Scott discusses some of the nuances of buying notes with low UPB when compared to the current market value and why you should or should not chase equity deals.
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Today’s topic is one of the most misconceived areas of note investing, and that’s buying notes that have a ton of equity, buying the unpaid balance. I’m talking first liens here. We’ll talk about second liens in a minute. I see a lot of note investors who struggle when they see notes with equity deals. A lot of note investors, when they’re looking at tapes, they’ll see an asset that the unpaid balance is $45,000. Let’s say the value is $90,000. There’s a substantial amount of equity there. Value is $90,000, the house is worth $45,000. The people go excited about that. The thing you have to keep in mind is most note sellers, banks, hedge funds, when they see stuff like that, they’re not going to sell that note at a substantial discount. They’re not going to sell it at $0.50 on the dollar unpaid balance. There’s no reason for them to. If they foreclose, what happens to the note? What happens to the foreclosure auction? There’s a lot of equity there. In most foreclosure auctions, assets are getting bid up $0.80, $0.90 on the dollar of true market value. That would be great if you’re the property owner of the asset. You sold the asset for $80,000, $90,000, great. You pay off your mortgage of $45,000 and you’re seeing $35,000 in profits, but that’s not the case.
As a true note investor, first lien, the most you could bid at the auction would be your payoff amount. That’s your unpaid balance plus back payments plus late fees. That’s your highest bid price. Let’s say it’s $50,000 or $55,000 and it bids up at $80,000. You’re not going to get the $35,000 difference. You’re going to get the $55,000. The $35,000 then is going to go back to the borrower, or if it’s a deceased borrower, back to the borrower’s estate. You’re not going to be able to claim that overage at the foreclosure auction. It doesn’t work that way. I see so many people get excited, “There’s equity,” because they come from the real estate side of things where they love equity. As a previous postcard mailer real estate investor, one of the things that I would use to do is I would target properties with equity. I’d find properties I can take over subject soon because maybe it was worth $120,000 and they only owed $100,000. If I took over $72,000 then I’d have that equity. If I sold the property at that point then I would capitalize a net $19,000 to $20,000 in equity. That would go in my pocket being technically the property owner. It doesn’t work that way in notes. First liens, you’re not going to see that equity.
What is a little bit different, second lien investors will go after equity deals especially on their seconds because they’re buying the second as a substantial fraction. They’re going to get made whole with that. They’ll chase those with equity because if there is a second on those compared to what the first balance is towards the market value, if there is a second they will often get paid in full at the foreclosure auction. Since they’re in a second lien position behind a non-performing first, they’re still going to buy the discount. Those are also getting bid up as well as the amount is going down and values have accelerated. Whereas seconds weren’t always fully paid off, now the values of these assets that have been around for awhile are exceeding the first and the second balances. That equity beyond the second balance will then go to the homeowner or the seconds are hoping to foreclose subject to the first to do the eviction and then take that equity back.
The only time that a first lien note deal makes sense to buy with equity is if you can get the borrower to do a deed in lieu. You get the borrower to do a Cash for Keys. You have to think of the mentality of a homeowner. If they think there’s a lot of equity there, they’re going to fight you. Say the house is worth $150,000 and they only owe $100,000. There’s equity there that either they have paid for by paying down the mortgage or they have written the valuation waive up as the property values have increased. They think they’re entitled to something. They’re going to fight you for that. Those have always been the deals that have dragged out the longest as the owner of the equity. That’s not saying you can’t offer substantial Cash for Keys. You could but you have to realize too, some people know what their property’s worth. All they’ve got to do is have somebody to talk to and then they will drag stuff out. Then you’re often paying too much for the first lien.
