Is any one here using promissory notes as collateral for more financing?
Investor · Durham, NC · Member since 2010 · 20 posts · 5 votes
If so what are some good sources for financing the paper?
Actually some of the most sophisticated investors out there make loans against promissory notes secured by real estate all of the time.
I can't believe that a "promise to pay" would ever be considered as "collateral". Let them have some property to secure the loan, and you might find a lender who will consider that as collateral. Otherwise, you are seeking a "personal loan" or "personal line of credit".
http://www.ehow.com/how_5764863_use-promissory-collateral.html
http://en.wikipedia.org/wiki/Hypothecation
Collateralized promissory notes (the ehow article) and hypothecation are the same thing. A loan is made and the borrower offers something of value - collateral - as security for the loan. If the borrower doesn't pay, the lender can take the collateral.
Rehypothecation is, I think, what you are wanting to do. In this case the lender uses the loan they have made as collateral for a second loan. That's a reasonable thing to do because a loan you make is an asset. That loan is generating a stream of payments.
So, the scenaro here is a borrower, A, gets a loan from a lender, B. A gives B a promissory note (note #1) and makes payments to B. Doesn't matter if this loan is collaterized or not, nor exactly how the payments work.
Now B takes this promissory note to a lender, C, and gets a loan. B offers note #1 as collateral. C agrees to make the loan, and B gives C note #2. If B doesn't make payment to C, C will take note #1 and start collecting the payments from A.
B and C would have to agree on the value for note #1. That's going to be very dependent on the strength of A and the collateral under note #1. If its a personal loan from B to A, the value might be only a tiny faction of the amount lent. If its a 20% LTV first mortgage the value might be almost the same as the amount lent.
Now, if you mean how could A use the loan from B as collateral for another loan, then, IMHO, A cannot. Note #1, which A gave B to get the loan, is not an asset for A. Its a liability.
What A could do is to use the cash received from the loan as (for example) a down payment and get another loan from another lender. If note #1 is using some property as collateral (for example), and A then gets another loan that uses the same property for collateral, the new loan is a second mortgage.
It's certainly legal, but not practical. You might be able to find an unsophisticated investor willing to take a note as collateral but generally real property is required. Even if real property is the collateral it's value will most likely have to be way more than the loan amount.
Actually some of the most sophisticated investors out there make loans against promissory notes secured by real estate all of the time.
Makes sense. Its just a variation on "selling a note". For the lender, the note is an asset. It can be sold. If it can be sold, it can be used as collateral for a loan.
John,
Where would you find lenders that will loan you created against your promissory note.
For example if I wanted to make a hard money loan at a 65% LTV to a private investor at a high short term interest rate with the property secured as collateral. I could present the promissory note to the lender and somehow negotiate a lower interest rate and keep the spread.
I'm a novice real estate investor (only a few properties and 26 years old), and have no experience in private money lending so excuse the questions if they are not practical.
Ron - no question a bad question... glad you asking!
There are most definitely lenders that will establish credit facilities collateralized by promissory notes. My primary credit facility prior the crash in 2008 was a rediscount facility with a lender out of the Philadelphia market (who is no longer lending in this space by the way).
I have received many inquiries from lenders looking to finance notes receivable for my company over recent months. I will need to go back and review my notes to recall names of those lenders. Typically they are not looking for one note here or there, but are instead looking to provide financing for a lender with a sizable portfolio.
That said, there are potentially private lenders in your market that would offer financing on your notes receivable, with your equity subordinate to their debt, or even in a pari passu arrangement (which means basically their loan is on a equal level with your cash in the deal - you share in upside and downside in the deal).
As an example, here is how our credit facility would work. We would fund the note, then the lender, upon receipt of a complete collateral package (note, recorded deed of trust, and an assignment of our security interest in the note, along with other collateral documentation) would advance 75% of the value of the note, freeing up our cash to make additional loans. We kept 25% skin in the game, and our equity was subordinate to the senior bank debt.
So here is the word of caution. Leverage is wonderful when the market is heading up - exponential impact on your return on equity. It will kill you when the market is heading down. Be very careful with leverage when financing notes receivable. When a market drops 30% and you are using debt to finance 75% of the note receivable, your equity is gone and you are upside down on the note.
Here are some things to think about related to leveraging notes receivable in a declining market, which will happen at some point - not a question of if, is a question of when. And no, I didn't read this - learned from the school of hard knocks.
Your borrower, just like you, will be facing issues, from cash flow challenges to the declining value of their asset. They will chose not to pay your interest due (and will very will pay themselves instead) and will force you to make a move to take control of the asset.
As the lender, you have limited options to control the cash flows from the asset collateralizing the note. All are painful to execute (from a deed in Lieu to a full foreclosure, pursuing personal guarantors - none are without pain), and all will cost you time and money. In the meantime, your cash flow stops (because your borrower stops paying you and starts paying themselves) and your lender still wants to get paid. So be careful if you do pursue this route.
