My partners and I started our note business in the fall of 2007, and like most entrepreneurs who start a new venture, our first big hurdle was raising capital. It wasn’t until 2008 that we realized we had another problem (recapitalization).
We were able to overcome these challenges and build a company that we are continuing to scale up to this day. So, how did we do it? And how can other investors recapitalize?
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Sources of Capital
In the beginning, we used our own capital to buy four notes just to see if we could work through the assets. Next, we formed an LLC, created a company, and got some more capital together to start buying more and more notes.
We pretty much tried everything to get the money together once we realized we could make significant returns by getting notes that are in default (non-performing) back on track with current payments (performing) or by exiting the deal through the property.
We gathered all that we could from savings and retirement accounts to loans from credit cards or HELOCs (home equity lines of credit) — pretty much any type of asset that could give us capital to buy notes.
Once my partners and I put all of our own money to work, we knew it was time to start raising money for a fund. But we were still running into the same roadblock.
For example, if we purchased some non-performing notes and were working through them, it could take anywhere from a few weeks to a few years to exit depending on the deal. How long it takes varies depending on borrower intent, foreclosure timelines, the REO market, etc.
So, let’s say we exit a few, we get a few re-performing, and a couple notes we’re still working through. Now what?
To keep going back to the marketplace to purchase more notes, at some point, you have to recapitalize.
Whether you want to go the broker route and flip a note (hopefully with the markup) or sell a note (or part of a note, also known as a partial) after you got it re-performing, you suddenly run into your next hurdle: Do you have any buyers?
Luckily, today, it’s much easier to sell a note since the number of note buyers, along with knowledge of this investment vehicle, has increased. For PPR at the end of 2008, it was more difficult.
Related: So, You Just Bought a Real Estate Note? Here’s What to Expect Next.
There wasn’t a large market for re-performing second mortgages at the time, and we were just starting to build a buyers list. So, an alternative strategy was to borrow against the secured note and mortgage.
Collateral Assignment of Note and Mortgage
At that time, luckily, I was flipping through an old seller financed course my partner Bob had on his desk from Donna Bauer, and I came across the concept of a collateral assignment of note mortgage. So, I took the idea to our attorney, and the next thing you know, we were borrowing money from private investors against the notes we had already gotten re-performing.
Similar to how a car itself is the collateral for a car loan, a re-performing note served as collateral for the private investor’s loan.
This strategy involves two documents. One is the promissory note, which spells out the terms of the loan. The other is the collateral assignment of note mortgage that, along with the legal description, gets recorded in the county courthouse where the house behind the re-performing mortgage is located, thus putting a cloud on the title.
If the borrower ever wants to sell or refinance his property, you have to address or satisfy your loan from the private investor, unless of course you had a substitutional of collateral clause in your documents, where you can replace the underlying mortgage with another of equal or like value to protect your private investor.
Advantages of Collateral Assignments
There are many advantages to the utilizing collateral assignments of notes and mortgages, especially when you are in an up market with plenty of equity. You can even cash flow off of these.
For example, you may be able to borrow up to 80-85% of the payoff of the re-performing note, as long as it’s covered by equity. This could help you recapitalize on the expenses of the deal, such as the note purchase cost, legal fees, cost of capital, etc. If the payment you receive from the borrower of re-performing note is higher than your payment to the private investor, you may even be cash flowing.
On top of that, since you borrowed against the note instead of selling it, this type of recapitalization is usually not a taxable event. Technically, it’s tax-free because it’s a loan.
For my firm, this was a great way initially to finance the growth of our startup business.
Today, we have a much larger money list and buyers list, with a much more robust trade desk through which we can recapitalize very quickly, so we no longer have much of a need for this strategy.
For a note investor just starting out, though, this old strategy might be a good one to pick up off the shelf and dust off, especially as we expect more and more equity to keep coming back in the market.
If you’re a note investor, how did you tackle recapitalization?
Let me know your thoughts with a comment!