For the longest time, this podcast has been going deep into some quite advanced material in note investing. However, there are quite a number of requests for some basic information for those who are just starting. If you are new to note investing, or have just heard of it and want to know what it is, then this episode is for you! Dan Deppen goes over the basics and discusses what a note is, how to profit from them, and some of the advantages and disadvantages of investing in notes versus other types of real estate. This is not a rainbows and unicorns promotion of note investing. This episode covers everything from the good things to the potential negatives. Listen in and decide for yourself if it’s something you would want to pursue!
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Note Investing For Newbies
In this episode, I’m going to take a little different attack. I’m going to be talking about note investing for newbies. This is intended for people who are brand new to the note space. They are trying to wrap their head around it and figure out what’s going on, how they can get involved, and what are some of the opportunities that might be in this cool space. If you’ve been following me, you’ll know that most of the content that I put out tends to be a little more advanced and down in the weeds. I’ve been getting a lot of requests for more beginner type of material. In this episode, I’m going to focus on some of the basics that you’ll need to know.
We’re going to start by talking about what is note investing? It’s when you’re buying a note or a loan instead of the actual property. Once you own this note, you can then begin either collecting payments or if the borrower’s not making payments, you can potentially foreclose and act like a bank. That’s why some people refer to note investing as being a lien lord instead of a landlord. You are acting like a bank. The difference is a note investor is buying a note that already exists and not necessarily creating a new one. Although a lot of times people do create new ones using seller finance. I do that somewhat myself, but you want to think of yourself as being like a bank instead of a landlord. As you can probably guess, being a banker is a good position to be in.
What Is A Note?
Let’s talk about what a note is itself. A note is a promise to pay that some borrower made or referred to as a promissory note. I first came across this when I was a kid, 6 or 7 years old, playing that board game Life where they had those red $20,000 promissory notes. I remember when I was little wondering what the is that. My dad worked in the loan business at that time and explained to me how that works. You’re not going to have a note by itself, but there’s going to be a note and then some security interest attached to a piece of property. That’s a mortgage. Although it’s referred to in the industry as a note, in reality, you’re getting a note and a mortgage. There’s also another variation on that called a contract for deed that I run into a lot. I’m not going to deep dive on this one.
There’s work in a similar way, but there are some key differences there too. That’s a good topic for another show. When we say note, we’re talking about two things. Some promissory note and some security instrument attached to the property. What a security instrument is doing is saying if the borrower does not perform on the note, do not make payments, or do not live up to what they agreed to, then the lender can make a claim on that piece of property or that piece of collateral that’s used to secure the loan. There are two different types of notes you can buy as an investor. The first bucket is performing notes. When you buy a performing note, you’re buying a payment stream.
You buy this note and then you receive payments every month. Most of you have a mortgage and you pay it every month. You might be thinking what other kinds are there? Why wouldn’t you pay your mortgage every month? That doesn’t always happen. That brings us to the second bucket, which is the nonperforming notes. Nonperforming is a broad category. I’m keeping it simple for this episode. Nonperforming means that the borrower is either not paying or they might be making some payments, but they’re behind on the loan. If you buy a nonperforming loan, you’re not sitting back and receiving payments every month. The notes going to have to be considered working out in some way to get to a resolution. Later on in this, I’m going to talk about some of the things you can do to work out a nonperforming note.
You might be wondering, “Why would you ever buy a nonperforming note? Why would I buy a loan with borrowers not making any payments?” There are a lot of good reasons why you might want to do that. For one, they sold at a much larger discount than a performing note. There are all things we can do with nonperforming notes either working with the borrower to get them reperforming and now we can resell it at a smaller discount or foreclosing or doing a few other things to get the property back and you can use it as a property acquisition strategy. The reality is there are a million shades of gray in between. For the sake of this, I’m putting it into two buckets. There are all different types of nonperforming loans. One is where they’re a little bit behind. I’ve seen loans where the borrower hasn’t made a payment in ten years and the property’s abandoned. In my system, I put those in different categories but for the sake of this, I’m going to try to keep it straightforward.
Why Buy Notes?
We’ve talked about what note investing is, what notes are, and the types of notes. Now I’m going to talk about why I buy notes, and why you might be interested in doing the same. There are a lot of good reasons why you might. Number one is cashflow. Investors are always looking for investment options to generate cash. Notes are a great way to do that because they don’t necessarily carry some of the obligations that buying rental property would have. The returns are going to be a lot better than a dividend-paying stock or some kind of treasury bond or corporate bond or things like that. You can get good cashflows with these. Often, when I’m buying performing notes, it’s 8% to 15% annualized return, based on the riskiness and some other characteristics of a loan.
