How to Make Profits With Note Purchases, Secured by Real Estate

By Dan Harkey

Definition of a note purchase:

When one party owns a promissory note and deed of trust, or mortgage, secured by real property, and sells the note ownership (conveys 100% interests) to another party, the new party becomes the note owner and enjoys the rights, title, and interests. ?The new lender/owner assumes all risks and responsibilities to collect the monthly payments from the borrower/property owner, enjoys the cash flow payments, and retains the right to foreclose if the borrower defaults.

However, this raises the question of whether a single investor or a group of investors can amass enough capital to become purchasers of a single or a group of notes and deeds of trust, sometimes referred to as (paper). Remember that due diligence is critical in these transactions, reinforcing the importance of being responsible and diligent in their approach to investment.

This article serves as a roadmap for single and small groups of investors, empowering them to compete with larger entities in the note purchase industry. The unique benefits of local market knowledge, control, and a hands-on approach make small investors a force to be reckoned with, instilling confidence and control in their investment decisions.

Notes and deeds of trust (mortgages) are financial assets:

A real estate loan occurs when a willing borrower signs a promissory note “note,” which is a promise to pay, and a deed of trust, or mortgage, which are security instruments evidencing the indebtedness. ?The transaction is complete with the recordation of the deed of trust (or mortgage) and distribution of proceeds from the escrow closing. ?Some states use deeds of trusts, and some states use mortgages. ?The distinction between the two is significant.

The recorded deed of trust or mortgage with the municipal records office becomes a matter of public record. ?The recorded lien, or money charge against the property, encumbers or clouds the property title. ?When someone reviews public records relating to that property, the documents will reflect a notice of the lien. ?All recorded liens or encumbrances after that date and time stamp are subject to, and subordinate to, the recorded lien until that lien is paid off and released from public records.

Notes and deeds of trust (mortgages) are financial assets, also referred to as securities:

A lender/investor who owns a financial asset evidenced by an executed promissory note, recorded deed of trust, or mortgage, and a title insurance policy ensuring the correctness of the recording owns a security. ?The owner of this financial asset has multiple options.

·????? Keep the financial asset and enjoy the cash flow from the payment stream. ?Owning multiple notes is an excellent loan-term financial strategy, and note ownership provides a fantastic passive income stream.

·????? Sell the note and deed of trust asset to a third party to regain the capital.? Selling the note and deed of trust may be at par, meaning total face value or a discount on the principal balance. ?Suppose the interest rate on the promissory note is below market. In that case, the seller can expect to discount the price to compensate so that the “effective yield” (the actual rate of return considering the discounted price) reflects the current market yields or higher.

Promissory notes can be sold to meet emergency cash needs such as tax obligations, marriage dissolution, judgments, liens, or partnership conflicts.? The note seller can also leverage the net proceeds into another business opportunity and make geometrically greater profits in their venture.

·????? A note owner may borrow against the collateral interest in the note. ?????? The note owner and the prospective new investor/lender of the note investment will open an escrow to convey the title and the documents in exchange for the net proceeds at the closing.? Another article covers the procedure of note hypothecation (a process where the note owner uses the note as collateral to secure a loan).

·????? Note Purchase and Sale Industry vs. Loan Origination Industry: Understanding the Difference

The purchase and sale of notes industry deals with existing owners who are the principal owners of the promissory note and deed of trust as a financial asset.??? They have flexibility with this financial asset, giving them a sense of control over their investments. ?In almost all cases, owning notes (paper) as an asset that comes with cash flow from payments is far less management intensive and less hassle than ownership of income-producing real estate. ?Ownership of income property comes not only with economic, historic wealth strategies but also with the propensity of the government to steal equities through the systematic elimination of property rights during and after COVID and multiple taxations on the income streams.

In the loan origination industry, a real estate owner who wants to borrow obtains a new loan secured by the property through an origination process. ?The business is enormous, although it is currently dropping because interest rates have increased.

Sources to find both performing notes and non-performing notes for sale:

·????? The best practice is to network with professionals involved in real estate transactions.? The following professionals may locate or need a source of note purchasers:? Real estate brokers, mortgage brokers, family estate planners, estate planning lawyers, investment advisors, CPAs and enrolled agents, local and regional banks, credit unions, bankruptcy lawyers, real estate and note trade organizations, and direct marketing solicitations.

·????? A well-thought-out email marketing campaign is advisable.? Remember, “You locate a buyer; you do not create one through languaging.”

?Subsets of the note purchase and sale industry:

??????????? Each subgroup has its unique characteristics.

·????? Individual investors are purchasing single-performing notes.? Borrowers are performing on their obligation, and the purchaser’s motivation is for cash flow and annualized yield.

·????? Individual investors purchasing a single non-performing note.