Would I use leverage again to finance our notes receivable? I have strongly considered it, but at very conservative leverage ratios, and only in a manner in which I take a very cautious view of the potential what ifs on the horizon. Massive gains utilizing leverage can be wiped out quickly in a declining market. Explore it, consider it strongly, but proceed with caution.
Nice post, Bill Worsley.
Bill is speaking mostly from the perspective of a lender seeking to borrow against the notes he holds and is collecting payments on.
I receive requests from the other direction: Investors buying mortgage notes and looking for the financing to buy them. I have considered it, and decided against it, because of the very lengthy and cumbersome process needed to get my money back if the borrower defaults. First I would need to go through the the legal process to take possession of the note(s) that were put up as collateral. Then I need to initiate foreclosure.
In MA that process together can easily take more than a year, so it was too lengthy and expensive.
So if your reason for asking the question was to find financing to buy notes, perhaps you can connect further with Bill and get the names of those companies.
I too have had a credit facility for note purchases. You do not see many street level or small balance facilities as the remedies of breach of contract are cumbersome and expensive.
When a mortgagee pledges the note to the credit provider, a U.C.C. lien is used in most cases. This may or may not include additional guarantee depending on the credit provider. In one of the more secured structures, the note along with an assignment and a note endorsement are all executed and put into an escrow for the benefit of the credit provider upon contract breach.
Some other credit facility structures include all the loan payments to be sent to the credit provider which then nets out their fees and passes the balance through the note investor. This is a bit more like a typical receivable contract finance situation. So the mortgage servicer would pay the credit provider and the credit provider would pay the note investor.
The barriers to this type of credit being readily available to street level investors are the cost of structuring the deal and the costs of default remedies. It simply does not pay for a credit provider to do these types of deals on single assets as in most cases the issued credit would be less than $180k. A 3% setup fee of $5,400 would not be enough to pay for the legal prep and due diligence needed to underwrite the note. Even doubled at 6%, still a tough deal. BTW, look at how much back lash street level investors give when it comes to fees on hard money lending. A one off investor is likely only worth a couple of these types of deal as they do not have sufficient equity to do more deals to begin with.
Another and equally important barrier for widely available one off note financing for street level investors is underwriting the note investor. Most current credit providers want to see years in the business. This helps ensure some internal systems are setup at the note investor's shop. How he will deal with delinquency and default borrower situations matters. Fact is, from the experience angle, most street level folks simply do not have the experience to rep and warrant back to a lender on these types of assets.
Are note credit facilities available, yes, in fact they are far more abundant than most think. Many lenders both conventional and private have some form of credit facility. These are usually multi-million dollar facilities where the cost of setup can be recouped over the life of the facility.
It is important to note, a mortgagor (borrower) default event which makes the note investor who took the credit insolvent is a two layered event. If the credit facility default is a function of the borrower default, you must first take possession of the collateral for the credit facility and then you must also deal with the defaulted note itself by way of some form of mortgage disposition either foreclose, re-trade the note, etc. to get the credit facility capital back.
That's basically how it works! Good posts above!
At one time about a third of my portfolio was financed for additional capital, when you're not a member of the federal reserve, you finance receivables. It generates a spread on interest and servicing income.
Credit facility? Let's say conduits and accounts receivables financing, I used banks. We also brokered receivables and leases. Where do you think these rent to buy and car dealers get funding to finance...?
The notes are usually underwritten by the financier prior to making the note/loan for it to be purchased, but after awhile of working together and trust builds as well as demonstrating the ability to repurchase or exchange other paper it is rather an automatic assignment. You can usually get money when you can show you don't need it....LOL
A private investor can also make a loan, as Ann mentioned, collateralize that loan with assignments. This gets tricky as you can get sideways to the SEC quickly, I hesitate to even mention it.
This is common for new construction sales, pledging underwritten notes to the bank for construction financing on the next build.
We had a mortgage broker go to jail getting involved with private investors and pledging notes, the collateral was insufficient and they lost, they called it fraud.
:)
Speaking for California properties only:
It's simple.
You hold a note secured by real property.
You may not want to sell the note at a deep discount and lose a large portion of the money that you stand to collect.
You but up your note as collateral and borrow about 50% of your note balance. The costs of borrowing are far less than the discount you would suffer if you sold the note.
If the note pays off in full as you anticipate it will, we (yes, we make those loans) get paid off in full and you get the rest of the money.
In summary, you own note, you use it as collateral to borrow money.
(Very similar to using a house you own as collateral to borrow money.)
Investors should keep this basically SIMPLE method of raising capital in their inventory of knowledge. You will (sooner or later) get stuck carrying paper. You will have a need for capital.
Joffrey Long
I'm a novice real estate investor (only a few properties and 26 years old), and have no experience in private money lending so excuse the questions if they are not practical.
For someone with little experience, Ron, you asked a pretty insightful question and your example is spot on. You too, Michael Lawrence.
Your state laws notwithstanding, it’s absolutely legal. I’m glad Joffrey Long responded with a non-institutional answer for the small investor. There’s another equally simplistic approach, valid at least in California and I suspect elsewhere, which relates to private loans.
