60,000 on a $100,000 house, that’s 60% so you would go then at $50,000 because it’s over encumbered. I don’t want to chase assets that have a lot of equity behind them because the fact is it’s not a traditional real estate where you foreclose. You don’t get all that equity. If you foreclose and it sells off on the foreclosure auction, the borrower is going to get the overage. That’s something to keep in mind. I have different exit strategies. Foreclosures are going to happen a chunk of the time, but we try to alleviate that with offering Cash for Keys to the borrowers. Some financial incentive for them to walk without dragging a foreclosure on and things like that.
Nonperforming notes are what I like. We’d been buying it for the last several years. We’re buying nonperforming first because the only thing that wipes us out is the taxes. We want to double check the taxes and make sure the taxes are paid. There have been times that we have used a tax sale to help us clean up an asset and take the property back and either initiates the taxes to get bid up at the foreclosure auctions so that we see a tax overage take place. We’re able to recruit that tax over a little bit timely. It can take a little bit longer, but it can be valuable, especially if you’ve got an asset that’s got a lot of stuff on the books. That may not get cleaned up.
Non-Performing Second Liens
Nonperforming first is a little bit easier to raise capital for. I noticed that some people are like, “I’ve got to go raise capital. I’d rather use my own money.” That’s fine. I get it if you use your own money, but if you want to do some big things, you’re going to use other people’s money to take your business to the next level. That’s one of the big things out there I would highly recommend for. Another thing a lot of people want to look at is nonperforming seconds. There are some caveats on nonperforming seconds. I had bought some seconds primarily behind my nonperforming first when I was the first lien holder. We bought the second. We pay off the second because the homeowner was working with us. That’s when we’re taking the property so they helped us expedite the foreclosure.
A lot of people have seconds, and they’re buying behind a performing first. You do not want to buy a nonperforming second mortgage behind a nonperforming first mortgage because you’ll get wiped out. If they foreclose, they can easily wipe you out. Some second lien holders like being behind it because they reach out to the first lien holder or foreclose Subject To the first. Take control of the property and then take over the first mortgage and start paying for something or look to the list of the property and get paid off. That only works well if you are under encumbered or means there’s more equity behind over-encumbering the first plus the second or more. They are covering above what you paid for the second. People are buying large seconds but not fully covered or the balance is not fully covered by the equity. That’s okay because if they paid $4,000 for the second and there’s $40,000 covering that $80,000 second, you’re still going to get $36,000 in profit. It’s still not a bad day at the office for a lot of people. Some people like to try to buy the seconds and then foreclose the first and take over the property after evictions and then work on taking the property down and selling it. That’s the second place.
Second liens have gotten more expensive as property values have continued to increase across the country. They’re no longer negative equity loans a lot of times. You see a lot of properties at first and seconds and now the properties appreciate above what’s owed between both the payoff for the first and the second. That means for pricier second lien pricing. If you have unseen second liens on properties, it’s below $100,000. Sometimes you will but there’s not much. Most of the second liens you’ll see are on higher valued assets for the most part. A lot of people love seconds for years because they can often buy it cheap because there is a riskier position in a second lien position and junior position. Often, you would have had to buy a portfolio of seconds to have them work out for you well. Everybody should tell you that you’ve got to buy at least five or six seconds to have two or three that work out for you and the remaining two to four or whatever it is that you put in a file cabinet and wait for either the seller or the owner of the property. At selling the property, they need to come and give you the payoff, or they’re looking to modify or reinstate or do something.
As long as you’re in a second lien position, it’s not a bad place to be as long as behind a performing first. If you’ve got the money and you sock it away, you have not relied on that money. That’s not a bad transaction. If you need to make money, I don’t think you can afford to invest in something that you’ve got to sit away for 36 or more months. I don’t think that’s a good investment. I want to try to be in and out of my investment in 12 to 24 months in the worst case. Some second investors talk about high returns but they paid cheap for the mortgage and they set it aside. If you’ve got to wait a few years to get paid in that deal, it’s not a good return on your investment or you’re going to be eating a lot of ramens or peanut butter jelly sandwiches.