The borrowers have defaulted on payment of their obligation. ?The condition of the loan asset is that there are arrears in payments, possible expired property insurance and property taxes, a possible deferral of maintenance, occupancy by an opposing party, and the risks related to future management involved in working through the problems. ??? This type of note purchase is usually more profitable but requires intensive management, Involvement, and risk. Those investors accustomed to purchasing non-performing notes, usually at a steep discount, will anticipate a substantially higher yield and higher returns, making this a potentially lucrative investment.

The purchaser(s) of non-performing notes or the purchaser(s) representative requires active management. ?They must contact the defaulted borrower to bring the payments current, renegotiate the loan if possible, actively begin a foreclosure process, possibly borrower bankruptcy, remove the defaulted borrower who still occupies the property after the foreclosure, take possession, possibly fix-up, and remarket the property to regain the principal with higher yield expectation. ?Purchasing non-performing notes is not recommended for unsophisticated investors.

·????? “Small groups” may purchase notes as fractional tenant-in-common owners, provided management, documentation, accounting, loan servicing, and regulatory compliance exist. ?Small groups may also create an entity like a limited liability company (LLC) and invest with managing member(s) in charge and less active members as members of an entity LLC. ?Rather than a principal or manager, the individual members hold limited liability member interests. ?The limited liability company will rely on managing member(s) to make the decisions and carry out the management responsibilities on behalf of the members.

·????? “Loan portfolio purchases,” larger groups created by securities issuers, may also make a limited liability company (LLC) or some other particular purpose entity (SPE) such as a real estate investment trust (REIT). ?The securities issuers are responsible for active loan servicing and asset management. ?The issuer is responsible for seeking regulatory approval, maintaining regulatory reporting, issuing securities, collecting investor proceeds, and using the proceeds to purchase large blocks of either performing or non-performing paper.? ?????????? ?Investors are usually passive, and the overall yield of the entire pool of investments determines results. ?When specific threshold yields are met, the issuer may pass through all profit distributions to the investors with a fixed management and loan serving fee or a profit participation formula.

Private parties and non-institutional level investors purchase notes:

There is also a large industry of lending professionals that engage in identifying, negotiating, and closing the sale and transfer of ownership of notes.? A transfer from a note seller to a note buyer is consummated by an executed note purchase agreement, endorsing the promissory note from the seller to the buyer and recording a completed assignment of the deed of trust or mortgage. ?The consummation occurs at the time of recording. ?Title insurance ensures that the conveyance occurred adequately. ?Also, the seller of the note will require an offset statement.

Note buyers may use their liquid capital to purchase the notes from willing note sellers. ?Yields on purchases of promissory notes are like those in the trust deed purchase field.

Institutional-level investors in the note securitization arena:

Institutional level, Wall Street, and Security & Exchange Commission public offerings engage in all forms of securitization and re-securitization of notes (paper). ?Like stocks, bonds, U.S. treasuries, and vastly different forms of securities that are marketable to the public, so are promissory notes and deeds of trust (mortgages). ?The structured obligations are unique in format and, in many cases, dependent upon another form of hedging instrument or security called derivatives.

Wall Street, referred to as the institutional market, notes purchases, resales, and collateral securitization as a multi-trillion-dollar industry. ?The U.S. is the largest securitization market globally, with approximately 12 trillion dollars outstanding.?? Government Service Entities (GSEs) currently purchase 60% plus of all new mortgages (mortgage-backed securities).? GSEs include Fanny Mae, Freddy Mac, and Ginny Mae. ?Pools (large blocks) of note purchases, resales, and collateralizations are sliced into risk tranches. ?Tranches are subsets of a pooled collection of securities, usually debt instruments, that are split or diced up by relative risks or other characteristics to sell to various investors depending on their demands for maturities, yields, and degrees of risks. ?Even providing insurance or reassurance through super high-risk derivatives contracts is actively promoted.

Trillions of institutional-level dollars of transactions characterized by notes purchasing securities change hands each year. ?These include Government-Sponsored Entities (GSEs), federal-level SEC-registered pool offerings, state-level public offerings, and private or exempt-from-registration offerings.

I intend to stay aware of the complexities of the institutional-level securitization markets.

Securitization is an entire industry- bundling of loans into pools:

Securitization is the process in which various types of assets are combined into pools and then repackaged into interest-baring segments or tranches and risk/yield subsets. ?The principal and interest payments, or periodic distributions, such as a limited liability company, real estate investment trust, or a public or private offering, can be customized.

Various forms of securitization are available that invest in notes, such as single note purchases, multiple note purchases, or investment groups, usually in mortgage pools. ?The mortgage pool may have different structures and securities regulatory oversight.

With the guidance of securities and real estate transactional lawyers, I have originated $250,000,000 California state-approved public offerings and an approved $500,000,000 Federal Securities And Exchange (SEC) public offering. ?Additionally, I was responsible for creating the infrastructure to originate (purchase), loan service, manage, make periodic distributions, and comply with continuous public reporting.???

Underwriting is the due diligence process or loan quality analysis.

