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What to know before buying mortgage notes
By Harvey S. Jacobs April 19, 2013
Last of three parts
Buying mortgage notes can provide the savvy investor with secure returns without the hassles and risks of buying and flipping a fixer-upper, locating tenants for a rental condo or unclogging toilets.
When most folks think about mortgage notes they think about industry giants such as Bank of America or Wells Fargo. According to Mortgage Bankers Association estimates, these institutions will originate $1.3 trillion in residential mortgages this year.
But there is a subset of the mortgage market called private mortgages, which come in several forms.
A common one is “seller financing” — that’s when the seller agrees to lend his buyer all or a portion of the home’s purchase price. Often the principal and interest payments are structured to amortize over a 30-year period like traditional loans, but require a balloon payment — meaning the borrower must remit the entire outstanding principal — after five years.
The expectation is that the borrower will, during this five-year period, refinance into a conventional-type loan from an institutional lender. If the borrower is unable to pay the full amount after five years, the noteholder can foreclose and take back the home. The main risk to the note investor is that the net sale proceeds of the foreclosure sale are insufficient to cover the note balance.
These seller-financed loans are generally used by borrowers who are unable to qualify for conventional institutional financing. This may not necessarily be a reflection of the borrower’s creditworthiness. For example, under existing institutional guidelines, many self-employed borrowers with high incomes and top credit scores still do not qualify for many institutional conventional loans.
Retirees face similar hurdles.
For these reasons, private mortgage loans generally carry a higher-than-market interest rate. It is this high interest rate that makes them attractive to real estate investors.
Private mortgages are also originated by private lenders who are willing to lend money to home buyers at above-market rates provided that the loan is secured by the borrower’s property as collateral. These investors will want to conduct due diligence not only on the borrower’s ability to repay, but also on the property’s market value and condition, should the investor have to foreclose.
Private mortgage notes are readily saleable in a robust secondary market. Although their higher-than-market interest rates make them attractive as buy and hold investments, private mortgage notes can be sold and thus converted into cash. The amount they sell for is based on the principal balance, the number of payments that have been made (referred to as “seasoning”), the number of remaining payments, the home’s appraised value and the borrower’s creditworthiness.
The concept of “time value of money” also controls how much you should be willing to pay for a private mortgage note. This concept dictates that receiving a dollar today is worth more than receiving a dollar in the future. Tools available online will calculate the present value of a future stream of income. What this means is that the seller of a private mortgage note cannot expect to sell his note for the outstanding principal balance of that note. Rather, he can sell it only for the discounted “present value” of the sum of the future payments.
To illustrate this concept, assume a seller sells his home on June 1 for $500,000; he insists on a 20 percent down payment of $100,000 and agrees to lend the buyer the remaining $400,000. He agrees to amortize the loan over a 30-year period with a balloon payment after five years.
The note bears interest at 5 percent annually. To “season” the note, he holds it for six months and receives six monthly payments of principal and interest. After the sixth payment, the outstanding principal balance of the note is $396,593. By using the present value calculator, we see that the present value of this note on Jan. 1, 2014, is $391,443. This value is then a baseline for the note’s purchase price. Depending on the other factors, such as property condition, market interest rates and the borrower’s creditworthiness, the price a note buyer would be willing to pay may be adjusted up or down accordingly.
How can a potential note investor protect himself? If possible, only buy or sell notes to people you can deal with locally. Check the local Better Business Bureau, the Federal Trade Commission and the Consumer Financial Protection Bureau Web sites.
[Editor’s Note: This is a guest post from website advertiser Michael Episcope, the founder of Origin Investments. It is a bit of a part 2 to his previous, well-received guest post. I have no money invested with Origin at this time but obviously have a financial relationship. However, this is not a sponsored post. I neither pay for nor receive money for guest posts and they are judged solely on quality of the content. If you have chosen to venture outside of index funds for a portion of your portfolio, doing due diligence on your investments is critical to controlling risk and obtaining adequate returns. I learned something from this article that I can apply when doing due diligence on real estate deals and hope you do too.]
Every commercial real estate deal starts with a promise of high returns. But it’s rare for a deal to follow the path of its pro forma. A few will exceed projections, others will fall short and many will actually lose money.
The problem with relying on projections to make investment decisions is that any deal can look great by tweaking one or two variables. So the challenge for investors is trying to figure out which deals will meet or exceed expectations, and which ones will become a “learning” experience.