Seconds can be great cashflow if you get it modified because you did buy it at a cheaper price and often a good return on investment. They’re a little higher interest rate loans and that’s the beauty. At reperforming, you paid $0.05 on the dollar and you’re going to get them to reinstate. With $0.50 on the dollar, that’s still 50% return or better depending on what the money looks like. The thing you got to keep in mind too is that a lot of the inventory seconds have dried up over the last couple of years because there are not as many seconds left available for those. There are not as many of those out there available free to purchase. Maybe one out of ten or one out of twenty mortgage or loan first originations had a second behind it. When I was doing loans, we had people got lines of credit. That’s the second lien or a junior lien or home equity line that you have to be careful though in a bankruptcy deal. Often, the seconds can get stripped off and moved from the property. That’s a risky place to be. You only want to be buying seconds behind a performing first if there’s some equity and hopefully, the borrower isn’t filing bankruptcy and they wipe you out.
Contract For Deeds
We covered nonperforming first, nonperforming seconds. Let’s talk about the next thing a lot of people like looking which is the contract for deeds. I’ve been around for a while, but they’ve become popular among note investing community. A lot of the buyers of the low hanging REO, especially the large portfolios REO for the last few years were doing exit strategies. It was going off for owner financing via a contract for deed, and you’ve got borrowers putting $1,000 to $2,000 down or maybe less and getting a 30-year mortgage on the property. They don’t own it until the property is paid off. You’ll see this on a lot of $50,000 or sub $60,000 valued assets because most banks aren’t going to give a loan for that little amount. It’s hard to make any money that way.
It also allows for the seller of these assets the right to evict a lot of times versus foreclosing. I saw the case across the different states. Some states, depending on how much you put down, you’ve got to go through a full foreclosure. It still leads to a great example of, “No pay, you don’t stay.” Evict, turn around and do it again. Get the down payment and try to have something on there. We’ve been fortunate. We bought a lot of contract for deed. I had about 60% to 65% reinstatement or modification. We get the borrower to start paying because we look at it as a nonperforming first lien, although we control the property.
Those are things that have been attractive about it. That market is also starting to drive a little bit as a lot of people have gotten in. Some of these bigger funds that bought these large portfolios have been selling off their inventory and getting out of the business. There’s also some legislation out there in different states and trying to make it a little more difficult to sell on a contract for deed. They’re going to end up grandfathering in the ones that we have. If we end up looking to originate a new one, they’re going to want us to jump through some hoops. Our goal isn’t necessarily to turn around and rent some repeat. We’d rather almost sell the asset off as an REO and recoup the cash and go on from there.
At contract for deeds, the higher interest rate is 9.9% most of the time. They’re usually buying these at somewhere between 30% to 40% and sometimes 50% of the unpaid balance. The unpaid balance is based off a couple of years ago. There’s often a sizable amount of equity between the unpaid balance and the value of the property which works in your favor when you’re reaching out to homeowners. You’ve got some equity here and now you want to stay, let’s work to keep that. It works in your favor too. If they don’t pay, you don’t have to keep it evicted. Now you’ve got a lot of equity between what they owe and the value of the property. The equity on a lot of times is whether you’ve got to evict or foreclose based on how much of a down payment they out down at the beginning of the deal. Not at the end and not where they’re at now, but at the beginning. The nice thing on the contract for deeds is you’ll see a lot of that lower value stuff easy to raise cash. The thing you’ve got to be careful about is that a lot of these contract for deeds are out in the rural areas or small town. When you’re looking at your assets or you’re looking at a tape of contract for deeds, you still want to make sure it’s occupied.
A vacant asset in a rural or small town doesn’t stay in good shape long. Those are a couple of things to check at. You want to make sure that you’re buying at the right price. Check each state’s foreclosure laws or eviction laws when it comes to contract for deeds because each state is a little different. I like occupied assets. If I can find them and they’re occupied and the payments make sense, it’s an easy initial bidding process on the front end to run some numbers down a spreadsheet to figure out what our initial bids. Waiting for the hedge fund to respond on what we are looking to buy.