Most of the banks that are selling first liens that have ton of equity, they’re going to sell it at $0.90, $0.95 of unpaid balance because their justification is you’re going to get paid off at the foreclosure auction. What’s also disturbing, which aggravates the crap out of me, is some sellers will sell off a pay off, not UPB. Their total legal balance is $110,000. First liens is $80,000, you’ve got $30,000 in back payments. Don’t sell it to me off of payout. My purchase price is only going to be off the UPB. If there’s equity at that point, say it’s worth $150,000 and there’s $20,000 equity, that’s not a lot of equity you can put because you can figure out one comp. A lot of times you get comps that fluctuate a little bit between $5,000 and $10,000 or sometimes $15,000 depending in the market and depending on the condition. As we all know, homeowners like to think the value of their property is based off pristine condition, not as is, “That one sold for $150,000. It’s brand new.” My piece of crap has got to shag carpet from the 70s, the pink toilet still, the green walls, the flowered wallpapering, wood paneling.
The reason I bring this up, I encourage people to email me deals that they’re working through. I have to give a big shout out to Todd who sent a deal to me. He said, “It’s in a desirable area where a lot of fix and flippers. Supposing the BPO value is $90,000, the unpaid balance is $45,000.” I’m like, “Don’t do that deal because there’s too much equity there.” Your pay off is probably going to be around $52,000 total. That’s the most you could bid. The seller is going to want closer to the $45,000. They’re going to sell that asset to you at $0.50 of unpaid balance because of all the equity. A lot of investors, they end up buying stuff thinking like the profit if you’re a traditional fix and flipper or traditional real estate investor where they tell you, “Go after equity deals. Equity deals are good. Take thousand on these deals because there’s a lot equity,” or if you’re going to buy it at the foreclosure because there’s a ton of equity on the ARV. That’s not the case with note investing. You’re buying the balance of the loan. You only have the legal right to foreclose on the amount owed. You can’t get shady.
Don’t get me wrong, you can negotiate Cash for Keys, deed in lieu in some cases. The borrower’s not going to know exactly what they have as far as values but you have to be careful when you end up foreclosing. There have been some equity stripping loans that have gotten in place. They have gotten some nasty in the last few years. I think California enacted a law a few years ago that if you bought a note then foreclose and sold it for more than 85% of the value, you’ve got to give a percentage of that back to the borrowers especially on owner occupied. That’s not fun. You’re doing all the work and it’s all to give money back after the deal? No. You’ve got to be careful when it comes to that aspect of the first lien. That’s the first thing you should look for, “What’s the UPB versus value?” You have non-performing notes where you’ve got to foreclose. The one thing that is different in a couple of situations is contract for deeds. In contract for deeds, it’s more of an eviction process. If they don’t pay, they don’t stay, you evict. What you have to be careful of is there are few states like Michigan, I think Ohio is also one of those as well, that if the borrower on a contract for deed has been paying for more than four years or has more than 25% equity in the deal, you then have to foreclose. I think it’s fair to the consumer for the most part. I do believe that the equity side is a fair thing. Me being a note investor, I’d like it if it wasn’t. obviously.
For the most part, you have to keep that in mind when you’re looking at deals. If they have been there for four years or they have more than 25% in equity between what’s owed and the true value of the property, then you’ve got to foreclose. That’s a little thing to keep in mind. In contract for deeds, you shouldn’t be paying near UPB either way, especially non-performing stuff. I would not be going really over 50%. I think it’s better to be below that. When they’re not paying 50%, it’s going to be close to the borrower’s paid at least something in the last twelve months which is what we like to target. We target contract for deeds that the borrower has made something of a payment in the last six to twelve months because that really shows a lot of interest in staying in the property. I would rather keep them in the property than I would have to evict and then try to sell it as an REO for the most part.
We are excited. We are basically right about two weeks out from Note Camp 4.0. I’ve been working on the schedule. Equity deals, you’re going to have to foreclose most of the time. If you can buy the note and get it reinstated and it makes sense ROI-wise and the cash look great, that’s great. But if you’ve got to foreclose and you only have a little bit of return, why would you spend the year foreclosing if you’re only going to see about 5% to 10% return? That’s not a good use of your monetary funds. That’s not good when you can do better and get a high return for something that has no equity. The thing to keep in mind is when I’m buying notes, I like to make sure I control all the angles. I want to be the person that actually control which way we go ultimately. That means if I have to foreclose, I’m going to foreclose. What I also want to keep in mind though is if you’re buying a note and there is no equity and the borrower is not going to fight you as much, but they’re going to be more willing to work with you to try and stay.
