Note Investing: Go Forth and Hypothecate!
Many of you have dealt in notes secured by real estate. Most dealing notes regularly bought them at a discount. For those who have notes they’d like to turn into investable cash — without selling the note for a loss, or at least no profit, this could be your answer.
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The concept in a nutshell is relatively simple. You own a note secured by a trust deed — typically on improved real estate. You get monthly payments including interest. Sometimes it’s fully amortized, usually not. You’d like to get a lump sum from it for an opportunity that’s popped up recently, but don’t wish to sell for the discount you know is market price. You have an alternative — hypothecation.
It's simply you borrowing from a bank, or another investor, pledging the note as security for the loan. I've done it several times in the past, usually during down times. Let's do a quick, down ân dirty example, using elementary school math.
Your note has a balance of $110,000 — it began as a carry back second trust deed and note which you bought at a discount from the seller. Originally it was $120,000, payable interest only per month, at 10%. The payor has normally paid just the required payment, but every now and then paid a little extra. This has resulted in the new, lower balance. The terms of the note allow for this without penalty, but also says the note payments will remain at the original $1,000 a month ‘or more’ regardless of an principal pay downs.
It’s all due and payable in six years.
You go to the bank or investor and ask them for a $45,000 loan, pledging the note as collateral. This loan will be for five years, fully amortized at 12% give or take. The payment is the same $1,000 you’re gettin’ from your payor. Bottom line? You get the use of $45,000 while foregoing the grand a month income. It’s completely paid off about a year before your note is due. A year later you get paid in full, around $100,000 or so, depending upon how much the payor paid in principal pay downs.
NOTE: When I say pledge the note as security, I mean it in the same way we do with car loans. The car is security for the loan, but the bank doesn't get the car, we keep it to drive. As long we we make the agreed upon payments we maintain possession of the car.
The bank or investor lending you the $45,000 was satisfied through their due diligence that the note was solid, with enough true equity behind it to be safe — measured using their standards.
Meanwhile, you used the $45,000 to buy property, or another discounted note, or . . . whatever. Your opportunity cost is measured in a couple ways. First, for the five years of the loan, you gave up the use of $1,000 monthly. Also, it would make sense, that the money borrowed should be yielding a bottom line of more than 12%. See last week’s post on leverage.
Don’t look at this as a soup to nuts review of hypothecation. Just know as a note owner that it’s an option on your menu. It’s been an incredibly productive tool for me when I used to own notes regularly. It allows you to do transactions in real estate or notes you wouldn’t otherwise be able to do, while allowing you to avoid having to discount your note to make it happen. I’ve often viewed it as havin’ my cake and eatin’ it too.
You have a $110,000 note with $1,000 minimum payments, due in six years.
You borrow $45,000 for five years, fully amortized at 12%, the same $1,000 a month in payments.
You invest the $45,000 — earning a yield in excess of 12%.
You still get your $110,000 a year after you paid off your loan.
Meanwhile, your $45,000 has grown for six years to — who knows how much?
In addition, you now have $110,000 to reinvest in whatever puts a smile on your face.