Be careful with note deals that look like they have potentially higher return because they generally carry higher risk as well. Click To TweetThe second reason is those are higher returns. If I’m buying a performing note and I’m getting 8% to 15%, that’s a lot better than my other fixed-income options. If I’m doing nonperforming notes, I have the opportunity to potentially make even more, although that carries risk with it. One of the things I always emphasize is there’s no free lunch. You want to be careful about grabbing a deal that looks like it has a potentially higher return because of the higher risk that goes with it. That doesn’t mean that’s a bad thing. It just means you want to be thoughtful about how you do these things, but generally speaking, you can get much higher returns than in other investment classes.
The reason number three for buying notes is there tends to be a lot less competition. Let’s say your model is you want to buy REOs to either do fix and flips, or turn them into rentals, or turn them into turnkey rentals, there’s a lot of competition. There are a lot of people in that game or if you’re trying to wholesale, there are thousands of people who do that. Note investing has a much smaller pool of investors, even if it’s a niche to your industry than some of the other forms of real estate investing. What I like about it is I can get better returns. I’m not competing with hordes of people to do it. That’s part of the reason why you can get these higher returns. There’s a reason for everything. It’s not this magical thing where the higher returns are just sitting around. There are reasons for that. A lot of it is not as many people know how to do this. The good news is it’s not necessarily as hard to do as some people make it out to. You don’t have to spend $75,000 with some guru to learn how to do it. I like it a lot.
Reason number four is that you can avoid some of the issues related to rentals. When you’re a bank, you’re collecting payments and dealing with the loan. You have an interest in the property and you can foreclose it, but you don’t own the property. If your toilet clogs, you don’t call Bank of America who may have your mortgage. You don’t have to deal with that. There is a flip side to this as well that I’m going to get to here shortly. If you foreclose and end up with an REO, now you’ve got something that could be more challenging than a rental. In general, these are a lot more hands-off. You’re not hiring a property manager. It can be simplified, particularly if you’re buying performing notes for cashflow.
The reason number five can be a lower-cost method of acquiring property. Some of these depend on what your strategy is. If you’re buying performing notes for cashflow, you’re not trying to acquire the property. That means the loan stops paying. That’s not good. What some people do if they want to do fix and flips or create rentals, especially now with COVID and some of the courts slowed down, the supply of real estate inventory is low. I was talking to a friend of mine here in the Denver area that’s at Keller Williams Realty. He was telling me that in the Denver Metro area, the total housing supply is 3,500 houses for sale. To have a stable market, they need 35,000 properties on the market.
In Denver in late 2020, the supply of inventory is 10% of what you need for a stable property. If your investing model counts on you getting properties, that’s difficult. However, if you buy a distressed note and then either foreclose or got a deed in lieu with the borrower, that can be a way to get properties that are off-market. Your total acquisition cost is going to be quite a bit lower than if you go out and you’re bidding against everybody and their uncle on a property.
Reason number six is it’s a great way to grow your IRA. In my IRA, I own a bunch of performing notes that have high yields on them. I let those sit there and grow. With the stock market being high and a lot of volatility and potential volatility as we get into the next couple of years, and these after-effects of the pandemic shake out, there are a lot more impacts to come. The stock market is dicey. Yields on bonds are low. This is a good way to get a high yield in your IRA, but then also have collateral behind it. The other advantage is property values have gone up. A lot of these loans that you can get good yields on have good equity. For some reason that the borrowers stop performing, you’ve got a lot of equity there to make yourself whole and even profit more in some cases. It’s a great way to grow your IRA account.
There are also some disadvantages to notes. One of my pet peeves in this industry is when a lot of people talk about all the good things, and they don’t talk about any of the potential negatives. They take the rainbows and unicorns approach that everything is rosy and great. While I think it’s a much better space than others, that’s why I play here, there are some things to be aware of. Number one is the loss of some of the tax advantages. One of the great things about investing in real estate is some of the amazing tax advantages that you can take advantage of.
Everyone was talking about Donald Trump’s $750 tax bill. The people who get upset about that don’t understand all of the amazing advantages that the IRS gives you if you’re investing in real estate. If you invest in notes, you don’t get a lot of those advantages. You’re not able to claim depreciation and some other things. Another partial reason for some of those higher returns, net net, you still do better overall, but it’s something that you should be aware of. The second one is I mentioned how notes can be a lot better than rentals because you don’t have as much to deal with. However, if you have one that stops performing, and you need to foreclose and you take it back, oftentimes, those properties are in rough shape.
You can end up with more headaches than a rental in some situations. It doesn’t happen often to me. When it does, it’s a pain. I had one a while back that was a hoarder house with tons of trash. That was a lot more work to deal with than a tenant called me up about a clogged toilet or something like that. It doesn’t happen often but it can. It’s something to be aware of. The third thing is I mentioned how there’s less competition in notes. The flip side of that is when you sell your notes, there are fewer buyers out there. It’s a little less liquid of a market overall. You can still sell notes easily, and I’ll talk about some ways to buy notes coming up. You can sell them using those same resources. I sell notes all the time, but that process is a little different. It can sometimes take a bit longer than a traditional real estate transaction.
Where Can I Buy Notes?