This is why it’s important to look at what the rental rates are and true values of an asset so that you have some flexibility, “I know you’re upside down and there’s no equity here. You owe $120,000. The house is worth $100,000.” Those type of conversations put me in a powerful position, in the power seat. “Let me help you. Let’s to come to arbitration and come to something that makes sense for you.” What isn’t always an easy conversation is when you come across the opposite way where it’s worth $120,000 and they owe $100,000. We have pay offs and things like that. They may not have much equity. It’s something that the borrowers need to keep in mind. If they won’t go out and get a loan to get pay off, it’s just going to drag out. Those loan modifications never usually work. I’m not saying usually. I’m not saying that somebody hasn’t gone, somebody will get modified and made sense in that aspect. The law of numbers out of ten notes you buy, half you’re going to foreclose on, a quarter of them you’re going to get deed in lieus, a quarter you’re going to get re-performing, depending on what you’re buying.
If it’s a non-performing note with equity, and I’m talking a sizeable chunk of equity, expect the sellers are going to sell it close to unpaid balance. In the case where they owe $0.50 on the dollar of value, the sellers are going to want closer to $0.45. It’s not worth taking the time to foreclose. Could you get a deed in lieu? Yes, but there’s no guarantee to that unless you know something that we don’t know, unless the borrowers express that in their servicing files or things like that. You also got to be careful. Another thing on the side notes here, you also got to be careful what the seller’s BPO says. Is it just a valuation? Is that $90,000 value that they’ve given true or is it really $70,000? Is that $90,000 based off at Zillow estimate? Good luck with that. I get bombarded with people, “Do you want to do these deals? Do you want these deals?” The first thing I look at is, “What’s the payoff?” If you take considerably true payoff, then it gives you an opportunity to say there is no equity with these. A lot of times, that’s not the case. There’s equity. Somebody’s going to fight you. I don’t want to fight people. That’s why when I get a tape in, I almost automatically kill those deals. I just go ahead and remove them. It’s not worth it. It’s not worth to be fighting back and forth, “Will I get a better deal?” when it’s truly non-performing note there.
One of the things too you’ll run into is people that maybe they don’t have the money to modify but those that have equity will often then do one of a couple of things. They’ll either file a TRO of pre-foreclosure, it’s a Temporary Restraining Order. That can delay things 90 days. They usually show the judge good cause for that to get a temporary restraining order or either the seller have not done the things they’re supposed to do. The other thing that often happens a lot is the seller files BK. They file bankruptcy. The beautiful thing about bankruptcy is you then have somebody to talk to. You’ve got an attorney to talk to. It does delay things some. You’re talking another three to six months. But there’s a couple of things that are great about bankruptcy is while they’re filing bankruptcy, they’re supposed to be making payments. They’re supposed to make their existing payment while they’re working through the bankruptcy. That doesn’t always happen. They can have it often to help to work to have the bankruptcy discharged.
Once somebody files bankruptcy and they come up with a Chapter 13 is a workout plan. It’s supposed to get come back up in five years. Those can be really nice modifications. Those can be really good desirable notes if somebody’s in a BK Chapter 13. Our buddy, Jack Crupi over there runs a $100 million plus fund that focuses primarily just on BK Chapter 13. They want that cashflow. One thing you’ve got to keep in mind too is how long is that payment’s coming in. What’s beautiful about a bankruptcy deal, it’s literally like an x-ray machine. You can see underneath the clothes. You see the true colors or you see the true behind the curtain. Borrower has to open the kimono. You’ve got the flasher there from the Pacer.gov in the bankruptcy files. You can find so much information now. What do they have for assets? What are they making? What do they value the house at? That’s a nice thing too. You see what they value the house at. That helps dramatically because you have to look at this. If the seller of the note is valuing the house a lot more than what the owner of the house as the borrower is, that works as a negotiating chip in your due diligence. You’ve got your value at $130,000 but the borrower only values it $120,000. That’s a bankruptcy file. That’s a lot more accurate, unless you’re going to share your BPO with me, “It’s with AVM, an Automated Valuation Model.” No, that’s not accurate. A BPO, appraisal are two of the better things that you have to have. You’ve got Pacer.gov and it’s relatively cheap. You can download a whole BK file and throw just a few dollars and you get so much information like that.
