Buying Notes at a Discount: Perfect for Real Estate Investors with Cash
Sunday was fun, as some of us at BiggerPockets enjoyed lunch together in Hollywood. It was cool talkin’ with investors — beginners up to battle scarred vets. One of them, an incredibly intelligent guy, was using as one of his strategies, what I’ve had clients do (me too) in markets like we’re currently experiencing. What’s he doin’? Pretty simple, almost boring — and very profitable. Also, I’m not gonna go into all the numbers crunching here — just concept.
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He’s buying notes at a discount.
If you’re a flipper buying your properties for cash, or even (Maybe especially?) if your strategies are longer term, buying notes can be not only far more profitable, but less sweaty too. I loved the example he used to illustrate his point.
He’d bought a note at a healthy discount. He then approached the property owner, offering to reduce the interest from 8% to 6% if he’d agree to increase the monthly payments from $750 to $1,000 monthly. This lead to the note’s value being increased — the basis for a bar bet if ever there was one.
How’s is possible to lower interest while increasing the note’s value?
The increased payments, combined with the lowered interest significantly sped up the time the note was gonna be paid in full — it was fully amortized from the start. This resulted in the note’s investor being able to quickly flip that note for a $12-15,000 profit. Took him just over a week or so. Does that work for ya?
For the record, none of this is new. It’s just not widely practiced.
But what if instead of buying the note for the note’s sake, you bought the note about to go or already into default? Look around at all the upside down homes in your area. How many local lenders, some of them (very few) private, would love to take a discount to Get Outa Dodge? Here’s the example we used at lunch, with a couple changes.
House worth $400,000 — note amount 380,000. Buy the defaulting note for $240,000. What are you options?
1. Go ahead with the foreclosure. In the process, approach the home owner with an attractive plan to get them out. Pay for them to move, and remove all dings on their credit report. That last one can sometimes be done completely, sometimes not. You, as the note owner can certainly remove anything you've generated.
You’ve then created multiple options.
A) Sell to a flipper for say, $300,000. Even counting some expenses, you’ve made somewhere in the neighbor of $50,000 relatively quickly.
B) Make the property perfect yourself, then sell it to the end user. Even if you sell slightly below market value, maybe $385,000, AND paid a Realtor to boot, your net profit would be in the range of $70-90,000.
C) You choose to keep the home, rent it out for market value, $2,000/month, and refinance it for roughly $235,000. At prevailing non-owner occupied rates, that allows plenty of room for it to easily pay for itself. You’re now operating on (Huge groaner pun alert.) ‘house money’, as you’ve almost completely recouped your original invested capital. Of course, you do it again. Duh.
D) This is my personal favorite. After spending maybe $10,000 sprucing things up — it was never a fixer — you sell it for market value. While in escrow you convert the sale into a tax deferred exchange. You net equity would be roughly $360,000 — possibly a bit more. That would allow you to easily acquire $1.25 Million (Possibly $1.5 Mil) in very well located small income properties in a solid growth region. In just eight to 13ish years or so, you'd be enjoying $90-100,000+ annual cash flow. (Assuming no increases to NOI ever.) You would've accomplished that enviable result with your original note purchase, which cost you lest than three times the amount of that lifelong annual cash flow. Moreover, your capital, even sans any appreciation whatsoever, would've grown to $1.25-1.5 Million.
Works for me. Does it work for you?
What if the note in question isn’t in default?
If you opt for the monthly income, you can do what the first guy did. Obtain an increase in payments in return for an interest rate reduction. Besides increasing your income, you simultaneously increased the note’s market value (Not always, but most of the time if structured correctly.). Furthermore, you’ve also moved up the date that the note is paid in full. When goin’ this route, many astute investors will convert the note from fully amortized to interest only or partially amortized, in order to enjoy a lump sum payoff at a time suiting their agenda.
Lastly, think about this one.
Make use of the concept of hypothecation. Simply put, you pledge the note as collateral for a loan. Let's say you own a note with interest only payments at a decent interest rate, all due and payable in five years. The lender will loan you maybe 30-60% of the note's face value at the same payment (more or less) as the note. The note payments still come to you, which you dutifully hand over to your lender. If your note was $100,000, and you borrowed $40,000, you'd make the payments for the five years. Since your loan was fully amortized, you're paid in full. The original note comes due and you're paid the $100,000 owed.
This maneuver isn’t a taxable event. It gets you some quick cash when you need it, but without coming outa pocket. It preserves the value of the lump sum payoff — all of which comes to you in full. Meanwhile, you had the use of the money, which no doubt made you more — or should have.
There are many more options when it comes to the use of notes to make hay in real estate investing. It’s truly one of the most productive methods I’ve ever employed. If you’re buying homes for cash, this approach should absolutely be in your arsenal.