Setting the Record Straight: Should You Only Buy First Position Notes?

In the next few weeks, I’ll be writing about some universal truths—that simply are not universal or true. Here’s the first post and a favorite of mine.

Universal Truths? Not Freakin’ Likely.

False Universal Truth #1: When buying discounted notes secured by real estate, it’s always best to buy first position.

This “universal truth,” at least in my experience, is anything but a truism. The key for readers is to understand WHY this statement is so horribly false most—if not all—of the time. Let’s take it step by step and look at the facts on the ground.

I’ve been buying, selling, and brokering discounted notes for over 43 years, and these so-called known facts would be funny if they weren’t so often terribly injurious to those who believe them.

Always buy first position notes? Really?

Let me state from the start—there is no inherent safety due to the position of the note. From 1976 to 2015, I never owned a first position note. Period, end of sentence. Let’s look at some real-life evidence.

Example #1

You have the chance to buy a discounted note in first position, secured by a single family residence. The note has a current balance of approximately $50,000, and you can buy it for a slight discount at $45,000. The value of the home securing said loan is around $65,000. (For the record, a few years ago, this same note woulda sold for far less. The market is the market, and it’s always changing.)

How I gauge the safety of that note?

I wouldn’t sell that note to my worst enemy, much less buy it myself. The reason is simple. The LTV (loan to value), the relationship between the note balance and the market value of the house, shows insufficient equity in the house, at least for me, at 76.9 percent. In fact, even with the discount, the LTV between the note price and the home’s value is too high at 69.2 percent—oo slim in my experience.

That leaves precious little room for any potentially—read: likely—required fix-up money, sales costs (such as broker’s commission and the like), and closing costs. Of course, that assumes you could sell it at all, at any price, once you’ve finished the foreclosure process, which will add roughly $2,000 to $4,000 to your costs. Know what I mean, Vern?

OR you could buy this third position note and be infinitely safer.

Current balance is $50,000. It can be bought for around $40,000. It’s behind a first loan of about $100,000 and a second loan of roughly $50,000. The home’s current market value is $325,000. That’s an LTV of 61.5 percent. If you must foreclose on this note, let’s explore the potential costs to see what you’d net.

NOTE: Holding period at time of default notice was three years.

Sales Price: $325,000
Foreclosure cost: $3,000*
Lipstick on This Pig: $10,000*
Commission/Closing Costs: $25,000
Back Taxes: $4,000*
Payments on Both Loans in Front of You for a Year: $10,000*
The Infamous “Unforeseen” Costs: $5,000*
Payoff of First/Second Position Loans: $150,000
Total Cash In: $72,000* (My experience says it coulda been a lot more, or it coulda been less. But those are the exceptions, not the rule. It’s a “cost” if it came outta your pocket and not sales proceeds.)
Net Proceeds: $150,000

Yeah, yeah, but what’s the actual return?

Total Time Owning Note/House: 4 years. That’s first day in ’til last day out.

Total Outta Pocket Investment: $72,000. That includes the purchase price of the note ($40,000) and all outa pocket costs. Those costs are denoted by an asterisk.

Total Pre-Tax Profit: $150,000 – $72,000 = $78,000

In the four years you held the note, that’s roughly the profit you’d have made. That’s an approximate return of 20 percent.

Wanna know a secret? The above is what happens when all goes right after foreclosure. Yep, no kiddin’.

What if you foreclose, and you can’t give the house away?!

I’ve run into that conundrum many times. It’s called “real life,” and it can suck if you’re not prepared. Here’s what happens, based on personal experience.

We’re due for an economic downturn, right? We all know it, but we have no freakin’ idea when it’s gonna hit. Also, and this is an exception to the rule: if it’s not a first position note, your due diligence better have covered what the reasonable rent would be in case this scenario becomes reality.

It’s not that you wouldn’t find that info for all purchases. It’s that it’s far more important when there are loans in front of yours. Let’s explore this set of circumstances while using the above mentioned note and home.

Related: 3 Unnerving Signs a Recession Is Coming

Again, the bottom line is simple: It’s more about the home’s equity behind you, than the position of the dang note!

It’s a four-bedroom/two-bath home with a small family room, somewhere in flyover country. It sports a two-car attached garage. Its square footage is roughly 2,500 feet. It’ll rent easily for $2,200/month. Your debt service is a bit under $10,000/year.

Let’s just divide the annual GSI (gross scheduled income) in half, and say the NOI (net operating income) is, give or take, $13,200/year. That gives a cushion of about $3,200 a year for Murphy’s Law. (Whatever can go wrong, will go wrong, and at the worst time.)

