I love these threads. And as always, I love the reality Bill Gulley puts in black and white.
A common theme from 'newbies' is that the note business is glimmering with easy profits and good margins. Certainly Andrew was not sure that assessment was correct so he asked.
Aside from the points Bill made regarding installment sales and the point about not assuming you will get the property. There are many reasons a note Seller goes to market. Too many to list. When you are accessing the deal on a NPN the current collateral value of the real property should be scrutinized. I would also suggest you double check your math. For the most part, easy recovery of default is not sold off, that simply doesn't make sense. A Seller would retain that in most cases and do it themselves. I always like to say a Seller is not going to simply hand you some large total return opportunity. You will have to work for it. The guru sales pitches seem to be these discounts are huge and you almost couldn't loose. Well, if that was true, banks would have not crumbled in recent past or even in the RTC days.
Fact of the matter, NPN investing has been around since the secondary market has been around. In the recent past, large (giant, even) firms have invested in NPN's and choked, loosing money. I think another concept that gets passed off, which simply is not true, is that there is some duty to sell these assets at substantial discounts. Far from true.
The discount that is applied is a function of the current value of the real property, the costs and time of getting through the foreclosure process. As stated, jumping on a note because the percent of UPB (Unpaid Principal Balance) is small is not a good way of accessing the deal. For instance, in areas such as Midwest, Florida, Arizona and Las Vegas, where real estate values fell off a cliff, that discount is a function of that decline in real property value. A home that was mortgaged for $250k in 2004 is now worth $50k. (and yes, those are real numbers in some markets)
If we continue with that example. In this case the debt far exceeds the property value, so as the mortgagee you could send the entire balance to foreclosure sale as your bid and chances are pretty good that nobody will hit your number. So then you get a house back that is worth $50k. Your cost of sale for the REO, say 10% for easy math, nets you $45k. Foreclosure cost you $3,500. Taxes are not paid and cost you $1,500. Since there is no borrower acting responsible the home is uninsured which will cost you $1,000. The seller you bought it from let the property fall into disrepair and you have a fine from the city for $500. When the borrower left the home they left trash and it need to be cleaned for another $1,000.
So you stand to net $37,500 after the above expenses. FYI, that is 15% of the UPB of $250k. Problem is, you have not made a dime if you purchase at 15% of UPB. Additionally, you have had to capitalize the asset with another $7,500. So let's get a margin in there, say 20% or $7,500. And finally the humdinger, time, this whole process will take you 18 months. So generically you just made 13% per annum on your money. To achieve that you would have to be purchasing at 57% of RE Value and 11.4% of UPB.
That is an interesting exercise because that price level is relative to the institutional market. Note, there is not much room for error. If the real property has any type of physical defect such as roof problem, or mold, or whatever you just cut into your profit. Those are unforeseen problems as you cannot inspect the whole house or interior prior to purchase. If an unexpected $2k expense comes up your return drops to 9.7%. If the foreclosure takes an additional 6 months without the added expense your return drops to 10%. If that $2k pops up with the added time, you are down to 7.3%. So hopefully you see how quickly your position can erode and your return can go away. Welcome to NPN investing.
This is an industry of thin margins and the solid players are operationally efficient. Reducing time and expenses everywhere possible. This is key because a Seller doesn't care what your margin is, doesn't care about the time and frankly completely opposite of what you might have heard, is not at all interested in being realistic with the asset's recovery. The Seller is negotiating a loss, their job is to minimize that loss, which in English means sell to you for as high as possible. If someone told you they are just giving these things away, they lied.
The other humorous chatter I tend to hear often is that the banker, asset manager, etc is stupid and doesn't know what they are doing. My friend if you believe that I have some deeds to on Pluto I want to sell you. The banks selling off NPN's have a solid understanding of what they are worth and what type of recovery can come from each asset. Can you find diamonds in the rough? Absolutely, but that is not because the Seller is incompetent. For instance, modification options, which some folks act like is new and it is not, are deployed by most banks and note investors. Internal restraints may prevent a treatment like you would do. For instance, most banks do not forgive principal, they reduce the interest rate. For a private guy, with no restraints, forgiving principal makes sense for a bank it is more complicated and typically not an option. Additionally, the mortgage servicing food chain is a bit convoluted and difficult to at times to be effective, so it is not unusual in due diligence to see a borrower has lined up a short sale for months but for some reason it was never approved. These are the types of operation efficiencies you have to look for and develop to be good at the game.
The last concept I will leave you with, is many newbies tend to speak very leaner about their disposition strategies for notes. What I mean is they tend to have one plan and they plan to carry that out on all notes. For instance, we are going to modify all the notes, every time. That is asking for trouble. Disposition strategies are a layer of processes and outcomes. Not all modification strategies workout. Sometimes you cannot find the borrower or the borrower can't afford any payment (let alone the current payment) or sometimes the borrower just doesn't want to work with you. It is romantic to think that everything works out in the end but most of time that is dream not a plan.
As was stated, I think by Bill, there is plenty of money to be made in this business but this business is not as simple as real property. In its own nature it is more complex because it involves real property and mortgages. I would also chime in that applying that logic, commercial property is more complex than residential property so you can infer commercial notes are no where close to a walk in the park by any means. Anyone who pretends any of this is easy and mountains of cash fall from the sky is not actually involved in the industry. That I will guarantee.