Most real estate managers build models with good intentions, believing that the assumptions can be achieved. Others build models to appease their investment audience in an effort to attract capital. Projecting real estate returns is an inexact science. There are hundreds of assumptions that go into building a financial model and every input is at the discretion of the manager. By tweaking a couple of variables here and there, a manager can make it look like any deal will work. I’ve yet to see a deal that didn’t work on an Excel spreadsheet.
It’s the manager who decides what price to pay for an asset, how to build value, appropriate capital structure, how to course correct when things go wrong and when to exit. A good manager will be realistic and thoughtful about the assumptions. Finding a real estate manager who will behave reasonably and responsibly is paramount to success in this industry.
That makes asking the right questions critical during the due diligence phase to understand if the manager’s investment strategy fits your personal risk profile. Open-ended questions are great as they force the manager to think about what they are going to say instead of offering up a scripted answer. But you need to listen to cues along the way and read between the lines. Think of this as a job interview, and you’re hiring the manager to be a good steward of your capital and a good partner.
So what to ask? Basic due diligence questions include probing the real estate manager’s historical track record, the quality of their team and their strategy. Simple tactics like a Google search on the company and the company’s principals can also provide valuable information. We’ve put together 10 questions and tactics below that should help give you a telling picture of a real estate manager’s approach, ethics and potential performance.
# 1 Question every assumption – Go Deep!
One of the best ways you can ascertain a manager’s approach is by questioning every assumption in the model. Projections are only as good as the inputs, and every one of them is at the discretion of the manager. How a manager underwrites a deal will be a telling sign of how aggressive or conservative they are.
The first thing to note is the projected IRR. If you look at ten opportunities in the same industry and the IRR projections range between 16% and 19%, what is the likelihood that another sponsor can achieve a 30% IRR? The market is generally efficient, so beware of aggressive marketing tactics. How does the location of the property and its physical attributes stack up against the competition? Is it an apples to apples comparison? Real estate can change dramatically block-by-block, so comparing the property to one that is five miles away may not be appropriate. What rental rates do they need to achieve compared to the market? If competitive properties are achieving $23 rents, why do they think they can get $25 rents?
Set yourself up for success by getting into deals with assumptions that are easily achievable. What is their exit cap rate assumption, and is there a built-in cushion for expanding rates? It’s easy to make a pro forma look great by simply tweaking the exit cap rate. Generally, exit cap rates should be 50 to 100 basis points higher than today’s cap rates to account for risk. [Editor’s Note: Remember if the buying capitalization rate is higher than the selling cap rate, you get a higher return than if the opposite situation occurs.] Make sure that the value creation is not financially engineered.
Good managers create value by increasing net operating income. How are they going to achieve this? Net operating income is impacted most by occupancy and rental rates. What is their assumed growth rate of revenue and how do they determine it? What is their terminal occupancy rate? Every pro forma has an occupancy assumption at stabilization. Make sure the property is in line with the rest of the market, or slightly below it.
How do they treat expenses such as property taxes and are they applying a realistic inflation rate to all of the expenses? Property tax increases can have a big impact on the bottom line. Make sure the sponsor is resetting them based on the new purchase price and not using historical figures. They will go up, and sometimes substantially.
Most importantly, what is their business plan and do you believe it is realistic? Use a common sense approach. Can a class A property also be home to low income renters? A business plan should be easy to understand and make sense intuitively.
If you can’t get past this section, don’t bother with the other 9 questions below.
# 2 “How much of your money are you investing in the deal?”
Alignment is everything. Your manager should be investing a significant amount of his or her own capital (not capital funded by others) right along with you. And the bulk of his or her earnings should come from investment returns — not transactional fees. “Skin in the game” ensures that they are motivated by the right outcome. You want them to win when you win, and lose when you lose.
# 3 “What is your competitive advantage in the market?”
What does the manager believe his or her team does better than anyone else in the market? If they don’t have a competitive advantage, then why invest with them? A competitive advantage is generally something quantifiable. For example, if their competitive advantage is in sourcing opportunities, then how many deals do they look at before they pick the best ones to do, and where do they find them? If it’s in operations, then they should be able to benchmark themselves against an industry standard.