The third-place besides nonperforming first, nonperforming seconds, contract for deeds, let’s take it over to performing notes. A lot of people like performing notes because they don’t want to do the work. They’ve got an IRA, whether it’s self-directed or 401(k) or they don’t want to do any work. They want to see a good return on investment. Good can be between 8% and 15% depending on a person. If somebody is getting zero or less than 1% on a CD, 2% would be good. What you have to look at when you’re looking for performing notes for your portfolio is be realistic. Most often a fund or an investor will sell a performing note off to somebody. It’s somewhere between 12% and 15% yield. That’s taking the twelve months of payment divided by what you’re bidding to get a 12% to 15% yield. It does not say you can’t find them higher than that. You may find them less than that at 8% because the fact is if your money is not getting anything, often investors that have done some work will sell a note off, but we’ll keep ourselves involved in the deal. I’m glad to pay an 8% flat return on your money and leave some equity in there. We are splitting the payment string coming in. In that way, if anything goes south, you’ve got somebody to jump in and help to get back online or handle the work.
I don’t like selling performing notes off and walk away unless somebody who’s got a history of buying notes and they’ve got their servicer and everything set in place. That means I’m not opposed to it, but I want to make sure somebody is not going to get it over their head by me selling a performing note that goes nonperforming in the next 90 days or 120 days, and they don’t know what to do. That becomes a bigger pain in the ass at the backend for me and anybody. If you’re looking to boost your ROI and your IRA and get somewhere around 8% to 10% return. Performing notes is not a bad way to go if that’s going to make you happy. If you want a little more aggressive, then you may want to look for nonperforming notes that have become reperforming that are being sold as performing notes at 13% and 15% yield on your money. The reason I like nonperforming notes was to buy those at a bigger discount and get them reperforming so my yields are looking good. On the backend, if we’ve got the borrower paying on time and then looking to sell that note off after a while.
Often, you’re able to pick up performing notes from either self-directed IRA investors or also other investors who’ve done some workouts and have worked hard to get the borrower paying on time. If you are looking at buying some performing or semi performing notes, make sure they’ve got at least six months of payments on time. Make sure they’re going through a third-party servicer. Make sure the borrower put some skin in the game to get it reperforming. They don’t put any skin in the game. There are no incentives if things get a little rough for them to stay around. You want to make sure your yield is off of your stuff. Make the borrower pay for the servicing costs. It’s not that much extra $20 to $30 depending on the servicer once the borrower made easily three on-time payments. Most servicers will reclassify it as reperforming at that point. It saves money, but you’re going to have them pay the PITIS: Principal, Interest, Taxes, Insurance, and Servicing. There’s nothing wrong with that at all.
Another thing to keep in mind as well is when you’re looking at performing notes you may want to leverage your account a little bit. If you’ve got $100,000, you may want to leverage $250,000 so that you’ve got a yield. If one does go nonperforming, you still got something coming in. Be careful about this. Make sure that if you’re using your self-directed IRA. You’ve got to be careful that you’re not using all the money in your self-directed IRA. You’re leaving some money in their extra that can be used to pay for servicing costs for foreclosure cost. You’re going to want the payment stream to go back directly to the IRA because you can’t touch it unless you’re beyond. You either start taking withdrawals or you’ve got mandatory withdrawals if you’re 70.5 or 70. Check with your self-directed IRA. As always, we recommend Quest IRA to help you out with that. Once again, nonperforming first, nonperforming seconds, contract for deeds, and performing first.
Owner Finance Notes
We’ve been talking about institutional paper for the most part. One of the things as well is residential. A lot of people like buying owner financed notes. You have two types of owner financed notes. You’ve got performing and nonperforming as well. That’s why I always tell people like, “It’s good at nonperforming, but if something goes out for the nonperforming, you’re going to want to know what you have to do as well.” There’s nothing wrong with buying a performing owner financed note. What I like is getting more in one batch from a hedge fund or a bank in the nonperforming institutional debt. If you’re buying an owner financed note, you’re going to see one note from an individual. You’re not going to see a larger inventory. There’s nothing wrong with going after homeowners who’ve owner financed property to either tenant or new buyers. It’s completely fine to do that.
You want to make sure that the note was written after January 2014 that it’s Dodd-Frank compliant. What does Dodd-Frank compliant mean? It means a registered mortgage loan originator reviewed the notes, reviewed the borrowers, and signed off on it. If the loan was originated before January 2014, you don’t have to worry about that. It could be written on a napkin. I’m not necessarily saying that I would want to buy that note because I still evaluate owner financed notes. It’s similar to how I underwrite the paper or the mortgage of nonperforming or performing note. I’m going to want to see copies of all the documents. I’m going to want to see some financial documents. I’m seeing what the borrower put up. A copy of every assignment of mortgage or that mortgage has been sold a couple of times. I want to see allonges along with that mortgage every time. The more of that owner financed paper looks like a traditional mortgage, the happier I am. Another big caveat is I’m going to want that owner financed paper to be serviced with a third-party servicer.