A due diligence process should occur for every note purchase transaction.? ??The process is like one followed during the original loan transaction.? Escrow agents, title insurers, appraisers (affirmation of market value), property insurers, underwriting and technical staff, and documentation specialists exist.? All participate and serve as agents to prove the note purchase transaction’s economic viability and successful conveyance.

The due diligence process may be more rigorous for publicly traded offerings.? Private money lenders (non-institutional) allow for a quicker due diligence process that is just as good, if not better. ?Local market knowledge, hands-on, a sense of urgency, and the massive bureaucracies in institutional platforms give the private money industry a well-deserved advantage.

Assessing and approving the risk related to the loan purchase transaction:

The fundamental purpose of risk assessment is that a mortgage broker who solicits investors to purchase a loan investment must submit a loan package with the material facts and investment risks to the prospective investor so that a sophisticated prospective investor can make an informed decision. ?The investor can decide whether to purchase the loan and whether the investment is personally suitable given the material facts, risks, and economic reward.

If another lender intends to resell their note, it most likely has an underwriting package containing many relevant documents that will be helpful for the note purchase risk assessment.

?·????? Address of the collateral property or other forms of real property identification offered as security for the borrower’s obligation.

·????? Describe the property, type, usage, zoning, income-producing, and quality.?? Determine rents, vacancies, quality of management, and level of upkeep, and identify differed maintenance. ?Verify compliance with building and zoning ordinances.

·????? Estimate the fair market value of the securing property as determined by an appraisal, a copy of which should be available to the prospective investor/lender. ?However, an investor/lender may waive the requirement of an independent written appraisal on a case-by-case basis. ?The real estate broker shall provide the broker’s written estimated fair market value of the securing property, including the objective data upon which the broker estimates.

·????? Borrower data—obtain information, including?Identity, occupation, employment, income, and credit data about the prospective borrower or borrowers as represented to the broker by the prospective borrower or borrowers. A credit report and, in some cases, a public records background search are good policies.

·????? Loan terms of the promissory note for sale will be provided to the investor/lender. Current loan terms and servicing records will allow a broker to calculate reasonable terms for a new loan sale or note a hypothecation transaction.

·????? Pertinent information concerning all encumbrances constituting liens against the securing property will be determined. ?To the extent of actual knowledge of the broker, relevant information about other items that the borrower expects or anticipates will result in an encumbrance or charge against the subject property. ?As used in this paragraph, actual knowledge concerning any anticipated or expected loan means knowledge the broker gains through prudent inquiry. ?Best practices also suggest that the broker shall provide the prospective lender/investor the option to apply to purchase a title insurance policy or an endorsement (104.1) to an existing title insurance policy covering the securing property, a copy of a written loan application, ????? and a credit report.

·????? Provisions for servicing the loan, if any, including disposition of the late charge and prepayment penalty fees paid by the borrower.

·????? ?A detailed statement from the borrower of the intended use of the funds.

Purchasing at face value of the note vs. purchasing at a discount:

Notes may be purchased at full-face value or a discount.? Face value means that the purchaser would buy the total value of the note.? A $100,000 note paying 6% per annum interest, monthly payments, due in 6 years would be purchased by a prospective borrower, who would pay $100,000 and enjoy the 6% monthly cash flow.

Discount notes are purchased when the note’s interest rate is below the current market, the investor’s expected yield is below, or a borrower defaults. ?Using the above example, if the investor purchased at a discount, they may only pay 70% of the face amount or $70,000.? If the investor expected a yield of 10%, with a noted interest of 6%, the transaction would be short by 4% each year until maturity.? The note purchase would require a discount of 4% for each year or 4 X 6 (years until maturity)=24%. ?The example does not include the loan purchase cost, escrow, and fees associated with the note purchaser; the seller may pay part or both.

Yield calculations:

The above example is a simple cash-on-cash yield formula.

Many sophisticated investors use an internal rate of return formula to calculate the yield.? Internal rate of return (IRR) refers to the yield rate earned or expected for a given capital investment throughout ownership. ?The internal rate of return applies to all expected cash benefits, including the initial investment and net cash flow during the ownership period. ?All proceeds from resale at the termination of the investment are included in the calculation.? The internal rate of return for an investment is the yield rate that equates the present value of the future benefits of the asset to the amount of capital invested.? ?The formula may measure the return on any capital investment before taxes.? The method is an interpolation formula usually done best by a calculator or computer or by consulting an experienced practitioner. ?

Summary:

There are many different methods of generating wealth and income streams. ?Purchasing notes secured by real estate and originating private money loans are excellent investment options.

How does one find a specialist who purchases performing and non-performing notes? ?How do interested parties learn more about the opportunities? ?Contact me, and I will refer you to a professional source.

Thank You

Dan Harkey

Educator and Private Money Lending Consultant

949 544 8315 [email protected]

Visit www.danharkey.com

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