# 4 “How do you ensure that my capital is protected in a down market?”
What is it about their strategy and their track record that makes you feel comfortable? Have they consistently beaten their own projections? How much leverage do they use? Some avenues to explore here include the following:
- Ask about their underwriting and how they take into account a rising interest rate market and a rising cap rate environment. You don’t have to agree with them on which way interest rates are going, but every model should account for higher rates because that’s where the risk lies. And real estate investing is all about protecting against the downside.
- Do they cross collateralize assets? Cross-collateralization of assets is when one asset is used to guarantee the debt on another asset. In a fund structure, assets should not be cross collateralized because it destroys diversification and magnifies risk. This practice played a large part in why investors lost so much money during the financial crisis. Nowhere is this more prevalent than in debt funds, so read the fine print.
- How much leverage do they use? Used responsibly, leverage can enhance returns. But beware of deals that are financially engineered with mezzanine debt and preferred equity.
- Do they personally guarantee loans? Personally guaranteeing loans can be catastrophic for a manager and the investors if that loan gets called. How much do they charge the deal or the fund for that guarantee?
# 5 “How can the deal lose money?”
Every deal can lose money, and you generally won’t find this question addressed in the materials the manager provides. Listen for a sincere, well-reasoned answer. A good manager will have thought this through. Ask them for a stress test model to better understand the “what if” scenarios. Question the assumptions in the model. The easiest one to question is the exit capitalization rate. A good manager will assume a higher capitalization rate at exit to account for rising interest rates, the age of the building and potentially lower lease terms. For example, if the market capitalization rate today is 6%, then the exit capitalization rate should be between 6.5% and 7%. If the manager doesn’t follow this rule, then the other assumptions probably are not realistic either.
# 6 “Tell me about your worst deal and what you learned.”
This is always a telling question that’s worth the time. Do they take ownership for the loss? Every manager has a bad deal in their past. It’s your job to decide if it was an ill-conceived business plan or the function of a bad market. Did they communicate to investors during this period? This is important because how they treated the investor during this period is an indicator of their integrity. Ask to speak with one of the investors in that deal to verify their story. Did they do anything for the investors in that deal? Again, you are trying to vet their integrity. While no one is obligated to go above and beyond what they state in their documents, an honest manager will have done something to make amends.
# 7 “Can I speak with one of your current investors AND someone who no longer invests with you?”
Try to pick a random investor instead of one they give you. Generally, you won’t learn much from a current investor, but you can from speaking with a former investor. What was their experience? Would they recommend the manager? If you really want to get creative, get in touch with one of their former employees through LinkedIn and ask them about the company.
# 8 “How is your company funded?”
This question is designed to determine whether or not the company has ample cash flow to pay the bills. Is there risk that they will go out of business? What does their balance sheet look like? If the project runs out of money, will they lean on you for additional capital? Avoid managers who operate on shoestring budgets or are just starting out. If you are buying into a fund, it’s best to wait until Fund II or III, after the kinks have been worked out. But whether investing through a fund or not, experience matters and it may be best to wait until the management team is more experienced and better financed.
# 9 “How’s your team incentivized? How do you retain team members? What’s your retention rate of key team members?”
Making sure that the team is aligned through performance is also critical. Conflicts of interest are prevalent in this industry and minimizing them is important. One way to do so is by making sure that the team is compensated based on performance and not on the transaction. Also make sure that the team that’s in place today is the same one that was responsible for delivering the manager’s historical returns.
# 10 “What is included in all your fees?”
This question often makes managers uncomfortable. Is the deal a fee frenzy, or is it reasonable? Make sure you ask about every fee throughout the structure. Sometimes fees are buried in other LLCs below the investment entity. Ask for an organizational chart, and then inquire about fees in each and every one.
Just because a manager may not meet every criteria on this list in a way that satisfies your expectations, doesn’t mean they should be written off. But do listen for cues in their answers that shed light on their honesty and integrity. Does it sound like they are hiding something? Unfortunately, too many deals get funded with nothing more than great marketing materials. And there are many unqualified investment professionals in today’s market passing themselves off as experts.
Don’t commit your hard-earned capital without taking the time to get to know a manager on a personal level. Only then can you be sure you are investing with true professionals in every sense of the word. It’s better to be with a great manager in a good deal than in a great deal with a bad manager. Most importantly, don’t fall in love with a deal and then justify the manager. That’s the tail wagging the dog. Any deal can look great on paper and, prior to forming Origin, I learned this lesson the hard way.
