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.
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.