There are a lot of states out there that will allow you to service some of your notes. Texas being one of those states that you could do your owner financed and you can self-service. I don’t like it because there’s nothing that I can go check like, “Here’s a copy of the pay stubs or the copy of canceled checks.” That’s not the same as being able to go on and print out a statement from a third party like Madison Management or checking a portal out. It’s not the same thing. If you’re going to be originating paper, you want to make sure that the borrowers make it affordable. You want to make sure that they’re over 40% debt to income ratio. Make sure the property and the note aren’t written for a lot more than what the property is worth. That’s a big mistake I see with owner financing. I see people write a loan for $115,000 and the house is worth $100,000 or $110,000. A little bit extra is okay, but you start adding $10,000, $20,000 to $30,000 over in the balance of the mortgage more than the property is worth. If you try to sell that note, you’re going to take a discount regardless. I’m not going to pay above property value for a note.
One of the better ways, if you’re going to be buying owner financing notes, is you want to see some skin in the game from the original borrower. I would say at least 5% or greater. I prefer 10%. Going back to my loan origination days, I structured deals a lot of times where the borrowers gave 5% down then we’re doing one a 70% first lien and a 15% second lien for the 5% down payment. I wouldn’t want that first lien balance, especially if it’s split up like that, not to be any greater than $0.80 on the dollar. Why is that? It’s a lot easier for that borrower if they’ve got a higher interest rate to pay the payments for twelve to 24 months. If they look to get refinanced out, maybe they’ve got to illustrate at 6% to 8%. It’s not unheard of. It’s not overly charging either if you’re going to be the bank. That gives them the carrot in front of their face to go out and get refinanced out on a traditional bank loan without you taking a big discount on the back end. If your first is at 75% or 80%, that’s a great LTV. You’re carrying a 15% to 20% second. I keep that second for cashflow or sell it off at a discount or sell it off on partials. There are a lot of ways to do that.
I know plenty of people are buying owner financed paper and that’s great. You can still get a decent yield. It all depends on the yield you want to get. One of the big mistakes is I see a lot of people originate paper put a 5% interest rate. That doesn’t make any sense because if I want to get a 10% return on my money, the most I’m going to offer you on a payment stream by that whole mortgage is $0.50 on the dollar to get my 10% return. I’m all for half to double my yield of the 5% coupon. It means 10% is only paying $0.50. It doesn’t mean you’re making any money for your own originate, especially if you’ve done rehab on it or put any work into it overpaid for the asset. Everybody gets excited like, “I’m going to create a paper on my fix and flips.” Maybe you don’t want to do that. Maybe that should only be your last resort, and we can’t sell it. I would structure it. 70% to 75% first, 15% to 20% for second and then 5% to 10% down payment. The more you get down payment, the better. You can do a 30-year loan with a five-year balloon. You can do that if you want to. There’s nothing wrong with that at all.
If it’s your doing and you’re on one, you’re allowed to do that. If you’re getting more and you’re doing more than one, then you’ve got to be careful out there and make sure you’re Dodd-Frank compliant. It’s still best to service that loan with a third-party so that everything will be verified as far as payment streams and stuff like that. The thing you’ve got to keep in mind is there are nonperforming owner financed notes out there. Be careful on that stuff. You’re still going to discount that depending on where they’re at. There are great things you can do. They are great investments as well as long as you’re doing your due diligence. Double checking and making sure the value of the asset is there.
That’s the important thing and then making your offer off of a discounted property depending on foreclosure processes. There are some other great things that you can do with that aspect. Double check and always verify. Check to mention there was title insurance purchased and a mortgage insurance policy in place when it was originated. That’s an important thing to look at. If you’re originating paper, some people won’t do that because they’re with a bank and they’re like, “I don’t need a bank policy.” You probably do especially if you’re doing an owner financed deal where it’s a wraparound mortgage around the first.