What do you think? How do you do due diligence on real estate investments? How do you balance the need to do due diligence on managers with the need to diversify with various managers? Comment below!
SAN DIEGO – San Diego County’s real estate market kicked into high gear last month with increases in both prices and sales, the California Association of Realtors reported Monday.
The median price of a single-family home that changed hands in the San Diego region in March was $571,000, 2 percent more than the month before and 3.8 percent above the same month last year.
The number of houses sold skyrocketed 42.3 percent compared to February and was 8.2 percent higher than March 2016, the CAR reported.
The San Diego performance matched the statewide figures.
“March’s solid sales performance was likely influenced by the specter of higher interest rates, which may have pushed buyers off the sidelines and (to) close escrow before rates moved higher,” CAR President Geoff McIntosh said. “The strong housing demand, coupled with a shortage of available homes for sale, is pushing prices higher as would-be buyers try to purchase before affordability gets worse.”
The median price of a house in California last month was $517,020, 8 percent more than February and 6.8 percent above the level of March 2016. The number of houses that changed owners statewide in March moved up by 4 percent over the month before and 6.9 percent over the same period last year.
For condominiums and townhomes in the state, the median price last month was $430,620, 5.8 percent above the previous month and a 7.6 percent hike over the same month in 2016. Condo sales climbed 46.8 percent statewide in March over February, and were 6 percent higher than March last year.
According to the CAR, a 12 percent drop in new listings from last year, combined with the increased sales, dropped the state’s unsold housing inventory to its lowest level this year, and the third-lowest level in more than three years.
The CAR’s index of unsold inventory, which measures the number of months needed to sell the supply of homes on the market in California at the current sales rate, dropped to three months in March from four in February. The index stood at 3.6 months in March 2016.
The median number of days it took to sell a single-family home in the state fell from 33.5 days in February to 26.7 days in March, and was down from 29.9 days in March 2016.
By City News Service / Patch file photo
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Mortgage Note Buyers, Who are they and How can they help You?
To understand what a Note Buyer does you need to understand “Owner Financing” also called “Seller Financing”
What is Owner Financing and Why it is Crucial to Understanding the Role of a Note Buyer?
Owner financing is an important aspect of the note buying industry and must be understood in order to fully understand what the role of a note buyer is.
When an owner/seller puts their property up for sale with themselves acting as the financier of the property, rather than a banking institution, they are called a note holder. Instead of traditional bank lending, a home buyer pays the seller a mortgage because the seller acts as the lender themselves. This has numerous advantages to owners seeking to sell their property as well as home buyers looking for less restrictive options.
The advantages of owner financing are shorter length of time the property sits on the market, fewer costs including closing costs, reduced restrictions of home buyers (e.g., bad credit, income restrictions), installment sale tax deferral, secure asset for the note holder, liquid asset for the note holder, a means of passive income to the note holder, the ability to sell the mortgage note to a note buyer as a liquid asset, who will then receive the future mortgage payments of the home owners and act as the financier.
What is a Mortgage/Real Estate Note Buyer?A note buyer in the real estate/mortgage industry is an individual or company that buys a mortgage note from a note holder (e.g., a property owner who has sold their home via owner financing and is acting as the “lender” and is financing the individual(s) who bought their property). These note buyers are called mortgage note buyers or real estate note buyers, and they are working the real estate niche in the note-buying industry.
The note holder (the seller who sold their home via owner financing) can sell their mortgage note at any time. This is where the note buyers come in. Note buyers are the investors who take over the future payments (e.g., the mortgage) that would be paid to the note holder who finances the buyer of the property. The note holder decides if they want to sell, and if they do, they connect a note buyer, who offers a fair lump sum deal; and after the transfer of the deed, documents, and disbursement of money has been completed, the note buyer then becomes the financier, and will accrue the payments and interest of that mortgage over time. This is how note buyers make a profit.
What Part of the Cash Flow Industry Does Note Buying Fall Under?There are different areas of the cash flow industry such as Factoring Receivables, Insurance Based, and Private Notes.
Note Buying falls under Private Notes and can be explained as the following:For individuals or other entities that provide debt financing in real estate, business, or other assets can convert their future payments due on a promissory note into immediate cash.