Now, let’s say you were one of the many note holders who had to foreclose, back in 2010 or so. You’re gonna own that property for at least four to seven years afterward, maybe more. But wait, it was actually worse than that back then, right?

Exactly—as prices went south and big time. Let’s say this property went down to $260,000 or so.

If you waited until late spring/early summer of 2017, you’d have been back to $325,000 or more, which uses a pretty conservative 4.56 percent annual appreciation, assuming it didn’t start rising until January of 2012. The cycle, if not its timing, is almost thoroughly reliable. Key word: Almost.

If we take out the highest/lowest appreciating markets, over half the markets have gone up approximately 5 percent a year since 2012. They’re not doing that this year, but you get the point. We assumed no increase in rent, whatsoever. In fact, we assume that in the years from 2010 through the summer of 2017, the net result was no cash flow—as in zip, nada, nothin’.

Your net proceeds would be slightly higher due to the principal paydown of the two loans you took over—but not much. Your return would also be totally acceptable, around 11.6 percent per year without cash flow, and 14.7 percent with cash flow (or $3K/year).

These are just some observations about buying notes in first position. Bottom line: the principle of LTV still reigns.

Let’s say you bought a $50,000 first position note for $45,000. The value of the home was $85,000 or so. If you must foreclose, and you can’t sell it in the current market, you’re now a landlord. The major difference is that you own the home free ‘n clear of debt.

If the current market rent is roughly $900/month, and your NOI for the year is around $5,400, your monthly cash flow is, give or take, in the same range as your original note payment. Let’s look at the overall return though.

If we end up holding it for the same time as our first buy, and the home sells for roughly $95,000, using the same parameters as above, your net proceeds check is gonna be in the neighborhood of $87,400. IF you spent $10,000 fixing it up and had no surprises whatsoever, that ain’t bad. Your overall return would be in the range of 15 percent, possibly higher.

As you might now surmise, that’s just not likely to happen—though your return would most certainly remain in the double-digit range, maybe 10 to 13 percent or so. As I’ve stated countless times, I’ve never owned a note where my annual return, from first day in to last day out, was less than 10 percent—no exceptions. That counts every note I’ve ever owned OR brokered, performing, non-performing, and whatever position—since 1976. Not averaging 10 percent—every single note made a minimum of 10 percent.

That’s roughly $3 to $4 million in note purchase experience.

Although 43 years is a pretty long time to never make less than 10 percent a year on every kind of note, secured by real estate, that number can still change on a dime. Contrary to popular belief, history doesn’t always accurately predict the future. I know, cuz I’ve seen it happen in other real estate-related investments. I’ve seen the discounts for notes rise and fall like crazy.

For Heaven’s sake, I completely abandoned the entire SoCal market back in 2003 because it crossed the line of “making any sense whatsoever.” Why do ya think I haven’t bought/brokered a note in California in almost two decades?

Just a few short years ago, the discount for first position notes was 30 percent! Now it’s down to 10 percent, some at par. There are some fairly complex explanations. But bottom line: supply and demand is the short answer.

Boomers have found out about notes. I’ve seen the cash-on-cash return increase/decrease by 25 to 50 percent in surprisingly short periods of time. So, if in 2020, I buy a note that ends up with an overall return of 6.75 percent, I won’t be surprised in the least. If that does happen, you can bet the return on the alternative investments will also be lower than notes.

I’ve never, as in never ever, seen the actual cash flow on residential real estate in relatively decent to excellent areas equal to or higher than notes in the same time period. (Potential exceptions: flips and nightly rentals.)

I’d say the probability of that scenario is over 90 percent. But at this point, I don’t see that happening anytime soon. Still, that opinion, plus $20 will buy you and me a whole bunch of caffeine and sugar at your local coffee house.

Summary

The position of any note is always subject to the actual LTV of said note. No exceptions.
Due diligence will never be the most reliable factor.
Murphy’s Law is real. This is why being “generous” with the LTV maximum isn’t recommended, ever. Remember what O’Toole said about his buddy Murphy: He was an optimist.
Economic cycles are your backup when you must foreclose and must keep the property for a significant amount of time. In my experience, the next time any given cycle fails to follow “the script,” it’ll be the first time I’ve ever seen it in 50 years.
Nothing takes the place of high equity behind you. Equity is what gives us room to breathe.

What to Remember

Ignore this at your peril: The Holy Grail for acquiring discounted notes secured by real estate IS NOT the position of the note. It’s the equity behind you.

Do you invest in notes? Why or why not? Do you have any note-investing questions for me?

Let’s talk in the comment section below!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.