Summary:
When one party owns a promissory note and a deed of trust, or mortgage, secured by real property, and decides to sell the note ownership (conveying 100% of the interest) to another party, the new party becomes the note owner and enjoys the rights, title, and interest in the note and deed of trust. The new lender/owner assumes all risks and responsibilities to collect the monthly payments from the borrower/property owner, enjoys the cash flow payments, and retains the right to foreclose if the borrower defaults. These risks and responsibilities include potential non-payment by the borrower, depreciation in property value, and the requirement to take legal action in the event of default.
However, this raises the question of whether a single investor or a group of investors can amass enough capital to become purchasers of a single or a group of notes and deeds of trust, sometimes referred to as 'paper' in the industry. 'Paper' is a colloquial term used in the note purchase industry to refer to the promissory notes and deeds of trust that are the financial assets being bought and sold.
Remember that due diligence to determine the viability of the transaction is critical in these transactions. This thorough investigation ensures that you are making informed decisions and can provide a sense of security in your investments.
Article:
This article serves as a roadmap for individual and small groups of investors, equipping them to compete effectively with larger entities in the note purchase industry. The distinct advantages of local market knowledge, control, and a hands-on approach make small investors a formidable force, bolstering their confidence and decision-making power in their investments.
Notes and deeds of trust (mortgages) are both financial assets and securities:
A real estate loan occurs when a willing borrower signs a promissory note, which is a promise to repay, and a deed of trust, also known as a mortgage, which is a recorded security instrument that evidences the indebtedness. The transaction is complete with the recordation of the deed of trust (or mortgage) and distribution of proceeds from the escrow closing. Some states use deeds of trust, while others use mortgages. The distinction between the two is significant.
The recorded deed of trust or mortgage with the municipal records office becomes a matter of public record. The recorded lien, or money charge against the property, encumbers or clouds the property title. When someone reviews public records relating to that property, the documents will reflect a recorded notice of the lien. All recorded liens or encumbrances after that date and time stamp are subject to, and subordinate to, the recorded lien until that lien is paid off and released from public records.
Notes and deeds of trust (mortgages) are financial assets, also securities:
A lender/investor who owns a financial asset evidenced by an executed promissory note, recorded deed of trust, or mortgage, and a title insurance policy ensuring the correctness of the recording owns a security.
The owner of this financial asset has multiple options.
Keep the financial asset and enjoy the cash flow from the payment stream. Owning multiple notes is an excellent long-term economic strategy, and note ownership provides a fantastic passive income stream.
Sell the note and deed of trust asset to a third party to regain the capital. Selling the note and deed of trust may be at par, meaning the total value, or at a discount on the principal balance. Suppose the interest rate on the promissory note is below the market rate. In that case, the seller can expect to discount the price to compensate, ensuring that the effective yield (the actual rate of return considering the discounted price) reflects current market yields or higher.
Promissory notes can be sold to meet emergency cash needs such as tax obligations, marriage dissolution, judgments, liens, or partnership conflicts. The note seller can also leverage the net proceeds into another business opportunity and make geometrically greater profits in their venture. This potential for significant returns can be a source of optimism and motivation for small investors.
A note owner may borrow against a collateral interest in the note. The note owner and the prospective new investor/lender of the note investment will open an escrow account to convey the title and documents in exchange for the net proceeds at closing. Another article on my website covers the procedure of note hypothecation (a process where the note owner uses the note as collateral to secure a loan).
Note Purchase and Sale Industry vs. Loan Origination Industry: Understanding the Difference
The purchase and sale of notes industry deals with existing owners who are the principal owners of the promissory note and deed of trust as a financial asset. They have flexibility with this financial asset, giving them a sense of control over their investments. In almost all cases, owning notes (in paper form) as an asset that generates cash flow from payments is far less management-intensive and less hassle than owning income-producing real estate. Ownership of income property comes not only with economic and historical wealth strategies but also with the risk of the government seizing assets through the systematic erosion of property rights during and after events such as COVID-19, bank bail-ins, non-voluntary liens, as well as multiple taxations on the income streams.
In the loan origination industry, a real estate owner seeking to borrow obtains a new loan secured by the property through an origination process. This differs from the note purchase and sale industry, which involves existing owners who are the principal owners of the promissory note and deed of trust as a financial asset. The business is substantial, although it is currently experiencing a decline due to rising interest rates. Understanding this difference is crucial for investors looking to enter the note purchase industry.
Sources to find both performing notes and non-performing notes for sale:
The best practice is to network with professionals involved in real estate transactions. The following professionals may need a source of note purchasers: Real estate brokers, mortgage brokers, family estate planners, estate planning lawyers, investment advisors, CPAs and enrolled agents, local and regional banks, credit unions, bankruptcy lawyers, real estate and note-trade organizations, and direct marketing solicitations.
A well-thought-out email marketing campaign would be best. Remember, you locate a buyer; you do not create one through language.
Subsets of the note purchase and sale industry:
Each subgroup has its unique characteristics.
