Investors who purchase real estate are looking for multiple benefits. These benefits include cash flow, appreciation, tax incentives, and other financial rewards. Eventually, they may sell, exchange, or leave the real estate to their children or heirs. Real estate is considered “real property,” as opposed to “personal property.”
Property ownership involves active management, including, financing, tenancy related issues, maintenance & upkeep, insurance, record keeping & documentation, government, physical deterioration, and potential physical or economic obsolescence, also, the accounting and tax ramifications are complex.
Financing is available from banks, institutional sources such as Fanny Mae and Freddy Mac, Wall Street based securities, Credit Unions, and loans from private party know as a hard money loan. Many sale transactions are financed by sellers known as “seller carry-back.” A seller may make the decision to become the lender when they sell the property.
A loan is made by having the borrower sign a promissory note, “note”, which is a promise to pay, and a deed of trust, or mortgage instrument. The deed of trust or mortgage is recorded at the municipal records office that becomes a matter of public record. A recorded lien, or charge against the property, encumbers or clouds the title of the property.
Just as stocks, bonds, US treasuries, and the vast different forms of securities that are marketable to the public, so are promissory notes and deeds of trust. There are millions of this form of securities that change hands each year. There is a large industry of professionals that engage in identifying, negotiating and closing the sale and transfer of ownership of notes. A transfer from a note seller to a note buyer is consummated by an executed note purchase agreement, endorsing the note from the seller to the buyer, and recording an executed assignment of the deed of trust, or mortgage. The consummation occurs at the time of recording. Title insurance insures that the conveyance occurred properly. An offset statement will be required by the seller of the note. Buyers may use their liquid capital to purchase the notes from willing sellers. Yields on purchases of notes are like those in the trust deed purchase field.
There is a due diligence process that should occur for each note purchase transaction. The process is like one followed during the original loan transaction. There are escrow agents, title insurers, appraisers, property insurers, underwriting & technical staff, and a documentation specialist. All take part and serve as agents to prove up the economic viability and successful conveyance of the note purchase transaction.
Notes may be purchased at face value or at a discount. Face value means that the purchaser would purchase the note for full value. A $100,000 note paying 6% per annum interest, monthly payments, due in 6 years would be purchased by a prospective borrower, who would pay $100,000 and enjoy the 6% monthly cash flow. Discount notes are purchased when the face amount of the note is below current market or investor expected yields, or a borrower has defaulted. Using the above example if the investor purchased at a discount, he/she may only pay 70% of the face amount or $70,000. If the investor’s expectation was a yield for overall 10%, the interest of 6% would be short by 4% each year until maturity. The note purchase would require a discount of 4% for each year, or 4X6=24%. This does not include purchase cost and fees associated that may be paid by the note purchaser or seller, or both.
Here are a few subsets of the industry. Each subset has its own unique characteristics.
1) Individual purchase of a single performing note. Borrowers are performing on their obligation and purchaser’s motivation is for cash flow.
2) Individual purchase of a single non-performing note. Borrower has defaulted on their obligation. This type of note purchase is usually more profitable, but requires intensive involvement, management and risk. Note purchaser usually purchase at a steep discount realizing that intensive management will yield higher returns. The note purchaser would have to confront the defaulted borrower for renegotiation, foreclosure process, borrower bankruptcy, removing defaulted borrower who still occupies the property after the foreclosure, taking possession, possible fix-up, and re marketing the property to regain the principal and yield expectation. Purchasing non-performing notes is not recommended for unsophisticated investors.
3) A fractional tenant-in-common small group of investors may purchase one or more notes together, provided there is management, leadership, documentation, and regulatory compliance.
4) Purchasing as part of a portfolio, created by a securities sponsor who specializes, who issues securities, collects investor proceeds, and uses the proceeds for purchasing either performing or non-performing. Usually, investor’s management becomes passive, and yield is determined by the overall yield of the entire pool of investments. The issuer may have a pass through of all the profit to the investors with a fixed management fee, or a participation in profits formula when certain thresholds yields have been met.
How does one find a specialist who engages in the purchase of performing and non-performing notes? How does an interested party learn more about the opportunities? If you are interested to be referred to a professional source, let me know.
Dan Harkey
Business and Private Money Finance Consultant
Bus. 949 521 7115
Cell 949 533 8315
dan@danharkey.com
This article is intended for educational purposes only and is not a solicitation.