The big question that I always get is, “Where can I go to buy notes?” There are a lot of different places you can go. I’ll hit some of the main ones here, but if you want a little more complete list, if you go to the FusionNotes.com website, you should get a pop-up where you can download a free guide with eight places to buy mortgage notes. There are a couple of different online platforms. The main one that I use is Paperstac.com. I like them a lot. When I sell notes, that’s where I tend to go for the most part. There are also some reputable brokers out there.
If you go to DirectSourceRE.com, a gentleman named John Keith sends stuff out on a regular basis if you get on his list. SN Servicing is a servicing company. They have a brokerage desk as well that sends out notes on a regular basis. David Pollio is the guy that runs that. The other place that I’ve been buying a lot is from other note investors. One of the best things that you can do is build a network and join some of the Facebook groups that are out there. What happens is people who are investing in notes often invest in other real estate deals, whether they’re doing rentals, self-storage or multifamily.
Oftentimes, they’re looking to liquidate some of their notes because they have some other hot multifamily investment or whatever it is they want to go do. If you have a good network and a good reputation as a solid buyer who’s going to follow through, I oftentimes buy notes where people contact me and say, “I want to get rid of this. Are you interested in it?” They know if it fits my investment model and the price is reasonable, and there are no issues with the note, then I’m going to be able to close on it quickly. That’s one of the best ways to do it. Those are some quick ideas to get going on buying notes. If you go to Fusion Notes website, you can download that guide for free. It’ll give you more resources beyond this, and also some links that you can click on and things like that.
What Vendors Do I Need?
When you start buying notes and running them, there are a lot of different vendors that you’re going to need to rely on. One of the nice things about note investing is you can set up a team of vendors and let them do most of the work. It’s a matter of following up with the vendors and making sure everything’s happening the way that it’s supposed to. I’ll talk about six different types of vendors that you’ll need. Number one is realtors. My realtors do a lot for me. I’m investing all across the country. I’m based in Colorado. I don’t buy any notes here because they’re not available because our market’s been too smoking hot to have any. The realtors are going to do a lot of different things for you. You’re going to want to have a good one in each of the markets that you’re operating in.
When you’re in the stage of buying a note and doing your due diligence, they’re going to be able to do drive-bys, give you photos and estimates of the value. If you do end up start taking properties back, they can sell your REOs for you. Also, when you get REOs, they can help coordinate with property managers, hook you up with local vendors if you need to do any rehab work or anything like that. I’ve even had some amazing realtors who have gone to court for me. Sometimes depending on the jurisdiction, if you’re doing a foreclosure, you have to have a representative in court. Your attorneys can do that for you, but I’ve even had some amazing realtors who have gone in and done that for me as well. Finding the right ones are gold.
The other thing too that I’ll point out when you’re looking for realtors in a particular area, you want ones who specialize in distressed assets and foreclosures. Most of the realtors aren’t going to be familiar with note investing or understand it. If you call around and start asking for ones who do short sales, foreclosures and REOs, you can find the right one in your area. When you find those good ones, remember them and treat them well. The second type of vendor is the title companies. I’m using this to pull title or O&E reports as part of my due diligence process. O&E report is an Ownership and Encumbrance report. I think of it as a mini-title report and then also, if you get REOs and you’re selling them, they’re going to help you with that closing process.
There are infinite exit strategies in note investing. If game plan number one doesn’t work, you’ll always have a lot of fallback options. Click To TweetNumber three are your attorneys. This is something you’re going to leverage heavily. One of the most important areas to utilize an attorney is doing a review of the loan documents before you close. Every state has its own nuances. You’re going to want a foreclosure attorney and licensed in that state to review your documents before you close. Sometimes you can find little issues on mortgages or in the title work that they’re going to be able to spot. Full disclosure, I’m not an attorney. I’ve reviewed enough loan files that I know enough to be dangerous. I’m at the point now where I can spot most issues when I review the docs. However, sometimes different states have different little nuances.
I’m not an attorney myself, so I always get that document review done upfront as an insurance policy to make sure I don’t make a big mistake, buy something that’s not enforceable or I can’t get a clear title. You’re going to use attorneys if you start doing foreclosures or if you do a deed in lieu with a borrower. That’s when the borrower agrees to leave and sign the property over. You need legal documents to do that. If you are taking outside money or if you’re providing money to an operator for a deal, you’re going to have either a joint venture agreement or some partial agreement or something else. You’re going to want attorneys to review those as well to make sure that they’re solid and everything is correct.
The number four is your insurance companies. You use this for force-placed insurance. Oftentimes if you have a nonperforming loan, if the borrower is not paying a loan, they’re not paying the insurance either and often the taxes as well. As a lender, you have to protect your interests. If the borrower is not paying for insurance or providing proof of insurance, then you need to get your own on that property, which is called Force-Placed Insurance or FPI. It’s how people refer to it. This is important because I’ve heard a lot of stories of trees falling on houses, and houses burned down more than you would think. I had one burned down in 2020 and insurance paid off in full. One of the important things is you want to make sure that either your borrowers have insurance or you’re putting insurance in place yourself.