Anyone could make a personal loan to you. You could structure it as non-recourse and use a note you made to someone else, secured by real estate, as collateral. You could keep the points on the real estate loan you made and repay your personal loan at a lower interest rate, as the payments to you came in.
A few key points:
1) The real estate loan has to be legal, in compliance with your state laws, and result in a sensible, valid note to a capable borrower. In California, it would have to be originated by a licensed broker if the interest rate was over 10%, among many other rules.
2) You’re not selling the real estate note or assigning it in any way. It’s still your loan and your borrower still owes you the money.
3) The money you are borrowing would be a personal loan to you and it would be non-recourse. You’re obligated to make payments on this loan. If you didn't, your lender would get the note and could not come after you for any arrears. In effect, they would replace you as the property lender. That loan too, would also have to be legal.
Again, in California, since this note would not be secured by real estate, it would have to be at an interest rate less than 10%. There would be no broker involved, but you’d certainly want to obtain all your paperwork from an attorney and vet this process through him or her.
4) You could do with whatever you wish with your personal loan (Hint: Like lend it out again on more property and borrow against that note, etc., etc.)
5) Don’t even think of borrowing from more than one person, giving them a pro-rata share of the collateral on one note. This then becomes a security which must be registered and is infinitely more complicated and more expensive.
It’s a lot easier to do this Ron and Lawrence, if you have track records of successfully loaning money. The steep uphill battle is learning how to loan money privately and also finding lenders willing to accept your notes as collateral – a two edged sword. I’m always opposed to involving friends and family but professionals you know, looking for modest real estate returns, could be interested.
Jeff
hey Michael,
Just wounding how it went with using your notes as collateral for leavrage.
What kind of real market is there for this kind of thing.
Thanks for your original post.
Hi all
I'd also be very interested to learn more about whether there are lenders out there willing to finance this strategy. I've been an SFR investor so far, and am leveraging after purchase / rehab / tenant in place - so the lender in this case is relying primarily on the cash flow stream generated by the tenant, backed up by the underlying value of the property and finally my other personal assets / income. In my mind this should be a similar concept for notes: I purchase and build track record of performance, and a bank then lends to me, relying primarily on the cash flow stream generated by the property owner / mortgagee, backed up by the underlying value of the property and finally my other personal assets / income.
To my way of thinking, one of the biggest reasons I invest in SFRs rather than in notes is lack of ability (so far!) to leverage my own equity on notes. But I would think that a creative banker would be a very good partner for a notes buy-and-hold strategy. Does such a unicorn exist? @Michael L. @Jon Holdman @Marc Faulkner @Bill Worsley @Dion DePaoli @Bill Gulley
Ian
Arbitrage is the financing of notes and it's done everyday.
While the concept is simple, it is a much more sophisticated aspect than only but a couple of members I know of should get involved in such activities, I'm not being snide there underlying issues in arbitrage of notes between investors.
Obtaining a loan from a bank is fine, as an institutional lender willing to conduct this type of business will be aware of collateral, security, underwriting, valuation and collection aspects. The average note investor is not.
Developers and contractors who have financed sales will pledge notes for capital, a common tactic with banks.
Private or small brokers are another story, they don't usually have the deep pockets to take out a lending investor or participant. This lending/borrowing on notes by small dealers often gets into fractionalized interests as they can't raise capital from one player. This can get into SEC requirements and you'll often find that they may have a solution to defaults or demands for capital by substituting notes or collateral, this gets pretty much a scam as no note is identical to another, substitution with consent is one thing, substitution at the option of a lender/broker with a note holder or investor should not be agreed to. Those who go there may have good intentions, but they really don't know what they think they know and at some point, borrowing to cover demand or obligations and substituting collateral falls into the Ponzi scheme category and fraud when they represent that the substitute collateral is the same or very similar as that being released, as it won't be.
This isn't something for newbie note investors to get involved in. In some states fractionalized interests in notes is illegal unless the parties are registered or institutional lenders, where it is lawful it probably shouldn't be, but you never know what some state representative politician might be involved in either. :)
Thanks @Bill Gulley , I understand, this is legally / regulatorily complex and doing it requires investing in proper advisors. I'm prepared to do that. How / where would one seek a lender in this space?
Start with your bank's commercial lending department. Rule #2, don't participate in one note with other investors. #3, do your due diligence dealing with any broker and don't get involved in note swaps without your being in control. You can certainly obtain a loan from a small investor/broker and assign your note as collateral, just have the transaction reviewed by your attorney, these aren't complicated as a clean transaction. :)
If so what are some good sources for financing the paper?
Michael,
I have a had a hard time finding a good source here in Texas. However after a lot of looking, I think I have finally found one. What you are doing is smart and I would recommend you check with the small banks and credit unions in your state. Getting recommendations from RE investors who have found small banks willing to do LOCs on RE would be a good place to start. Good luck!
My last post about this type of product was deleted...
So, yes these types of loans and facilities are still available..out there somewhere and you evidently have to figure out how much they cost, how they work and where to look for them.