Well, I am glad you asked. The world of mortgage notes seems to be one of the more mysterious investment strategies in the real estate space. Great fear is instilled in most investors when the subject is brought up. The fact is that we all (at some point) have been affected by or used “notes” in some form or fashion during our lifetime. So, why don’t we learn a few fun facts about them?
EXPLANATION & Terminology
In essence, a “note” is a contractual agreement that requires repayment of a debt over a term of time. Another common term used is “promissory note”. Some of the more common structures of notes in use are student loans, vehicle purchases and capital borrowed to start a business. We are going to focus specifically on promissory notes in the real estate space for this article.
In real state, a mortgage note is typically created when selling or buying a property. And in most cases, where consumers utilize the mortgage note as a means to “purchase” a home, an amortization schedule is used to structure the repayment.
Without getting too geeky – that amortization schedule is the most powerful tool at a bank’s disposal. Amortization is an accounting technique used to incrementally lower the cost of an asset as it’s “life” runs its course. And as mentioned above, banks make their money by lending it. And the amortization schedule structured to pay it back ensures THEY ALWAYS WIN.
Increasing my chances to win in anything I set out to do sounds good to me. Always winning like a bank sounds even better to me. SO – I create mortgage notes like the bank thus setting myself (and my investors) up to win. Can things go wrong? Sure. But with a mortgage note in one hand and an amortization schedule in the other – all collateralized by the physical property – I have nets in place at every turn.
REMEMBER AMORTIZATION FOR STEP 3 BELOW.
Note Creation EXAMPLE: Lets go over a basic example of our note creation business model using round numbers.
Step 1: Plug In lender
We partner with private lenders in multiple ways. Most commonly, we work with an investor using a self-directed IRA on 8% fixed interest rate 5-year balloon loans. In addition to interest payments coming every month, they maintain a first lien on the property. In legal speak, that means they are “first in line” (behind only the government or HOA) to collect their money if things go wrong. Ultimately, they maintain ownership and control of the asset until its principle is paid to zero.
I find a house that is comparable in size and layout to others in a neighborhood valued at 100k full market value. It needs a lot of work to get it to that value though.
I borrow $60k from my investor to cover purchase price ($40k) and rehab capital ($20k).
60k at 8% interest is $400/mo. (60000 x 0.08)/12).
REMEMBER THAT NUMBER – 400/mo.
Step 2: FOR SALE BY OWNER
Once started with the rehab, I list the asset for Sale By Owner. We list immediately in case there are any interested parties who may actually want to buy from us and do the rehab themselves. Those are really special – the buyer is putting in their own money to improve a property they are paying you for.
After completion of the rehab work, we hire a state certified inspector to inspect the property. This just makes sure that there are no issues that we missed that will prevent our buyers from having a positive buying experience. We have a good reputation and always work to protect that.
Our buyers are good people, but they fall into a category we call “un-bankable”. Perhaps they had past credit issues ding their score or they have a job that pays an income heavily weighted on commission. For banks, these are high risk loans that they are unable to service. For us, they are also higher risk. We are flexible enough to offer a solution (“Owner Financing”) as long as the person has a respectable credit score that is showing a positive trend, they have a steady documented income and have enough capital for a 20% down payment. To accommodate for the risk be taken, we charge fixed interest rates in the range of 11%.
Some people ask – who in the world would pay 11% interest? I ask them to tell me how much rent goes up every year. In this example, we will assume that property managers mimic inflation so we will call it 2%. That rate is not fixed and can go up – completely out of the control of the renter. A rental cost of $1000 in year one will be over $1450 in 20 years as it increases year over year. The monthly payment to purchase the home is $1000 in year 1 and $1000 in year 20.
For a consumer who is “doomed” to rent for the rest of their life because they are un-bankable, that increase equates to over $50,000 in increased rent expenses year over year. Do you think that consumer could use a smooth $50,000 in their pocket over 20 years?
