Auburn Cohousing

Though I’ve dealt extensively in notes, both for myself and clients, I’ve not included them in my quiver since the 1980s recession recovery. Truth is, becoming proficient with notes and their trust deeds was a matter of survival. When interest rates are over 16% you get creative or you learn how to operate a cash register at the local grocery store. Lucky for me a couple of my sainted mentors were slam dunk experts on the topic. Their tutoring sessions were literally keys to the vault, though they sometimes gave me headaches. Ironically not cuz the principles, formulas, and investment strategies re: notes were so complex, though they were indeed. Headaches sometimes arrived when trying to remember the laws and tax regs that applied when using notes inside tax deferred exchanges. It seems like it’d be fairly straightforward, but the only simple use of a note in the exchange context occurred when structured as a partial installment sale. Everything after that? Um, more involved.

The main value found in the use of notes/TDs was either in acquisition or as down payments on property.  When sellers needed to sell, and buyers didn’t come in crowds, a note looked pretty dang good. In today’s market, that strategy would die on the vine most of the time. Way too much cash and low cost loans.

How beginners can build their capital more efficiently using notes.

I get calls from folks who have $ 15-30,000 and wanna get started investing long term. Since I deal in blue chip locations and properties, that’s not quite enough. The top of that range can actually get one’s foot in the door now. The problem however, is having sufficient cash reserves. Oops. That’s why I often tell them to acquire notes at a discount with the goal being the growth of their capital. This is why I like Kevin Kacmerek so much, cuz that’s exactly his area of expertise. I know real pros when I meet ‘em, and Kevin is a pro. Anywho . . .

If you have $ 15,000 and aren’t swayed by the nothin’ down school of real estate investing, here’s an idea. Buy an existing note at a relatively deep discount, with the idea being to sell for a short term profit. Short term in this context could be a day or two, or a year or two. Using this approach will allow you to more rapidly grow your capital without incurring the horrific risk often attached to the acquisition strategies used by fearless, yet equally cash challenged. I’ve seen serious people go from $ X to $ 2X in very short time periods without risking financial life ‘n limb. In fact, if you choose to simply create another income ‘basket’ in your portfolio, over 20 years you can create some seriously impressive monthly income, which would be completely separate and independent of your real estate cash flow. Imagine a note portfolio of a million bucks generating a minimum double digit yield. That’s a lowest case monthly income of over $ 8,300. Like investing in brick ‘n mortar, the million dollar value is far less than what you actually invested.

WARNING: Regardless of your DIY inclination, do NOT try this on your own. It took me a couple years of doing it almost daily before I wasn’t dangerous. The most valuable lesson I learned back then? The principle warning us about that the answers to the questions we never knew to ask are most often the answers that end up kneecapping us at the worst possible moment. When it comes to ‘trafficking’ in notes/TDs, find an expert and leave him/her to their specialty.

The math

Without going through endless number crunching, here’s the short version when opting for a long term basket. Before continuing though, understand that this basket can be used when appropriate, to significantly improve other factors in your Purposeful Plan. This would, of course, involve Strategic Synergism. OK, on to the general numbers.

The principle goes like this. Acquire the note for far less than its face amount. Until it’s paid off or sold, bank the monthly payments. When the note is sold/paid off you’ll have the accumulated payments plus any final principal payment if there was one. Rinse and repeat. Don’t smirk, as this seemingly simple formula can yield incredible results, given reasonable time. Let’s do one quick example, cuz I can’t help myself.

$ 15,000 buys a $ 25,000 note which is secured by a home with 25% equity behind you. The payments are monthly, interest only at 10%. The payoff is in 5 years. Payments = $ 208.33/mo. — $ 2,500 a year. Let’s say it pays off as agreed. In that time you banked $ 12,500 in payments. So, after 5 years your initial $ 15,000 investment works out like this, as far as yield goes.

Your yield was just under 24%. Or, if you were forced to foreclose it would, more likely than not, increase your yield. Two things I tell investors when dealing in notes.

1. Don’t buy a note for which you wouldn’t be happy to be ‘forced’ to take the property/security back and sell it. If that prospect scares ya, DON’T BUY THE NOTE.

2. There are NO exceptions to #1.

Take the $ 37,500 in cash (plus your lousy bank interest on the payments) and do the same, only more than twice as big. Every now and again you’ll be able to turn the profit very quickly, maybe even a few months.  Either way, those who do this with solid discipline can and do end up with bunches of income.

An obvious caveat is to realize the example used doesn’t account for taxes, which will surely reduce your gross profit, both from payments and payoff. But this applies to flippers too. It’s a cost of doing business. Those using their self-directed IRA/401k (yuck) will be able to defer those taxes ’til retirement. The takeaway is that over the long term, say 15-30 years, the ability to grow your ‘note basket’ will be relatively predictable. In fact, you can almost rely on the fact that in that 15-30 years there will come a market in which your current note portfolio will be able to be applied in a manner that will synergistically turbo charge your Plan.

When that happens, don’t forget to yell Bingo!

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

From Beginning Real Estate Investors To Aging Boomers – Consider Secured Notes As Another ‘Basket’

Real Estate Investing For Real | A BiggerPockets Investment Property Blog