Double check your values. Check your title insurance. Always pull an O&E report ownership in a commercial port across any asset you’re buying. It goes for a contract for deeds firsts and seconds that are nonperforming. If you can sell the property without owner financing, you’re going to recruit more money immediately and be able to go double down. A lot of seller finance educators like to talk about, “You’re going to make all this money and interest.” If my interest rate on the mortgage is 6% to 8%, it could not be making 20% by taking my money and the velocity capital kicking in. That’s the thing I look at as well on that aspect of it. You need to be careful. Double check and make sure you look at your full opportunity costs before you owner finance. If you’re to be buying for your portfolio, make sure you double check everything on that first or that second owner financed mortgage to make sure you’re not going to end up holding the short end of the stick. That talks a little bit about the first liens and second liens on a nonperforming contract for deeds, owner financed first and seconds as well.
Let’s talk a little bit about partials. At partials, you had that happen a lot more than the owner financed notes than you do with institutional debt. No bank is going to sell a partial loan off for the most part. You can often sell some of your notes off if you’ve been able to modify it as an investor. Some funds will buy partial mortgages or either pays five years, 60 months or twelve months. A lot of people will use partials to raise capital to take other deals down, and that’s fine. There’s nothing wrong. You’re giving up payments for twelve to sixteen months depending on what you’re looking to. The thing to keep in mind with partials is a lot of people would prefer to take the whole loan down. This is my opinion only. Partial is the most overhyped aspect of the note industry. If you’re going to be buying notes or trying to sell notes too like our buddies over at First National Acceptance Company, FNACUSA.com, one of the biggest buyers of owner financed notes out there. They’ll look at an offer to bid for the full note most of the time or partial. They don’t like the full thing. They look at the partial. They will give you the options. You even want to broker-owner financed notes, that’s a great place to broker too because they’ll work with you.
I’ve done two partials in my day. I’m not saying it doesn’t happen. I’m not saying it can’t happen. Partial is a great thing to do if you’re using self-directed IRA. You don’t have that much fund, so it’s a great way to build it up by being able to buy twelve months of payments. You’re going to get a yield on your IRA. It’s also a great place to buy to raise capital if you want to sell a chunk of the cashflow off versus the full asset amount. Those are some things to keep in place. At partials, you can get great with your HP 10bII+ financial calculator. Those are some great things to look at and go from there. If something happens along the way, the borrower stops paying your foreclose. You’d get paid back sooner, and you’re still sitting there and free. Partials are critical so make sure you do have a third-party servicer. With most of the third party servicers, if you sell a partial off can direct your payments to be wired directly over whoever paid you for that chunk of payments or pay it to you if you’re the payment stream buyer.
Wraparound Mortgage Space
Let’s talk about another thing a lot of people don’t talk about in the note space, especially in the aspect of it. You have Subject To deals and you also have wraparound mortgages, which fall on the owner financing. First, I’m going to talk about the wraparound mortgage space. This happens a lot. If somebody is trying to sell a house and they can’t sell it, they may have a little bit of equity or no equity or have a very low-interest rate. They may do a wraparound mortgage. Let’s say I got a 4% interest rate on a mortgage, $100,000 is what I owe, and the house is worth $120,000. I can owner finance that loan with a wraparound mortgage at say $120,000 for 6%. I now have a difference between the 4% interest rate and the 6% interest rate. It’s the difference between the principal and interest payment between a $100,000 mortgage and $120,000 mortgage. If I’m the owner of the property and I’m owner financing and I’m taking the payments that are coming in from the wraparound second at 6%, it should be a nice chunk of payment. If I’m applying that directly, got a mortgage all in full, I should be writing down the mortgage balance underlying mortgage quite quickly. I’m building a little bit equity faster between my buyer who is buying it at $120,000 and a 6% interest rate he’s giving.
I’m going to pay down my principal faster. If they don’t pay, then you have the right to foreclose as the lien holders since you did the second. Take the property back and start all over again. I would never do an owner financed deal, whether it is a traditional owner financed or wraparound mortgage if they don’t have any skin in the game. Always got to get some down payment for at least 5%. I still would want to have a registered mortgage loan or agent to take a look at it, a wraparound mortgage and make sure you’re not offering a too higher rate. Not making it too high above what the property value is. You want to try to write these with the idea they’re going to work out for you and not with the idea in mind that you’re going to foreclose and take it all back.