Individual investors are purchasing single-performing notes. Borrowers are meeting their obligations, and the purchasers' motivation is driven by cash flow and annualized yield.
Individual investors purchasing a single non-performing note.
When borrowers default on theirpayment obligations, a resale market for the non-performing paper exists. The condition of the loan asset is that there are arrears in payments, possible expired property insurance and property taxes, a possible deferral of maintenance, occupancy by an opposing party, and risks related to future management involved in addressing these problems. This type of note purchase is usually more profitable but requires intensive management, involvement, and risk. Investors accustomed to purchasing non-performing notes, typically at a steep discount, will anticipate substantially higher yields and returns, making this a potentially lucrative investment opportunity.
The purchaser(s) of non-performing notes or the purchaser(s) representative requires active management. They must be aware of state laws that strip property owners and lenders of their rights while protecting borrowers who default. In California, recent laws passed include SB-1079, AB-130, and AB-2424, which place handcuffs on investors and treat defaulted borrowers with every benefit possible, except for outright debt forgiveness. You will find an article on all three of these bills on my website.
Foreclosing on 1 to 4 residential income properties and all residential properties, regardless of the number of units, takes twice as long as the historic statutory procedure with which people are familiar. There is a long string of regulatory delays that did not previously exist. Borrowers can take advantage of every loophole, bring the payments up to date, renegotiate the loan, actively fight the foreclosure process, and possibly file for bankruptcy as a borrower.
Investors must pay for fighting against all these loopholes, then remove the defaulted borrower who still occupies the property after foreclosure, take possession, possibly make repairs, and remarket the property to regain the principal with higher yield expectations. Purchasing non-performing notes is not recommended for unsophisticated investors.
Small groups may purchase notes as fractional tenant-in-common owners, provided that management, documentation, accounting, loan servicing, and regulatory compliance are in place. Small groups may also form an entity, such as a limited liability company (LLC), and invest in it, with both active and passive members serving as members of the LLC. Rather than a principal or manager, the individual members hold limited liability member interests. The limited liability company will rely on its managing member(s) to make decisions and carry out management responsibilities on behalf of the members. The managing member is considered the issuer under securities law.
Loan portfolio purchases, which are larger groups created by securities issuers, may also be structured as a limited liability company (LLC) or some other specific purpose entity (SPE), such as a real estate investment trust (REIT). The securities issuers are responsible for active loan servicing and asset management. The issuer is responsible for seeking regulatory approval, maintaining regulatory reporting, issuing securities, collecting investor proceeds, and using the proceeds to purchase large blocks of either performing or non-performing paper. Investors are typically passive, and the overall yield of the entire pool of investments ultimately determines the results. When specific threshold yields are met, the issuer may pass through all profit distributions to investors, along with a fixed management and loan servicing fee or a profit participation formula.
Private parties and non-institutional level investors purchase notes:
There is also a large industry of lending 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, which endorses the promissory note from the seller to the buyer and records a completed assignment of the deed of trust or mortgage. The consummation occurs at the time of recording. Title insurance ensures that the delivery was adequately completed. Also, the seller of the note will require an offset statement.
Note buyers may use their liquid capital to purchase the notes from willing note sellers. Yields on purchases of promissory notes are like those in the trust-deed purchase field.
Institutional-level investors in the note securitization arena:
At the institutional level, Wall Street and the Securities & Exchange Commission engage in all forms of securitization and re-securitization of notes (paper). Like stocks, bonds, U.S. treasuries, and various other marketable securities, promissory notes and deeds of trust (also known as mortgages) are publicly marketable. The structured obligations are unique in format and, in many cases, dependent upon another form of hedging instrument or security called derivatives.
Wall Street, referred to as the institutional market, notes purchases, resales, and collateral securitization as a multi-trillion-dollar industry. The U.S. is the largest securitization market globally, with approximately $12.8 trillion in residential mortgages and $4.5 trillion in outstanding commercial securitizations. Government Service Entities (GSEs) currently purchase more than 60% of all new mortgages (mortgage-backed securities). GSEs include Fannie Mae, Freddie Mac, and Ginnie Mae. Pools (large blocks) of note purchases, resales, and collateralizations are sliced into risk tranches. Tranches are subsets of a pooled collection of securities, usually debt instruments, that are split or divided by relative risks or other characteristics to sell to various investors depending on their demands for maturities, yields, and degrees of risk. Even providing insurance or reassurance through super high-risk derivatives contracts is actively promoted.
Trillions of institutional-level transactions, characterized by notes purchasing securities, change hands each year. These include Government-Sponsored Entities (GSEs), federal-level SEC-registered pool offerings, state-level public offerings, and private or exempt-from-registration offerings.
I intend to stay aware of the complexities of the institutional-level securitization markets.
Securitization is an entire industry- bundling of loans into pools:
Securitization is the process by which various types of assets are combined into pools and then repackaged into interest-bearing segments or tranches and risk/yield subsets. Principal and interest payments, or periodic distributions, such as a limited liability company, real estate investment trust, or a public or private offering, can be customized.