These are in no particular order. Number five are your loan servicers. The loan servicers are the ones that you’re probably going to interact with the most on a regular basis. I highly recommend that you always use a loan servicer. Some note investors try to save money by self-servicing notes. That is a horrific idea because there are a lot of regulations that need to be complied with. As an amateur doing it yourself, there’s no way you’re going to comply with all of them. Even if you can manage to, it’s going to be so much work. It’s not going to save any money at the end, unless you’re valuing your time at $0.10 an hour or something like that.
The loan servicers are going to do a lot for you. They’re going to send statements out to the borrower, collect the payments from the borrower, and make the deposits to you. They’re going to manage the escrow account. There are borrowers that have taxes and insurance escrowed. Your servicer will track that, collect those escrow payments, make tax payments out to the county. They will also track the unpaid balance of the loan as payments come in. If the borrower’s behind, they’ll keep track of late fees, past-due interest, other accruals. They can also do lost mitigation for you. Loss mitigation is when a borrower’s missing payments or delinquent, and they’ll do outreach to the borrower to see what’s going on and work out some deal.
Sometimes, depending on the type of servicer, they may coordinate the legal process as well. Some servicers are full servicers. They do everything or they are supposed to do everything, they don’t always. Other servicers do a certain portion of it, then I’ll manage other things like coordination with the attorneys. I like to do it that way because then I know things get done. One of the big things with loan servicers is you have to follow-up on them because they have a lot of loans.
A lot of times the asset managers who are working these are not well paid. In theory, loan servicers should be like nirvana. You hand off your payment every month and they do everything. The reality is not quite like that. I could have included this in one of my disadvantages of the buying notes section earlier. You do have to make sure you’re following up with them. If you’re following up with them on a regular basis, establish a good relationship, they can become your best friends.
Number six are property managers. If you’re buying performing loans and collecting cashflow, you’re not going to need a whole lot of property managers. If you start doing nonperforming, taking properties through foreclosures, and you’re going to have REOs, you’re going to need someone on the ground to help you with doing inspections, winterizing the property, especially if they’re towards the north, which a lot of these are, securing the property. When you take an REO back, you’re going to need to change the locks, get everything secured, winterize it depending on the time of year and the geographic location. If you decide to take on rehab work, a lot of times your property manager will have vendors that can help coordinate that as well.
How Are Note Transactions Carried Out?
We talked about the vendors that you need. The other question people have is what’s the actual process for buying a note? How do you do the transaction? How is that different from a traditional real estate transaction? These are quite a bit different. I’ll walk through some of the steps. Once you’ve made contact with some of these sellers, they’ll send you the tape of notes on a periodic basis. A tape is a spreadsheet with a list of notes that are for sale. You’ll hear that term tape mentioned a lot in the business. Once the seller sends you a list of notes for sale, you’ll review it. You’ll do your initial due diligence, and if there are ones that fit your model and your criteria, then you may submit offers to the borrower.
That offer is considered an indicative bid. You’re not committed at this point. You make your indicative offers. The seller is either going to accept, reject or make a counter. If you get to a point where offers are accepted, then you’ll be getting your post-bid due diligence. This is the part where you are going to dive deeper and make sure that the title is clear, try to do some assessments of the value of the property, and know that you’re good to close. At that point, you’re ready to close the deal, fund it and then transfer the loan to you. Now, I’m going to walk through a few more of the details on this. I know this is the note investing for newbies. I think some of these nuances of the transaction are important to understand upfront because they are a little bit different than some of the other things you may have done in the past.
I mentioned in that flow that there are two phases of due diligence. We did a certain scrub before we placed our offers or our indicative bids. We did our deep dive after our offers were accepted. The reason for this is most offers don’t get accepted. I was keeping stats on this for myself but I’ve stopped doing that for a while. I was running at about 10% to 15% that my offers are getting accepted because of that and some of the deep dive due diligence costs money. A lot of times you’re paying for BPOs, O&E and title work. You don’t want to spend a couple of hundred dollars if you only have a 10% or 15% chance of getting the deal. We do our initial scrub before we put in our offers. We’re doing things like filtering the notes to make sure that they fit our investing strategy.
If we’re looking for cashflowing notes, we’re not going to want to put in offers on nonperforming. If we have certain states that we’re focused on, we’re not going to want to bid assets in states that don’t fit that. You’re going to look at your return, do your return analysis, and your pricing. At that point, you make your offer. Once an offer is accepted, we’re diving deep. We’re going to review the complete pay history and the servicing notes from the previous lender. We make sure that’s all in line with what our expectations were. We’re going to verify the property value as best as we can. They’re pulling a BPO or having a realtor go by, and they are pulling some comps. One of the big challenges or one of the things that’s different with note investing, when you’re verifying your property value, there’s a borrower inside the property so you can’t get inside.