Subject To Deals
Subject To mortgages and Subject To deals are buying the paper as well. It’s not taking me to buy. It’s taking it on the paying stream and not assuming the loan because the mortgage still stays in the borrower’s place. Substitute To deals are starting to pop up a little bit. When we see a downturn, you’re going to see more of these pop-up. Think about the Subject To deal with and the way to make money on a Subject To deal. You have to make sure there’s a chunk of equity between what you owe and what the property value is worth or it’s a low-interest rate even if there is no equity. At mortgage payment on $100,000 mortgage at 3%, it will be a lot less than it is at 6%. You’d get that 3% spread there. That’s one way to look at like, “I’m going to take us over cheap interest rate. I can owner finance 6% to 8% and make a difference on this spread.” I took over the existing mortgage and I said somebody else’s name, but you’ll see that happen when people got to move or they’re stressed or in a divorce situation. There’s a variety of different factors that can cause that.
A lot of people will take our Subject Tos and then turn them into rentals. That’s another way to look at what’s going on. Maybe there’s not a lot of equity, but there is a sizable difference from what PITI payment is and what market rent would be. For a market rent on a $100,000 house, let’s say it’s around $700 or $600, but market rent is $1,200 and you take away your taxes and insurance, you’re still going to have a couple of hundred dollars a month in cashflow. That’s not a bad day. I’ve known several people who have used Subject To deals to take down and build a nice rental portfolio. The borrowers on the original mortgage didn’t care because they were either going to go in default or motivated to get out from under the property. They still have that mortgage on their credit and the Subject To deal. You want to make sure in your documents if you’re doing a Subject To deal, but you’re very big bold letters or big description verified, this is not getting rid of the mortgage on your credit profile. They’re still liable for that. If you don’t pay the mortgage, it will worsen a credit situation so be careful about that. It’s important to keep that in mind when you’re thinking about a Subject To deal.
Subject To deals are great. It’s as if someone giving you property walking away. The only thing about the Subject To deal is to make sure that there is not a huge outstanding balance. That doesn’t mean it’s a bad deal. I’ve bought properties that were Subject To deals that we took over the mortgage for a year, and we brought money on the table. We brought some money to the table to pay the arrearages to keep it from going to foreclosure because it was such a nice equity spread in the back end. You want to make sure that the Subject To deal that you have the borrower add you on is a contact data. You also want to make sure to add that on the insurance.
Some people will say, “What about the Subject To on sale clause?” As long as the bank is getting the payments and they’ve been notified, if they start receiving checks, there’s a way to do that creatively that we’ve done before. We send in a check from us and say it with a letter. If someone says, “We’ve never had the check return.” If they ever come back like, “You sold the property. You took it over.” I’m like, “You’ve already accepted payments from me. We sent you a notice to the notice department. We’ve informed you of that.” No judge is going to rule against you on that aspect for the most part because you did your stuff. You sent in a letter sending payment, they’ve accepted the payments, and then go from there. Subject To deals is not a bad thing. Wraparound mortgages are not a bad thing.
You’ve got to know your numbers and know how to set those things up. More importantly, close with an attorney. Always have a real estate attorney to review your documents and make sure everything is cordial for your state. Don’t be using a generic form if download online and trying to do it all yourself. Spending a $500 to $1,000 is going to take. Document and create it well. The last thing you want to do is make an $80,000 to $100,000 mistake because you were cheap and you didn’t want to pay for a form or not to pay a couple of hundred bucks to have an attorney do their job for you. Another important thing to keep in mind here is you also have to consider what’s going on in the market.
Markets are constantly changing. If your market isn’t an appreciating market, you don’t want to take over some Subject To deals, especially if they’re losing equity or losing the value. It’s the same thing with an owner financed note or a wraparound mortgage. You don’t want to be doing that in a market that is starting to drop because the borrowers will lose motivation statement. If he’s making the mortgage payment and the market is dropping, they’re over-encumbered. They’ve got a mortgage that’s more than what their house is worth. That’s not a fun position to be in. We can all agree to that.
