How Does it Work?

Investing in a note is essentially putting up a lump sum in order to purchase a contract that promises to pay you a stream of payments.  These payments will provide you with a return on investment (ROI).

When someone purchases a house, they make a down payment, usually 20-30%, in order to take title of the house. Then, they continue to make monthly mortgage payments to the bank with interest. Of course, if the homebuyer does not make payments, the bank may take the house back through the foreclosure process. Or they may sell this defaulted note to a hedge fund or to a note investor.

Mortgage Note Example

Payments                      $ 565.42
Home Purchase Price    $100,000
Down Payment             $20,000
Down Payment             $80,000
Interest Rate                7%

Sometimes, the bank needs cash quickly and will want to sell this stream of payments to an investor for a lump sum.  Good investors are concerned with the preservation of capital. Because of this, how the loan is secured is very important. Let’s look at how investors evaluate the loan collateral.

When the bank loans out $80,000 on a $100,000 house, the bank’s Loan To Value is 80%.  However as a investors, we could acquire this note for $ 60,000 or a 60 % Loan to Value.  If the foreclosure process costs $ 5,000. Then if the homebuyer does not make the mortgage payments, the investor will be able to take back a $100,000 house for only $65,000.  As you can see, the lower the Loan To Value, the more secured the investment is.

Let’s look at this if this was a performing note acquired at this discount

The original note is an $80,000 with 7% interest. However, if the note is purchased for $60,000 the Return on Investment to the investor jumps to 10.47 % as the result of the discount.

In order to find this return on investment, use the 10bII financial calculator…

Return on Investment Calculation
ROI (I/YR)                          8%
Purchase Price (PV)            ($65,000)
Payments (PMT)                 $479.64
Number of Payments (N)    360
If your portfolio is invested 8%, it’s value will double every 9 years.

In this circumstance, the more secured the investment is, the better the ROI is.  For instance, if you were able to negotiate the purchase price of this note down to $50,000, instead of $65,000, you would be in at a 50% Loan to Value, and the return would be a massive 13.04%
Not only this, the investor can count on receiving this monthly payment regularly, regardless of what happens in the unreliable stock market.

The loan collateral is the most important part of the investment.

Investing in mortgage notes (sometimes referred to simply as “notes” or “paper”) is safer, more predictable, and yields can be much higher than returns on average investment vehicles. We purchase distressed debt and “become the bank” with total control over our investment. It is secured by a 1st lien on the property, affording us numerous ways to exit safely and profitably, The target range of profit is above 10 % for our J.V. Partners

Essentially, the sale of distressed notes is the sale of debt obligations for property. For example, if a mortgage is for $100,000 and the borrower is currently unable to pay, the bank, or hedge fund may sell the mortgage for $50,000 in order to get at least some of its money back.

Why?

Banks are in the business of lending money, not owning and operating real estate. By selling the note rather than going through the expensive and sometimes drawn out process of foreclosing, a bank stays out of the chain of title, doesn’t become liable for the property’s environmental conditions and doesn’t have to worry about the time—and expense—of other property management and ownership issues. Add in the cost and effort of marketing the property to potential buyers following the foreclosure and the numerous existing properties already being carried on their books, and you can see why banks were looking for an alternative. Selling its debt has provided that alternative avenue.

We the obvious benefit of purchasing distressed notes — the opportunity to obtain the loan and underlying property at a steep discount from its initial price. This discount provides a high margin for potential profit on the note depending upon how we reposition the debt with the borrower, and provides the borrower an opportunity to remain in their home and avoid foreclosure.

Performance From Repositioned Notes

Once we establish an agreement with the borrower and performance has been established, an income stream is realized from the repositioned note, converting it from a distressed note to a performing asset. We then have the flexibility to hold the note for income or we can liquidate the repositioned & performing note to another investor at a discount of face value, realizing a profit from our acquisition and repositioning costs, and generating new capital to reinvest in new distressed notes or value-added properties.