When you’re assessing your property value, you have to assess the outside and then make your best guess of what’s going on the inside. That’s one of the risk factors in notes that you may not have in other forms of real estate investing. That’s part of the reason why you can get a higher return in note investing as well. You’re going to run your title work, which is that ownership and encumbrance report. We’re going to do things like check if there are past due taxes, verify the chain of title is clear, and see if there are other liens on the property as well. There could be a code violation liens and other things.
The other thing I like to do is make some phone calls. If the property is supposed to be owner-occupied, then I’m going to do things like call to verify that utilities are on. If the seller says the loan is owner-occupied, then I call in the water and the electric to shut off. There’s probably no one there. I also like to call code enforcement to see if there are any violations. Sometimes you learn amazing things. I’ve had loans that I was interested in buying where I talked to the code enforcement guy. I find out that this property is their problem child property in the neighborhood. There are all kinds of issues with the borrower. Other times, things are quicker. We end with our attorney review. After we go through all of this, I send the title work and the soft copies of the loan documentation to the attorney to review, to verify that everything’s good, and there’s not something that I missed or some nuance in this state that may cause a problem that I was unaware of. The big thing I’ll emphasize to new people because I have heard horror stories of people doing this, is you must never ever contact the borrower. With loans, borrowers have a lot of rights and there are a lot of regulations to comply with. I’m not an attorney. I’m not going to try to deep dive into all of those and explain what they are.
One of the big ones is you’re not contacting the borrower especially when you don’t own that loan. Even after you buy the loan, I don’t recommend contacting the borrower directly. I would recommend letting your loan servicer handle that. I’ve heard stories of knuckleheads looking to buy a loan, and then there is a story of somebody knocking on the door of the borrower. They’re trying to figure out if they’re going to start paying again or not. You can’t do that. You can get in big trouble for doing that sort of thing.
Note investing is like playing poker. The best player wins over time, but there’s a lot of randomness in the middle. Click To TweetClosing a note deal, this is the other area that’s a little bit different. I’m going to show two different workflows. The traditional closing in the note industry is the Wild West. It’s important that you know your seller and you know who they are. Typically, note transactions don’t go through escrow or a title company like a traditional real estate transaction. What happens is you made your offer, you’ve agreed to some price, you’ve done your deep dive due diligence, and you’re ready to proceed. At this point, there will be a loan sale agreement that both parties will sign. The buyer wires the funds directly to the seller, and then the seller will do two things. They’ll tell their loan servicer to transfer the loan to you.
They’ll then ship you the hard collateral file. This is done all the time and it works okay. A lot of people are freaked out by this because you’re wiring funds to somebody. What happens if they don’t transfer the loan or they don’t ship you the collateral? That’s a risk. It is sort of the Wild West. I do this all the time, but I know my sellers, people that I’ve worked with and trusted. However, what I consider the newer model is what Paperstac.com is doing. They’re an online platform for selling loans. I mentioned this in the section where you can find places to buy. It’s a place I like going to. Their method is the way of the future. This is a little more traditional.
In the Paperstac system, they have a detailed checklist that they go through. Instead of wiring funds directly to the seller, you’re wiring funds to escrow. They have an auditor that they use. The buyer wires the funds to escrow. The seller ships the hard file to their auditor. The auditor verifies that everything’s included in the file and the file is clean. At that point, they initiate the loan transfer. They wire the funds to the seller and then they ship the hard collateral to the buyer. This is a lot more protected that saves you if you run into some bad actor who doesn’t ship you all the collateral, or you run into some problem that way. This is the way of the future.
It costs an extra couple of hundred dollars to do this. It’s well worth it. It’s the right way to do things, but I use the traditional method all the time with people that I know. It’s not uncommon to do that. Although, it’s also not unreasonable. Let’s say you’re doing this between two people and maybe you don’t know them as well to ask to set up escrow. It’s not done a lot, and a lot of people will push back, but that’s reasonable to ask.
We found our notes and the agreements, we bought them and had the loan transferred. What happens after we close? There’s a lot going on here that I want to explain because everything in the loan transfer and the setup tends to take longer than everybody expects. When I first started buying loans, I came to this from a stock investing background. If I want to do a stock trade or buy an option, I do the trade, I click a button and it’s on a minute later. When transferring a loan after the close, it can take 1 to 2 months. Usually it’s a couple of weeks, but I’ve had some that take longer. Some of these servicers can be pokey in how they do things. You often need to follow up with them during the transfer process.
It can take fully 1 to 2 months to transfer a loan. If you’ve changed or even if you haven’t changed the servicer, but once the loan changes hands, there will be some RESPA requirements that need to be met. The new servicer will send out a hello letter to the borrower, and the previous servicer will send out the goodbye letter. This is notifying the borrower that their loan was sold. You may have had this before. I know that the mortgages I’ve had on my primary residence have been bought and sold several times over the years. That’s notifying the borrower and that’s needed to comply with RESPA requirements and other things.