Various forms of securitization are available that invest in notes, such as single-note purchases, multiple-note purchases, or investment groups, typically in mortgage pools. The mortgage pool may have different structures and be subject to varying securities regulatory oversight.
With the guidance of securities and real estate transactional lawyers, I created a $250,000,000 state-approved public offering in California and an approved $500,000,000 public offering under the Federal Securities and Exchange Commission (SEC). Additionally, I was responsible for creating the infrastructure to originate (purchase), manage, make periodic distributions, and comply with continuous public reporting.
Underwriting is the due diligence process, also known as loan quality analysis.
A due diligence process should occur for every note purchase transaction. The process is like the one followed during the original loan transaction. Escrow agents, title insurers, appraisers (who affirm market value), property insurers, underwriting and technical staff, and documentation specialists are involved. All participants serve as agents to demonstrate the economic viability and successful conveyance of the note purchase transaction.
The due diligence process may be more rigorous for publicly traded offerings. Private money lenders (non-institutional) offer a quicker due diligence process that is just as thorough, if not better. Local market knowledge, hands-on, a sense of urgency, and the massive bureaucracies in institutional platforms give the private money industry a well-deserved advantage.
Assessing and approving the risk related to the loan purchase transaction:
The fundamental purpose of risk assessment is that a mortgage broker who solicits investors to purchase a loan investment must submit a loan package with the material facts and investment risks to the prospective investor so that a sophisticated prospective investor can make an informed decision. The investor can decide whether to purchase the loan and whether the investment is personally suitable given the material facts, risks, and economic reward.
Suppose another lender intends to resell their note. In that case, it is likely to have an underwriting package containing many relevant documents that will help assess the risk associated with purchasing the note.
Address of the collateral property or other forms of real property identification offered as security for the borrower's obligation.
Describe the property, type, usage, zoning, income-producing, and quality. Determine rents, vacancies, quality of management, and level of upkeep, and identify deferred maintenance. Verify compliance with building and zoning ordinances.
Estimate the fair market value of the securing property as determined by an appraisal, a copy of which should be available to the prospective investor/lender. However, an investor/lender may waive the requirement of an independent written appraisal on a case-by-case basis. The real estate broker shall provide the broker's written estimate of the fair market value of the securing property, including the objective data upon which the broker bases the forecast.
Borrower data: obtain information, including identity, occupation, employment, income, and credit data, about the prospective borrower or borrowers as represented to the broker by the prospective borrower or borrowers. A credit report and, in some cases, a public records background search are a good policy.
Loan terms of the promissory note for sale will be provided to the investor/lender. Current loan terms and servicing records will enable a broker to calculate reasonable terms for a new loan sale or note a hypothecation transaction.
Pertinent information concerning all encumbrances constituting liens against securing property will be determined. To the extent of actual knowledge of the broker, relevant information about other items that the borrower expects or anticipates will result in an encumbrance or charge against the subject property. As used in this paragraph, actual knowledge concerning any anticipated or expected loan means knowledge the broker gains through prudent inquiry. Best practices also suggest that the broker provide the prospective lender/investor with the option to apply for a title insurance policy or an endorsement (104.1) to an existing title insurance policy covering the securing property, a copy of the written loan application, and a credit report.
Provisions for servicing the loan, if any, including disposition of the late charge and prepayment penalty fees paid by the borrower.
A detailed statement from the borrower on the intended use of the funds.
Purchasing at face value of the note vs. purchasing at a discount:
Notes may be purchased at full face value or a discount. Face value means that the purchaser would buy the total value of the note. A $100,000 note paying 6% per annum interest, with 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 note's interest rate is below the current market rate, the investor's expected yield is below, or a borrower defaults. Using the above example, if the investor purchased at a discount, they may only pay 70% of the face amount or $70,000. If the investor expected a yield of 10%, with a noted interest of 6%, the transaction would be short by 4% each year until maturity. The note purchase would require a discount of 4% for each year, or 4 6 (years until maturity) = 24%. The example does not include the loan purchase cost, escrow, and fees associated with the note purchaser; the seller may pay part or all of these costs.
Yield calculations:
The above example is a simple cash-on-cash yield formula.
Many sophisticated investors use an internal rate of return formula to calculate the yield. The internal rate of return (IRR) refers to the yield rate earned or expected on a given capital investment over its entire ownership period. The internal rate of return applies to all expected cash benefits, including the initial investment and net cash flow during the ownership period. All proceeds from resale at the termination of the investment are included in the calculation. The internal rate of return for an investment is the yield rate that equates the present value of the future benefits of the asset to the amount of capital invested. The formula may measure the return on any capital investment before taxes are applied. The method is an interpolation formula, which is usually performed best with the aid of a calculator, computer, or by consulting an experienced practitioner.
Comment:
There are numerous methods for generating wealth and income streams. Purchasing notes secured by real estate and originating private money loans are excellent investment options.
How does one find a specialist who purchases performing and non-performing notes? How do interested parties learn more about the opportunities? Please reach out to me, and I will refer you to a professional source.