Note buying is the conversion of future payments due, into immediate cash for the note holder, in return for the note buyer to obtain the entire amount that will be received during financing of said entities, in the future.
Benefits to Being a Note BuyerThere are various benefits to being a note buyer. Sound and relatively risk-free investment is one of them. Once a mortgage note is bought, that note buyer is then the financier of the individuals staying in the home or property in question.
Should the individuals who bought that home not make their mortgage payments to the note buyer, then the note buyer can take back full ownership of the home. This is an example of how note holding and buying is a secure asset. The balance of the purchase price is collateralized by the property itself, rather than a banking institution. This allows a mortgage note holder (or a mortgage note buyer who purchases from a seller) to take back ownership of the home in cases of non-payment. For the note buyer, this would give them the option of selling the home and pocketing all of the profits.
Another advantage of owning a note is that it is a liquid asset that a note buyer can sell whenever they want. However, being the ones to initially buy that note from a seller, they would only profit if the market value increased on the property; enough to make a monetary profit off of a sale of the note. However, this is not usually a problem, because note buyers do not sell until they have profited from their buy.
Passive income is also great advantage for a note buyer. Not only do they collect the future mortgage payments and interest from the home owners they are financing, but this interest constitutes as passive income and is gained every month in the form of steady profit. The home owners find themselves paying their financer (the note buyer in this case) 3 to 4 times the amount in mortgage payments versus the amount they would pay if they had a traditional banking mortgage. This allows the note buyer to receive passive income without doing any extra work.
Like the real estate market, being a note buyer is a job in which the individual must make purchases quickly or else risk losing the buy to someone else. Note holders generally have a value range that they buy in and do not exceed, so when offers to buy come in, they have a narrowed-down list of properties that they can buy from the note holder. They also seek out note holders via note brokers or active marketing.
In terms of employment and workplace, being a note buyer also allows one the freedom of flexible working hours, working from home, dealing one-on-one with note holders or using a note broker, making a profit with each buy, earning passive and steady income, and the growth opportunities available. With a positive reputation and experience in the industry, a note holder’s income and/or company can continue to grow and receive offers from trustworthy and verifiable sources on a regular basis. They can also form relationships with note brokers who can bring business to them at the cost of the note holders, and not them personally.
Popularity and Recent Growth of Private Mortgage/Real Estate NotesIn real estate, sellers will often use owner financing to sell their property. This means that instead of banking institutions getting involved with mortgages and financing, the new buyer of a property pays the seller, who is financing the home themselves. The seller of the home in effect, takes the place of the traditional bank.
There are advantages to this practice: shorter selling times on the market, quicker closing, fewer costs, installment sale tax deferral, the maintaining of a liquid and secure asset, reduced restrictions such as lending requirements or credit scores of buyers.
In our economy, it is difficult to maintain a high credit score when so many people are living day-to-day. For those individuals or families who do not wish to rent and apartment or home forever, buying a home by owner financing, the restrictions that banks put up such as meeting a certain credit score, having a certain income, and other lending requirements, do not apply.
This leaves owner financing as a meeting of two worlds—over 50% of Americans are under qualified for a traditional loan due to meeting responsibilities in a world that is having economic difficulties. Due to this lack of representation in real estate, in 2012 the numbers of seller carry backs were up over 15%, which is no surprise. There was a niche in the marketplace and the note brokering industry took advantage of the needs of so many Americans.
Conclusion: Being a mortgage note buyer in the real estate market is an independent employment opportunity that many people do not know exists. By taking advantage of being able to pay a note holder a lump sum and take over as a financier of a property, the note buyer can continue to receive the mortgage payments with interest from the home owners under his or her financing, take back full ownership of the home should the individuals stop paying the mortgage, and can earn passive income right off the bat when purchasing a mortgage note.
While it takes time for the buy to pay off (the moment that the buyer earns more than the amount of the lump sum given to the previous note holder), when it does, the note buyer can continue to accrue interest or sell the home at full price. This is especially great if the property value increases by that time.Being a note buyer takes dedication, quick responses to queries and offers, and a learning period. Most individuals start out with becoming note brokers before going into business themselves as a note buyer. There is a lot to learn, but once one has the experience and know-how in this industry, being a note buyer can be a form of lucrative income once all of the buys start paying off.
Other Great Sites:
- We Buy Notes Fast
- The Paper Source
- The Paper Source Universcity