Once you get the loan boarded with the new servicer. Your servicer will give you access to a portal. They’ll have some online platform that you can log into, and you can see what’s going on with your loan, all the data on the loan, the payments that have come in the notes, and other things. Once they do that, you want to go back in and you want to verify that everything’s in order. Sometimes because these loan transfers take a while, payments will often come in between that transferring time. In your loan sale agreement, there should be a cutoff date specified. That means that after such date, all the new payments come in, get forwarded to the new buyer or the loan. Sometimes what happens is borrowers will send payments to the previous servicer even though the hello and goodbye letters went out.
What that servicer will do is they will forward it to the new servicer if it’s after the cutoff date, but they don’t always do that. You want to go back, look at the payment history and the loan, see if anything’s missing because sometimes I’ve had payments that went to a previous servicer that they didn’t transfer. I have to fight with them to get it back. You do want to go back and do a double-check once the loan gets boarded. If you’re buying a performing loan that’s continuing to perform, you’re going to be good for a while. At this point, you sit back and collect payments. This is where you get your cashflow. It’s what the whole thing is about.
If you bought a nonperforming loan, then now it’s time to start the loss mitigation. This is outreach to the borrower to try to work out some resolution. Generally, this is handled by the loan servicer. There are some third parties that can be hired. There was one that I used to use that I liked a lot that’s no longer in business. Some people do it themselves. If they understand all the rules, they’ve had the proper training, and they know what they’re doing. If you’re brand new, I recommend staying away from this and working with your loan servicer to have them contact the borrower.
How Do I Exit My Notes?
With other nonperforming notes, we’ve kicked off our loss mitigation. What are some of the exit strategies that we can use? What are some of the ways that these things can get resolved? I’m going to talk about five of the main ones. If you broke this down, there’s probably an infinite number that you can pursue, but I’m going to talk about the most common ones. The first one is reinstatement or what I call magical reinstatement. I bought more than a few loans where the borrower got caught up on their own. This happens if they’re not that far behind. It’s not a strategy so much as something that just happens.
What I’ve found a lot of times is when I’m buying loans, especially from some larger institutions where they might have portfolios of thousands of loans, they have some that get delinquent, and they’re too big to keep track of everyone. Sometimes we do that initial borrower outreach and loss mitigation. They see someone’s paying attention and they reinstate. This is a homerun outcome. This is the best case. It happens a little more than you think, but it’s not something that you want to count on going into the deal because it’s not something that you can force to happen. Sometimes it happens, sometimes it doesn’t.
Exit number two is a modification. This is more of my go-to strategy for nonperforming notes. This is where some borrower outreach is done to see what’s going on. Determine if they want to stay in the home or not. If they do, we go into some forbearance agreement with a trial payment plan. I had a previous show where I did a deep dive on how those work. It was episode 42. You can go back and check that out if you want more of the details on how those work. This is where we’re working with the borrower to come up with some agreement where they’re going to get back on track and demonstrate that they can pay reliably. We’re going to do some modifications to the loan. It’s now a current loan instead of a delinquent one.
Number three is deed in lieu or often known as Cash for Keys. Deed in lieu means that the borrower is going to sign over the deed in lieu of going through a foreclosure. Often when you do these deals as an incentive to the borrower, and also it often helps pay for some of their moving costs, you’ll offer a cash incentive to do this as well. You might approach a borrower and say, “We do this deed in lieu. If you sign it over, I’ll give you $2,000 to do it.” That will help them pay for their first month’s rent in their new place and cover some of their moving costs. You might ask, “Why would you pay someone cash who’s already not paying a loan? That seems disgusting.” It is in one way, but from your perspective as the lender, depending on the state you’re in, foreclosure process may take twelve months.
It may cost you $5,000. Spending $2,000 or whatever can be a lot cheaper and a lot faster than going through that other process. As you’re doing these deals, you’re always looking at what your alternatives are and what the outcomes are, not necessarily what you consider fair. More than likely, I’m willing to bet that almost all people pay their mortgage on time every month. They’re not going to expect someone to pay them to leave, but these deals happen all the time. One thing to watch out for on these though is a lot of times, if a borrower is being difficult and all of a sudden, they’re willing to do this, it sometimes indicates that there’s something wrong with the property. It could be a cracked foundation, a bad roof or a bad furnace. You want to look out for that as well.
Number four is foreclosure. This is something that I try to avoid. One of the great things about loans is when they’re paying and you’re just sitting back and collecting cashflow. I go out of my way to try to get to exit number two, where we get to some modification. If push comes to shove, then I have to foreclose to protect my interest and get a return to my investors. I’ve had some homerun results with foreclosures and some horror shows with REOs that have taken back as well. If you can get to a modification and a reinstatement, then you’re going to end up with a high return overall. That’s predictable. When you foreclose, it’s a crapshoot. I’ve had some that have had epic returns where the borrower was an idiot and walked away from equity. I’ve had others that have got upside down on. I’ve had hoarder houses with wasted trash throughout. It’s a crapshoot once you get to foreclosure.