Landlords and rental property managers fill a need for people who want to rent. My company provides solutions for people who want to own. This simple example just shows you the impact on the 11% fixed interest rate buyer vs. 2% compounding costs for a renter.
We agree, the interest rate is high. We also agree, making this type of loan to a buyer with a potential credit worthiness history is a bit risky too. We mitigate that risk by charging a premium interest and ensuring that our lenders and partners maintain first lien positions on the debt secured by real property.
How else are investors protected?
We set up our buyers to succeed – underwiting their loan and qualifications to meet all regulatory and sensible safe lending guidelines. Sometimes, they still mess up. We work with people as much as possible to follow our rules and ultimately, the contract in place. In the event that the buyer walks away and no longer wants or is able to own the house, we simply plug in a new buyer who pays us 20% down on a 100K valued home. We will use that number in the end when we analyze our financial performance. That’s a pretty excellent downside risk from where I sit.
Why is our model better for consumers?
Our buyer’s interest rates are fixed (typically amortized for 20 years). We base the purchase price for the buyer off current market rents. Let’s say rents in the area are $1000. We back into our sales price by making sure that the market rent ceiling doesn’t exceed our buyer’s monthly payments which cover principle, interest, taxes and insurance (also known as “PITI”).
Again, for simplicity, let’s say taxes are $150/mo. and insurance is $150/mo. That leaves $700 in the till to go to principle and interest in order to. Our buyer pays $700 monthly to principle and interest. All in, the are purchasing an asset for $1000 in month 1 and maintain that monthly amount due in month 240. That is alternate to paying rent of $1000 in month 1 and $1450 by the time they get to month 240 in 20 years.
Step 3: Wrap the mortgage.
Remember, we have a note due to our investor for interest only of $400/month. They have a top level first lien on the asset.
Our principle and interest received from the buyer on our 20 year 11% interest note is $825. We have a second lien on the asset wrapped in the first lien held by our investor. This is discussed with the buyer multiple times in the transaction such as during home visits and disclosed on the contract again at closing. A “wrapped mortgage” is about as accurate a term to coin the transaction. There are two notes in play with one single asset holding the value.
Our investor capital is never loaned above 70% of the market value of the home’s current value when we structure the note. Meaning if the home is worth $100k, our lender never lends more than $70k on the asset.
We do this solely to protect the investor’s capital from a market swing. Even the worst of market swings have yet to decrease home values in our target market of Houston to the tune of anywhere near 30% in lost value. In fact, our threshold for lender risk is lower “loan to value” ratio than regulators typically require consumer lending banks to maintain.
We find that us maintaining a second lien ensures we are always aligned with our first lien investors. If I win – they win. When I am losing, I ensure they still win by getting interest only payments. Pretty solid, if you ask me.
So you made how much on this transaction?
Even better, repairs and maintenance are never an issue. After all, do you call your bank if you have a toilet leak? I have friends that rent single family homes whose five years of profit are wiped out with one new AC or one new roof. This cashflow is the BANKS - Not the AC or roofing company’s!
Next week, we will cover what is done with the balloon is due with some charts and graphs. As structured in this example, until the 10-year mark, the principle owed by my buyer ($60k) remains lower than the principle owed by the buyer on the balance on the amortized loan ($61k).
The variety of options to disposition notes is fascinating and (in my opinion) one of the most flexible in the real estate investing space. Until then, embrace the journey.
If you have questions about notes, please reach out to me at www.NoteFlowREI.com.
I love talking mortgage notes and investment strategies.
“I am a successful and energetic real estate and business investor creating multi-generational wealth through strategic cashflowing income streams EVERY DAY."
"I am the world's greatest father and husband.”
I write this down ten times and say it aloud every morning before I get going on whatever my first task is. From checking web analytics results to conferencing with investors and partners or driving to my 9 to 5 W2 job (or 7 to 4 in my case). It is a mouthful.
I say it EVERYDAY and I MEAN IT.
The mind is a powerful thing. It can be both a useful tool and harmful adversary . Failure to understand the importance of how to best control and program your mind to reach your potential can lead to years of spinning your wheels or never getting started. I started my rehab and flip journey before getting my mind in order. It cost me a bunch of money and it wasted a lot of my time (and hair).
