Discount note investing durring different market cycles

11 Replies

I've always been a fundamental real estate investor, buying single family homes in Austin after the stock market dot com crash when foreclosures were plentiful and renting them until the market came back. Moving into value add apartment buildings in Arizona and Texas, after the 2008 crash, when prices were dirt cheap. 

As the market recovered, and building became cheaper than buying, we went into some new development deals. 

Now prices are high and we are selling into demand taking profits. So capital is coming back. Great! right? Well kind of. Capital doesn't cash flow by itself, and a CD isn't going to keep up with inflation let alone give a return.

So what to do?

I'm exploring discounted notes. Looking into PPR's Note Fund. 

Is it a bad idea to invest in notes with the market heading into higher territory? Is there enough of a discount built in, to protect my capital and still cash flow through a market correction?

Looking for input, thoughts, experience.

It sounds like you've been making all the right moves since the early 2000's. Congrats to you for that! I am curious why you don't trade up in multifamily? The right asset, in the right markets, should allow you to ride out a downturn, don't you think? And if the downturn turns out to be years away, even better. And sorry for hijacking your thread. :P

Hi @Kris Wong, The Multifamily apartmens I've been investing in are in the 200+ unit deals with partnes and onsite management. These types of properties are highly competitve and attractive to the institutional players.

The REITs have to put money to work if they have it, and in this market they are willing to pay up, even if it does't work. Unfortunatly the investors in the funds will get hurt as they go through a down turn and maybe do ok again years from now. The fund will take a hit as the cost of doing business, and still keep going.

With that said it makes sense to sell some assets (depending on business plan, especially if things haven't worked to expectations), to the institutional player when the market is high ( It would take years to make the money back that is sitting in equity, if we waited for rents to rise and get the cash flow.) So we sell and wait for a more attractive entry.

Some properties that we've purchased well in the past, and are cash flowing are being held, and will do fine through the next down turn. So it depends on the asset, what the business plan was for it, and the opportunity in the market now...etc..

I love Austin by the way. Good appreciation and fundamentals, population job growth. But be carful not everything is a good deal even if it cash flows. When I first went into Austin years ago houses that were renting for $1300 mo. went down to $950 to keep them occupied. Who says rents never go down.

@Tom Dillon
As a note investor here are my 2 cents. You buy. It’s based on a discount of either the UPB (unpaid principal balance) or the property value. Those discounts have gone up significantly since I started investing.

What you need to be careful of investing currently with notes is what happens if housing drops 10-20%, will you still be covered?

That begs the next question of do you invest in firsts or second position mortgages.

I do not invest in 2nd’s so I cannot come on them but I would see 2nd’s being riskier in a hot market that were to go cold because if the equity was lost in them a BK or FC could wipe them out completely.

For firsts I am positioning myself now to minimize any impacts on either unemployment going up = more delinquent borrowers as well as hedging against a dramatic drop in prices. Can you protect against all of it - nope... but I have changed my business plan slightly to minimize any potential impacts

Hi Tom,

I think the answer really depends on your overall goals. Notes of course do not appreciate like real estate, nor do they provide any real tax advantages or deductions outside of normal business expenses. For protection, equity is king. Having sufficient equity to ride out a financial downturn is important but you would be surprised at the amount of "emotional equity" people have to their homes, even when underwater. Just because something is underwater does not mean the borrowers will choose to walk away. Far from it in most cases.

Purchasing depends largely on what yield the investor is comfortable with. Discount is not as important. Don't get me wrong, discount does play a factor, but the main thing most investors are focused on is the yield, the interest your money is earning annually if the borrower pays to term as agreed.

Regarding a discount, and how much should it be, well this depends. Lets use an example.

  • UPB: $80,000
  • Rate: 3%
  • Term: 360
  • Payment: $338.09

Lets say you as an investor need a 11% yield on this note. You will need to purchase at $35,194.02. The difference between the purchase price and the UPB on the loan is your discount.

Now let's use another example:

  • UPB: $80,000
  • Rate: 7%
  • Term: 360
  • Payment: $535.20

To receive an 11% yield on this loan, you would pay $55,712.47 as the purchase price.

I say all this to mean that the discount is not the item to focus on, the yield is. Discount is nice but can fluctuate wildly based on the loan rate, terms and more.

To answer your question you can definitely invest in discounted notes to hedge your losses in a downturn. Is it foolproof? Definitely not, as with all investing. But you can significantly reduce your exposure to negative events.

BTW I am located in Austin. Feel free to reach out when you are in town!