If someone tells you that they've never lost money on a note, then either they're a liar or they haven't really traded many notes. Click To TweetNumber five is a strategy that I don’t personally use but a lot of people do, and that’s to sell the note. What some people do is they buy a nonperforming note. They’ll do their loss mitigation and outreach to the borrower to try to get some agreement in place to get it reperforming. If that doesn’t work, they turn around and sell the note and try again with another one. If you do that, you’re probably going to end up taking a small loss on the deal because you’re going to have some expenses. Maybe the loan is more delinquent than when you bought it. You’re going to take a small loss when you do it. The advantage of doing this is you’re not going to end up with a hoarder house REO like I have.
I don’t do this strategy because what I like to do is take everything to the map. If I can’t work out anything with the borrower, then I’ll drive it all the way to foreclosure. The reason I like to do that is it enforces some discipline on myself or in the buying process. I don’t want to buy anything that I’m not willing to own. It is a good forcing function to keep me away from stretching into some sketchy deals here and there. The other thing that happens with some borrowers is I’ve had several borrowers who I could not get to make a $300 or $400 monthly payment to save their life. When you got to the end of foreclosure, all of a sudden they cough up $5,000 to $6,000, $7,000 to fully reinstate the loan.
There are some borrowers who want to keep the property no matter what, but they also don’t like paying. If push comes to shove, they’ll do whatever they need to do to cough up a reinstatement. If you sell the note before taking it to that length, you also miss out on some of those reinstatements. You’re probably beginning to gather, even though this is the newbies episode. There’s a lot of flexibility in notes and a lot of different ways to exit, ways to recover if things don’t go the way you thought. One of the things I love about this is you got a lot of flexibility and a lot of options. If game plan number one doesn’t work, you’ve got fallback plans that you can rely on as well.
When you do foreclose or a deed in lieu, and you end up with an REO, there are a lot of different ways you can deal with the REO at the end. The one that I like to do is sell the REO as-is for cash to some cash buyer. All my notes are at a state. I try to avoid rehabs. I do rehabs now and then. For me, that’s asking for trouble. I like owning paper and collecting payments. I don’t like dealing with REOs. If I’ve driven one into foreclosure and I couldn’t work out anything with the borrower, I’m going to get what I can for the property. Sometimes that works out great, sometimes it works out not as good.
As we get to the end of 2020 here with the shortage of properties on the market, I’ve been doing well with my REO sales because there’s not a lot of them out there. When they have, they go quick. That’s my strategy. What a lot of people do is they like to do rehabs and sell it. Especially if they live in a state where they can buy notes, that’s what they like to do. If they’re using the purchase of the nonperforming note as a low-price acquisition strategy, then that can be a good way to get rehabs. Some people will do foreclosures to get a property that they can rehab, then resell for something closer to the ARV or some people like to turn them into rentals and sell them as a turnkey rental. If you do that, now your market for selling that property is not just in the local area, it’s nationwide.
What Kind Of Returns Can I Expect?
What a lot of people like to do is creating new notes. You can put a new borrower in there and you seller finance. I’ve done this one a little bit myself. It’s a strategy that I like as well. There are lots of different ways to deal with REOs depending on what your intention was going into it. The big question I should have led with this is, what kind of returns can you expect in doing this? I’ll start by saying that I’ve got a good sample size for the deals that I’ve done into 80 or so. I’ll give you my key takeaways on what you can expect.
There are a lot of variations in returns from deal to deal. I’ll give you some of the averages. When you’re doing notes, I used to be big into games. The analogy that I use is note investing is poker, it’s not chess. In chess, the best player tends to win. There’s not a lot of variability. If you take a certain strategy, you can expect a certain outcome sometimes. Whereas in poker, the best player is going to win over time, but there’s a lot of randomness in the middle. That’s how note investing is. It’s best if you can do these with the intention of doing several and getting a decent sample. You’re going to have some that are amazingly good. You’re going to have others that get sideways on you.
In general, if you’re buying performing notes, I’m targeting an annualized return of 8% to 15%. Most of the ones I’m buying are in the 12% to 15% range. There’s no free lunch with that. As you get into higher yields, there is a higher risk involved with that as well. If you check out, I’ve got a pricing course that’s cheap where I go into pricing performing notes, and I talk about some of that assessing the risk. One of the big mistakes people make sometimes is they want to try to eliminate all the risk. You can do that but you’re going to have a note that has a much lower yield. If you’re too risk-averse in these, you end up not getting any deals. The other mistake people make is they go, “I’m a good note investor. I only want to buy things with a 20% return.”
