Note Investing - Vertical or Horizontal Expansion?

Question

I spent some quality time with my Note Investing mentor at the IMN Conference a few weeks ago.Part of the discussion centered on the institutional non-performing notes being more difficult to source at low levels AND how I’ve been focused on buying upstream for the past year and a half.Put another way, I’ve set my sights on vertical expansion by moving up the food chain.My mentor encouraged me to consider new lines of note opportunities, such as business notes, etc. These notes are not secured by real estate (typically) but by the assets of a business and a personal guarantee.Given I’ve been a small business owner since 2004 and I’ve originated several of these myself, it made sense from the perspective of looking at new streams of cash flow.Speaking from humility, my only thought to express is to consider both options for expansion if the old way isn’t working like it used to.

I'd love to hear other people's thoughts on how they have evolved their business.

Don Konipol · Answer

@Martin

@Martin Saenz, Im not sure I understand your question. Are you asking for our opinion on owning notes secured by non real property business assets?  That's a different game completely.  Unless the business has readily salable easily repossessed assets that are valued for quick sale in excess of the loan amount, and those assets have not been pledged via a UCC filing to trade accounts or other liabilities, you're banking on the continuity and profitability of the business itself.

Small businesses are notoriously difficult to evaluate since the quality of their accounting varies widely; the key personnel play such a key role; their market position can be devastated by the emergence of a key competitor, the loss of a key account, or the exodus of a key employee.

That is why companies that buy receivables from small businesses target returns of 36% plus, and often the risk is so great they layoff some of the risk by partnering.  This is an area of investing where risk of your investment being wiped out completely is much higher than notes secured by real property.  So the return on the successful investments must be much higher.

My thinking is that if a business seller gets a good size down payment, owner finances the balance at say 9% interest, has collected a couple years payments, and financials show positive cash flow, it might be worth purchasing the note at a 24% annualized yield, depending on if their are real hard assets to attach.  But since cash flow is such an important part of the equation, its important to know how much debt the business carries.  Risk is that when a business starts going down owners tend to borrower from everybody and everywhere.  And if there's no assets securing your note, then the chance of default is much greater.

There's lots of 'cash flow' assets other than real property to lend on.  They all require a different expertise, different networking, different marketing, and higher risk tolerance.

Ken Hobbick · Answer

@Jordan Blackwell  @Martin Saenz  I was just about to say Martin has a book worth reading but is too humble to mention.  Its worth reading and looks like you are on the right track on finding good resources.

Jordan, your correct regarding note investing and buy and hold real estate ability to compliment each other,  it should be a function of the note investors business model such as some will avoid non-owner occupied because there is a very low change the borrower will work out a loan modification,  while others will seek those assets out because they intend to exit through the property,  rehab,  rent,  sell etc.   That's the great advantage of real estate and note investing there are multiple ways to make it work

Back to Martin's original topic,  thinking its always a good idea to be looking for different and multiple income streams.  I like the idea of being able to move upstream as it will become more difficult to find assets and needing the ability of smaller investors to form buying groups when it makes sense.   I haven't looked at commercial notes backed by business and personal guarantee but would consider this as a potential option after quite a bit of research, education and due diligence down the road.

Jordan Blackwell · Answer

You're definitely right! Dave's book on was probably the first book I read on the subject. He then led me to Jimmy Napier's Invest in Debt. I'm embarrassed to say that I'm one of the few who hasn't read Note Investing Made Easier (yet!). So much to learn. Hope to see you at the Mid-Atlantic Summit!

Chris Seveney · Answer

Martin

Great question. I don’t think there is a one size fits all to this but your points are very valid. I am a big believer of zig when they zag. I am reading about REIT’s right now and how they have been profitable is they typically are doing the opposite of real estate developers. They sell in times like right now where a lot of people are buying and when markets soften they start buying up again. While many think they by low sell high that is not really the case (look at 2096 vs 2008 as an example).

I believe you should diversify as much as possible - having a full time job I stick with 1st position notes on real estate because I don’t have the time to learn a new trade and I would rather be a master in one than a master in none. Thus for me it is being creative and thinking outside the box within this space, which I believe can be done.

If I could expand auto debt is where I would go next or (secures) student loan debt

Andy Mirza · Answer

@Martin Saenz I don't know anything about business loans so I won't comment on that. The farther you go upstream, the better deals you can get for institutional NPNs. I agree that it makes sense to branch off and take on other types of debt but that also takes away your focus. The more things you're involved in, the more you have to spread your focus and the less that you can potentially grow.

For us, we're focusing like a laser beam on severely delinquent, 1st position NPNs, whose most likely outcome is liquidation. We can get the highest returns with this strategy but it has its limitations. We want to grow our money pile as big and as fast as possible. Once the money pile is big enough, I want to branch off into high yield performing, re-performing, and scratch and dent, cash flowing notes. I think the two types of strategies can feed into each other i.e.  the liquidating fund can sell the re-performers to the performing fund and the performing fund can sell the NPNs to the liquidating fund.

Once I've got stabilized businesses that kick off great cash flow, I'd like to venture off into commercial, land, development, stuff that's really outside the box, interesting, and have the possibilities of even greater returns.

Martin Saenz · Answer

Good points, Chris.  Staying within your comfort zone and maintaining a balance is key.  Many folks rush to quit their full time job but it's about creating multiple streams of income and a full time job should be one of them until someone is bursting at the seams.  You are headed for good things by design my friend.

Martin Saenz · Answer

Big fish....little fish, we all run hungry.  You are in Philly which is the mecca for note industry thanks to @Dave Van Horn and the family he has built there.  He runs a great conference there that is coming up later this year.  I recommend attending.  Also, check out Amazon as there are some good books on Note Investing.

Martin Saenz · Answer

Hey Don, thanks for your assessment.  Having sold several companies for profit and taking back a business note both times, I have an understanding of the industry/process.  With that said, you laid out everything very nicely and gave great guidance on yield expectations, etc.  Thank you, sir.

Jordan Blackwell · Answer

Hi Martin! I am virtually at ground zero with my note investing business but I have thought about compensating for the few disadvantages of notes (lack of tax deductions, impermanence, etc.) by including buy and hold investing. Ideally, the two would complement each other, especially as the market changes and inventory either dries up or I become priced out. I know the disdain for rental properties is usually the reason people head into notes (haha) but there are still some awesome benefits that notes just can't give us. Excited to hear how the big fish do it!

Note Investing - Vertical or Horizontal Expansion?

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