- Josh

@Tom Dillon It helps to buy NPNs in a market that's going up but there's an element of uncertainty that can cause it to go the other way. How long will the hot market last? What will it turn into, flat or declining? When will this happen? With NPN's, the borrower's actions can make a 6 month to 12 month FC take 2-3 years and who knows what the market will be doing then. We assume that the market stays stable when we bid on notes. Any upside because of market appreciation is a welcome bonus. If a big drop happens, our strategy will adjust and we ill foreclose and rent the property until the market recovers. We typically stay in the $100k-$400k range of properties so rentals make sense at that level.

For performing notes, an increasing real estate market will make your investment more stable since there will be more equity in the property so you know you'll recover the entire debt owed if you have to FC. Assuming that you bought at 80% LTV or lower, the increase in market value will not increase the value of your note. Performing notes with equity generally sell at prices determined by yield

@Joshua Andrews

Thanks so much for the clarification. 

All the input so far makes a lot of sense and is very helpful.

It doesn't seem to be uncommon to get between a 10%-14% yield on notes. How is this yield thought about among investors? 

As I think about it I say to myself well there is inflation say 2.5% if you believe your government so really ( 3% - 4% at least), then there's risk free 10 yr treasury say 4%,..... Stocks maybe 7% - 8% (Stocks = risk free + inflation maybe 1%-2% above that). 

So Real Estate Notes...4% risk free treasury + Inflation (3%-4%) = 8%  so there is the cost of doing business what if I have to foreclose, maybe put some money into the house to sell it or rent it till I can be made whole again, how long am I sitting on the capital not making a yield + I have to do some work to get my money back = the other 2% - 6% to equal your 10%-14% yield?

@Andreas Mirza 

With the NPNs strategy are you in first lean position? (So if there is a foreclosure and there isn't enough equity left in the property due to a market correction, you can rent it out until a recovery.)

If there is a second lean on the property and both the 1st lean and second are underwater, does the 1st position have to make the second position whole before taking over the property to rent it out? (I'm sure the borrower is responsible for the second, but they were responsible for the 1st and that didn't work out now did it, so what if any complications are there for the 1st position? Does the 1st own the property free and clear?)

Again thank you everyone for contributing to this thread, I am learning a lot!

@Tom Dillon

If both the 1st and 2nd are underwater the monies go to superior liens (taxes/HOA’s in some locations etc), then the 1st gets the balance until it it paid off

A second essential gets wiped out (gets nothing). They can sue for deficiency judgement but in most cases you cannot get water from a rock.

The first would get the property free and clear if they were to be the high bidder (bid the payoff) at the auction and they would assume the property with any priority liens but any subordinate liens are wiped

To me best way explain it was Friday’s in elementary school when everyone wanted cheese sandwiches. There was not enough to go around so the tax commission goes first and any superior liens / then your the big hungry kid that gets the rest of the sandwiches but not enough to fill your belly. Junior behind you who was in second position gets shut out and had to get the tuna fish sandwich (i.e. the short stick)

Hope that makes sense

@Tom Dillon Yes, my strategy was referring to 1st liens although you could make it work for 2nds in certain cases. You can foreclose as a second lien holder and make payments on the 1st. I've seen some investors do this successfully and have positive cash flow. Over time, you'd be paying the principal on the 1st increasing your equity and return. It's not our strategy, though. The idea of foreclosing on a 1st and renting the property out is at the end of the option list. But at least it's an option in case we need it!

The 1st lien is entitled to collect all funds up to the total debt that's owed. Any excess proceeds go to the next lienholder in order of priority (2nd). Any further proceeds go to subsequent lien holders in order of priority. (3rd, 4th, etc.) Anything beyond that goes to the owner of record. It doesn't go in reverse i.e. if a 2nd forecloses, the excess proceeds go to 3rd, 4th, etc, owner and NOT to the 1st.



1st Lien                                 $100,000

2nd Lien                                $100,000

The 1st forecloses and the property sells for $150,000 at auction. The 1st gets $100,000, the 2nd gets $50,000, the former owner gets 0.



1st lien                                $100,000

2nd lien                              $100,000

The 1st forecloses and the property sells for $250,000 at auction. The 1st gets $100,000, the 2nd gets $100,000, the former owner gets $50,000


2nd forecloses, Underwater

1st lien                              $100,000

2nd lien                             $100,000

The 2nd forecloses and the property reverts to the beneficiary (2nd) because 99.9% of bidders will not bid more than market value. The 1st is owed $100,000 and the 2nd becomes the new owner of record. The prior owner gets nothing. The 2nd needs to keep payments current on the 1st or the 1st may foreclose