We had our Fast Track students this last weekend and one of the highlights that they liked was looking at collateral files. It’s different looking at the collateral file in your hand versus just an electronic file. You learned a lot of electronic filing but you’ll learn so much more looking at the hard collateral file. You come and you see you the backgrounds. You see the 1003 application. You see the notes in the files. You see pictures. You see sometimes if a borrower has tried to do a loan mod or short sale, a lot of times that stuff will end up in the collateral file. Sometimes, it’s just the loan file itself and the assignments. It’s a thin file, which is okay. It’s much more valuable when you do have the original 1003 application because then you see what’s going on with the borrower. You see where they’ve been at but if they’ve ever filed bankruptcy, that’s a good thing to check because you’ll get a lot more information. You’ll get phone numbers, you’ll get work information, salary. That helps you identify opportunities.
Let me give you a little example of identifying an opportunity. If a borrower is making $50,000 a year in salary, what you want to do as an easy calculation is to take a third of $50,000 which is $17,000 roughly. Homeowners, if you’re getting qualified for mortgage, you shouldn’t be spending more than really 38% on your mortgage payments, your PITI stuff. What you do is take $17,000 and divide that by twelve months. That’s going to come out to $1,416.67. That’s what the really combined PITI should be. That’s something to keep in mind when you’re looking at modifying a note, modifying an asset, looking to see the affordability. If they’re making $24,000 a year, that’s not a lot of money. It means $8,000 in total payments. That comes up to $700 PITI. That’s not a lot of income. It’s also not a lot of money, so you’ve got to be careful of that. Most people don’t understand that. They don’t understand when it comes from being ex-mortgage banker, that’s one of the things that we look at. What are you making roughly individually or combined to see if you can qualify for something that’s going to make sense for stuff like that?
Donovan was here. He really enjoyed it. He’s like, “What am I looking at?” He’s flipping and Marilyn was like, “I don’t understand this.” I was like, “Look and see what you have. Look at the story that the loan file tells you.” Donovan had a good time. Everybody had a file folder to look at. I spent some time going through it. I said, “Here we found the old 1003 loan application. This is what they’re working.” The person that we were looking at, his loan file was making $24,000 a year as a loan process or a loan servicer employee. You could see in the loan file that basically his house was originally unit 41 but he took a cash-out refi at $90,000 about three years after he bought the property. This is in Tampa. The loan was for $90,000. You can see he pulled cash out of the deal. That’s always a valuable thing to see if it was a purchase or cash refi because then my question is if I’m talking to a borrower is, what did you do with the cash? Did you spend it on toys? Did you pay it before you go to school? What did you do with the deal? What did you do with the cash? That’s always a valuable thing.
I have found collateral files where the deed in lieu has been overwritten in there and if that’s case, great, awesome. Let’s list it as an REO. I’ve also found insurance company checks sitting in the file folder that the previous note owner missed. After then, just got it re-endorsed and file the claim. You see so much information in collateral files that could help you determine things. Take the time to look at that stuff. Take the time to spend through the assets. If it’s the first couple of files, it’s going to be confusing. You may want to have somebody jump on it and look at it, maybe somebody who’s a little bit more experienced, “Would you mind looking through the collateral file with me quickly?” I’m not going to do it if you’re buying ten notes. We’re not going to spend time to do it ten times but I will look at one or two with you. It’s always good if you take the time to look at that stuff yourself first because you’ll see some things. It will help you identify what you’re looking at and give you much more accurate story of things.