About 6 months into working on the 8-month flip project (written before in this previous blog), I began working with a Business Mastery Coach. I will write another post on the power of coaching (when done right). When we began our work together, I was expecting to jump right in on growing my deal flow and business. Instead, we spent about 5 weeks on psychology and various tools and techniques to use to set myself up to succeed. I knew there was a method to the madness. And man, am I glad I bought in and picked up what was being put down.
We took a deep dive into the voices in my head and ways to control my narrative in a different light. My mind was full of self defeating thoughts and impossibilities. Reactions to events became more manageable and my outlook, over a period of about two months, really began to transition.
One of the keys to adjusting my mindset was the use of daily affirmations. As the great Napoleon Hill shared, “Whatever the mind can conceive and believe, it can achieve.”
There are a variety of great tools and content available about the subject of affirmations. When going through the process to build my affirmation muscle, the following seemed to work for me:
1. Start small and simple
Initially, I started out with 10 different short affirmations. Very simple and concise - each eliciting a specific feeling. I read those ten affirmations multiple times a day for 60 days. As the 60 days winded down, I began to look ahead to how to best use the tool. So, I combined a few of them that I felt moved me more than others. And thus, a single (somewhat longer) affirmation was born.
2. Commit to executing & timestamp it
As my wife can attest, I have a horrible memory. I can’t explain it but sometimes I really don’t remember something as recent as yesterday that we talked about. Because of this, I have become fairly good at time management and blocking off portions of my day to execute specific tasks. I maintain one electronic calendar (synced with all of my businesses and personal). I also maintain one single sheet of paper that has a 30-minute blocks of time on the left side and 7 columns (one for each day including weekends). I check daily that they match. It helps keep important topics top of mind for me as I check in – so I don’t forget anything inadvertently. My system has evolved to this method and it has worked well for me for about 6 months.
About five to eight items make it on my calendar for any day. 90% of the time, the number is six or less. For me, this allows me to really provide committed time to the task at hand. Only important items make it on the list – things that I REALLY want to get done that day. An investor call or lunch, kid’s doctor appointments, a podcast interview, working on my book or blog, networking with people that have deals in my market that fit my business model, etc. If it doesn’t make it on the calendar, it is simply a to-do list that are required to get done but are not important.
The difference between important and urgent is critical to understand:
Important tasks are tasks that contribute to long-term missions and goals.
Urgent things may include phone calls, tasks with impending deadlines, and situations where you must respond quickly. Responding to an email, when you must do it, is usually an urgent task.
Urgent things do make it on my list. But important things have priority when building out my week.
3. Reflect before, during and after
Before I get going, I think about what I am trying to accomplish from the task. I remember that through continually repeating and believing what I am saying, I am setting myself up for success in achievement of the life I want.
While I am now writing my affirmation (and before when I was simply repeating), I made sure it was at a time and in a place that I wouldn’t be disturbed. Usually first thing in the morning and last thing at night. As may be the case for you, all time in between is pretty jam packed with family, business and life.
After you complete the task, reflect once more on why you just did that. I believe it helps to acknowledge that you just started or ended your da doing something powerful aimed at improving your future. A small victory gives me a little pep in the morning and some good vibes at night as I go to bed.
4. Review results after 30 days and note changes
Every month, it is worth checking in to make sure you are achieving the results that you want by repeating the things that you want to embed in your head. As goals and life evolves, so too might your affirmations. The key is to work the muscle and be mindful of the results you are looking towards achieving through using this tool.
By following these simple steps, you can really set yourself up for success. Be consistent and have purpose in what you are doing - it will make a world of difference.
Justin Grimes has been an active business & real estate investor since 2007 participating at various levels in asset classes from single-family rehab and mortgage note creation to multi-family, self storage and mobile home parks. He enjoys building teams and scaling his portfolio of assets.
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SALES LEAD GEN.