A couple of things to keep in mind for that. Take a look at housing prices. Looking at comps and looking at days on the market. This is why you want to talk to realtors to pull comps. You want to talk to realtors in an area and see what’s going on. None of us have a crystal ball. We can’t predict the future, but you can by the use of looking at realtors and looking at ATTOMData.com. It’s a great website for that as well to see hot markets and cooling markets. You may want to track your foreclosure numbers in an area too. One thing I look at is I try to avoid areas or markets where I see a lot of, “100% financing or $500 down gets you the house.” If you see houses in those areas, those are places that default relatively quickly. Why do they default? You have people that move in, buy a house, and the tax values based on the raw land. It’s not based on the raw land plus the improvements to the house. Come April, come February, come January when the tax value of the houses re-appreciate or reevaluated and their escrow accounts and tax amount is quite a bit higher. Their taxes boost things up.
Many people are budget mindset. They’re getting their house for as little as they can get so they can make it affordable. With a $200 or $300 increase in a mortgage payment depending on the area, depending on the state, taxes were a little higher at 2.6% to 2.7%. That can lead to them being in a bind in the first six months. That can lead to them being defaulted in 90 to 120 days depending on when they buy. Be careful. If you’re around some of those neighborhoods or those foreclosures, those defaults are going to affect the property value of the asset you’re looking at. That’s not saying you can’t go and take over some property if they’ve got cheap stuff. You got to make sure you’re able to afford it or if there’s a nice enough difference between the mortgage payments and what the market rent rate is. I say this as a voice of experience from early on in my business career, especially my real estate career. We got into a couple of investments we thought were going to be rentals. The only person that made money on those deals was the realtor. We couldn’t rent it for what we owed on the property. We were behind on it and we had to sell it.
We need to get out of those assets ASAP. When the borrower felt pain or when the market rent rates dried up a little bit and there’s a lot of vacancies. What happens? Market rents drop. Your rent rates are going to drop so keep that in mind. You want to make sure you have a buffer if you’re going to investing in those areas. There’s nothing wrong with buying those areas. Make sure you’re careful. Make sure you know what’s going on around you. Drive the markers, drive the area. Don’t just look at what the block is. I’ll give you another example. Memphis is going through a lot of blight in the area these days. You need to know Memphis on a street-by-street basis. It used to be okay ZIP code-wise, but that’s not the case. On a street-by-street basis, one block will be extremely nice and great and the next block over it’s going to look ugly. Those are the things you’ve got to keep in mind. It’s important. They don’t teach that to you most of the time up there. They’re like, “It’s great. Let’s buy this owner financed or take this over Subject To.” When you take over Subject To deals, you’re upside down and not making money on it.
Some students come to me and somebody talk, “This is a great deal. Take him over Subject To.” I’m like, “That doesn’t make any sense.” The only time it makes sense is if it’s in a market where you’ve got a ton of equity, and you can sell that asset off and make some money. You don’t want to hold on to property that you’re upside down on or you’ve got negative rates coming in. That’s not a smart place. That’s not a being a real estate investor. You’re devaluing your mount. You’re losing money every month. Another thing to keep in mind when you’re looking at that stuff is to be smart.
I was talking with somebody in Tampa where I had lunch and learn for five hours. When I came in, she’s got a hassle, “I want to offer owner financing.” I’m like, “Where’s that?” She says, “It was in Georgia.” I’m like, “Where do you live?” She’s from California. I’m like, “How much is the borrower is putting down?” She’s like, “Not much.” I said, “Does it need work?” She’s like, “Yes, it needs a lot of work.” I said, “What’s going to happen?” She said, “They’re going to fix and flip themselves.” I’m like, “Do you have a bid on the workout? Do you have bid on what’s going to be repaired and how much money they need?” She’s like, “No, they’re going to do it themselves.” I go, “That’s not a smart place to be in.” If you offer owner financing, you want to make sure they put some skin down and that they have the repair costs either in their accounts already or on a credit card or something they can pay for the repairs.
If they don’t have that, repairs going to do it as they go. They’re not going to get it done in a timely fashion. If you’ve got an ugly property that needs some work, I would reach out to your local hard money lender and see what they would finance for the acquisition of property and any repairs. They’ll often know by looking at it and said, “This is going to be $20,000 repairs or $50,000 repairs to get it up to where it needs to be with an after-repair value.” They will often preapprove a project for finance. They’re like, “We’ll approve 75% of that plus this for repairs.” That’s great. They’re pre-approved. You market the asset out to them or tell your potential buyer/borrower to say, “I’m not going to finance it, but you can go get financing from the hard money lender and then buy it from me and have funding in place.” You, as the property owner of the ugly property, can walk away with your money and not having to worry about if the borrower is going not to be able to pay because they can’t get the work done. I see a lot of people making mistakes on.