If the property is really cute, “It’s so pretty. I like that. It’s such a pretty house. OTSC, oh that’s so cute.” Avoid the OTSC syndrome. If Donovan set me up for that with that soft ball, I have to pay a buck for that. So many people are like, “That’s so cute.” Don’t get me wrong, it’s nice to buy cute assets. It’s easier to market cute assets if the numbers work which should say, “Look at that return. That return is so cute.” That’s the better way to look at it. You’ve got to take the emotion out of it. I think so many real estate entrepreneurs, come in over whether they’re an REO refugee coming into the note game, they’re a fix and flop flunky who are looking for REOs. They have the idea of the whole equity thing. You have to assume you’re going to have to foreclose. Hopefully, your first strategy should be to modify.
In some cases, if it’s deceased like our good buddy, Adam, ends up getting a lot of deceased. One thing to keep in mind too if it’s a deceased borrower, you’re going to have to foreclose. If it’s a deceased borrower, that overage is going back to the estate or the other lien holders in the estate. In some cases, what’s good to see is what’s the property selling the foreclosure auction. In some states, you can actually see what literally is going to foreclosure, the bids, and things like that. Florida is really good about having their foreclosure auctions that you can check out online. It helps out tremendously when I’m looking at assets there, “What do I need to bid on? We’re getting ready to foreclose on something. Let’s look at what the comps are.” I believe we’ve used that several times in the past. Sold a six-unit apartment complex in Southeast Florida and we were able to see the similar properties, what were they foreclosing at and that’s helped us come up with our initial bid at the foreclosure auction which we got, we sold it, made $175,000. It ain’t much but that’s not a bad return. Not bad at all.
That’s the thing to keep in mind. I get it, “Equity is going to protect my investment.” It’s not really protecting your investment because the fact is there’s not a lot of money to be made on that aspect of the little bit of balance than the seller’s going to have. If the seller’s going to sell it to you at 50% of UPB, then it will make sense. Most of the time, you’ve got to be very careful on your values. Definitely, definitely, never trust a seller’s value. Check it yourself, jump online, pay the $50 for realtor to drive by, pay the $99 for WeGoLook.com to drive by and get you some photos. They’re not going to pull values for you but they’ll definitely give you plenty of photos and that’s pretty easy to then say, “This is a pretty good condition. I can then compare it with the recent solds online.”
I’m trying to think if I’ve ever bought any assets that have had equity in some sizeable amount than we’re able to take back rarely so than we’ve been able to do that. I get more from the second liens side where they foreclose somebody to the first, then they handle the eviction, and then they take the property back to that point and sell it off. That’s happened a few times. I know some people have done successfully with that but that’s not a strategy for what we do with the first lien position notes. Be very careful. It’s a little different story with the contract for deeds. If they’ve been there for four years or have more than 25% equity, there are states that will require you to foreclose instead of the eviction side and contract for deeds.
Equity deals, you’ve got to be careful. You just got to check it out, equity or no equity. Always verify, always pull your values and focus on the three biggest things: values, values, values. That’s making sure you have a true value that will protect your investor’s security. Taxes, checking taxes, making sure your tax foreclosure hasn’t wiped out your position, making sure that the borrower’s name on the mortgage matches up the borrower’s name on the property. Thirdly, title; checking O&E, checking title reports things like that, using ProTitleUSA, employment O&E report, Ownership and Encumbrance report, see what liens are on the property. Keep in mind too, if there is equity, you want to make sure that there are no other liens out there that are going to eat up that equity as well. You’ve got to be careful because sometimes, they’re the junior lien holder after taxes and then you often sometimes liens are in the third position. They can get wiped out if there’s no equity at a foreclosure auction. If there is equity, guess who’s going to have holding their hand out, “You need to pay me. Please pay me. Pay me my money. Pay me my money now.”
That’s all we got for the episode. Please make sure you go check out our back episodes. Make sure to leave a review if you’re enjoying the show. If you’re listening internationally like 5% of our listeners are, I’d love for you to leave a review. We’ve got people in over twenty countries listening in online. That really excites me. It really shows that note investing is a worldwide thing. We’ll see you all at the top.