What happens is you have sky-high risk. The only bids you get accepted on are junky loans. Mileage varies depending on the quality of the loan. You can get 8% to 15% annualized returns with reasonable and favorable risk-reward profiles. If you go into nonperforming notes, this is where it’s a crapshoot, especially when they turn in to REOs because I’ve had a wide variety. When you do nonperforming and you end up with REOs, then your exit is all based on the value of the property, but you don’t know the true value of the property because you can’t inspect the inside. If the note becomes an REO, I’ve had anywhere from minus 20% to plus 120% returns. It’s a big crapshoot.
However, if I follow my model for nonperforming notes, I get about 2/3 of them to reperform. If I’m getting a note to reperform, then my returns are going to be about 30%-plus annualized and sometimes higher, depending on how well I was able to buy it. What you’re looking at is about 2/3 of the time, I’m getting 30%-plus. The other third of the time, I’m getting a crapshoot with some homeruns and sometimes getting upside down on them. Another thing I want to point out too is that this is poker, this is a numbers game and there’s a wide distribution of outcomes. If you do enough notes, you are going to end up with REOs where you get upside down. It’s a fact of life.
One of my other pet peeves about the industry is I’ve heard people say things like, “If you do everything right, you’ll never lose money on a loan.” If someone tells you that they’ve never lost money on a note, either they’re liars or they haven’t traded many notes. They’re not experienced. That could even be both. It’s a numbers game. The numbers over time are favorable. I have the data to back that. I’ll caution you not to get drunk on yield.
Be a little careful about trying to chase the notes with the highest yield because they often carry additional risks with them. Make sure you understand the risk profile or the loans and what your goals are, and make sure everything is in line. For example, I like to buy performing notes for my self-directed IRA. I target lower yields in the self-directed IRA because I’m a little more risk-averse. I just want it to grow steadily. Those are some good things to think about.
I’m going to wrap this up with a couple of quick case studies. If you go to the Fusion Notes website, there’s a whole subpage with case studies where I’ve got twenty of these. I’ll show a couple to give you a flavor of some of the things you might see. The first one I’m going to talk about was in Evansville, Indiana. I like Evansville a lot. I’ve been through there. It’s not the biggest town in the world, but it’s a decent size and nice. I’ve done some road trips through the Midwest to check out some of these cities. It’s always interesting. Some of the cities I’ve gone to that I expected to be nice were not. Others are nice and have a lot going on. Evansville is one of the ones I like.
This was a loan that’s semi-performing. There were three months behind when I bought it. Technically, it’s nonperforming but there had been a lot of cashflow. They weren’t that far behind. This was one where the borrower had hit a hiccup. It was a temporary job loss or it might have been a medical bill. Medical bills, job losses and divorces are common reasons for a borrower to get behind on a loan where they then get caught up later. This is one that was reinstated on its own. They were able to get caught up on their own, which was nice. I ended up with an annualized return of 14.9% on this one that worked out well.
Here’s another one that was in Anderson, Indiana. I don’t like Anderson as much. I’ve done a few notes there. It’s an okay area. I’ll do stuff there again. You got to be a little bit careful there depending on where you are. This one was seven months behind. After I bought the loan, I found out that the previous lender had set up a forbearance agreement with the borrower right before I bought it. Some of these funds are not always the most organized. They sold this right after they did all the work, but they sold it to me at the nonperforming price. Fortunately, the borrower was able to come through on that agreement. This worked out well. This is one that I did a joint venture on where I was splitting the returns 50/50 with a funding partner. The funding partner had an ROI of 17.9% and an annualized return of 19.3%, but that was after the 50/50 split. If I was doing this purely with my own money, the results would have been double. I would have been in the high 30% of ROI. This is one of those 2/3 reperforming that can work out well.
This last one became an REO. This was a contract for deed which I’ll talk about in another episode, where you go through a forfeiture process. It’s similar to a foreclosure but slightly different. I try to work with the borrower to get this thing repaying. We had various agreements in place that they never followed through on. I ended up completing the legal process. It’s a strange borrower. She left the property in decent shape and walked away from a lot of equity. This turned out to be an ROI of 68% and the deal went fairly fast, and the annualized return was 83% to the funding partner. That was after the split. This was an epic home run. I mentioned in REOs. There are a lot of variations on returns. I don’t present this to suggest that this is normal. I’ve had two REOs that have had similar results to this. I had a similar one in Omaha. I’ve had other ones that have got 20% down. I’ve had a couple of those. I show these to give a flavor of some of the things that are possible.
If you go to the Fusion Notes website, I’ve got a bunch more of these that you can peruse. That’s my note investing for newbies. Let me know what questions you have. Please subscribe to our YouTube channel if you haven’t done so already. If you’re relatively new to notes and there are other contents you want to see or things you’re struggling with or can’t find information on, let me know. I’ll see if I can do an episode on that or maybe do another YouTube video. I want to try to put out more content for people that are new to this space. Until next time, thanks for reading.
Important Links:
- Paperstac.com
- DirectSourceRE.com
- SN Servicing
- Episode 42 – past episode
- YouTube – Fusion Notes
- www.SystematicDueDiligence.com
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