I’ve bought hard money loans before where people were unable to make the payments. They were going to do the repairs and they wanted us to pay parts and I was like, “I’m not going to do that.” We’re going to take a sizable discount because you are not smart enough to figure out the numbers on this and to prequalify your potential borrowers and rehab person. Be careful about that. That’s something you’re going to be looking at doing. It’s a niche out there. When the market turns south here, there’s going to be a lot of hard money loans available that you can pick up as a great little investment at discounts. It’s either to finish the rehab or to work something out with the existing borrowers to extend with a lot of them paying, or take the property back Cash for Keys and then sell them off as an asset. That’s a well-designed play in the next several months. We’re already starting to see some of that out there as well. Hard money lenders are starting to pick up the phone and say, “Would you buy my portfolio?” What’s going on with it? It’s the same thing, the same type of due diligence, same time to check in and out and making sure the numbers make sense in case you’ve got to take that property back yourself.
Let’s do a recap. We talked about nonperforming first and seconds. We talked about a contract for deeds. We talked about owner financed notes first and second. We talked about partials. We also talked about wraparounds and Subject Tos, two different things. Commercial notes are a whole different ballgame and whole different flavor. I would not buy a commercial second. I’d only be buying commercial liens secured by real estate. I had a portfolio sent me where it was an SBA loan that did not include the property. I’m not going to buy those loans. I want to buy the building. I’ll buy commercial notes on commercial properties. The same thing goes. You’ve got to look at the values. If you think of the commercial notes, you’ve got to make sure that the cashflow is there. It’s all about bringing income and cap rates with that stuff. If you don’t have the rent rates and you don’t have the leases in place, it’s going to depreciate the value of that asset. If there are long-term tenants in place and you’ve got the cashflow and all that stuff and rent rate go along with it, it makes it a far more desirable asset. There’s still some opportunity to make some things happen.
I like dealing directly with banks on the commercial side because they know what’s going on. Often, they have paperwork. They’ll know the rent rates. They’ll know the rent rolls. They’ll know what’s going on with the asset. Depending on the balance of the loan, they may often move the loan from the nonperforming side to the performing side if you take over control of the asset. We’ve had that happen a couple of times. It’s been nice. Anything in sub-million in value is balanced. They want you to move off the books and find somebody else to come take it down, but they’ll offer discounts, especially if it’s nonperforming for a while.
There’s also the scratch and dense stuff out there where borrowers are on time or late. We get caught back up. They can get stuff at a discount. It’s not just the case with commercial notes. You’ll see that with institutional debt and bank debt also on the residential side. A lot of people think about commercial loans. If the borrower is not paying, but they have tenants in place that is paying, you as the bank often have the right to go and collect the rents. The rental clause in the mortgage and the commercial loan allows for the bank to do that. It takes away a lot of the motivation from the borrower who is not paying to get working with you to do some workout or modification or do something to get taken care of. I would highly recommend each commercial asset class, whether it’s a mixed-used or big box or medical office or self-storage or apartments. Each one is a little bit different than hotels and motels. They’re in a different class of each asset. What I would highly do if you find something is to reach out to an expert in each of those fields or each of that individual asset class and have them work with you on the deal.
It’s better to get a part of something and gain a lot of knowledge about a commercial asset versus get 100% of nothing. Often, banks do not want to turn over or to sell up to somebody who doesn’t have any experience. You don’t have to have a lot of experience. I got this team member who’s doing all this turnaround with self-storage. He was doing this stuff with golf courses or whatever. As long as you got teammates that show that, it will add value to you and value to the bank still looking to work with you. I’ve covered up a lot of stuff on this episode. Hopefully, it was valuable. One of the great things being in the real estate industry for many years is we’ve seen a lot of different things. We invested in a lot of things and bought and successfully sold some things. It’s not to say we haven’t had our ups and downs and had deals that have gone south. We keep continuing to rock and rolling and keep going forward.
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