How do you profit from investing in notes?

I am frequently asked "Ellis, can you explain to me how notes work? How do I make money by investing in notes?"

Well, I will attempt to simplify the explanation. First, there are 2 different classes of secured notes or loans we acquire, Performing & Non-performing.

Let's look at performing loans first.

When we acquire any note both performing loan and non-performing that are secured by real estate (usually a house & land) there are 4 important numbers we look at: 1) How much is the property or asset worth? 2) How much is the agreed monthly payment? 3) How many payments are left in the contract? 4) How much are we buying the note for in order to have the rights to receive those payments?

So if the property is worth $200,000,and the bank gave them a $100,000 loan and the contractual monthly payments are $1,500 per month amortized, there are 100 payments left we buy the remaining payments of the loan for $85,000. Our yield would be 15.124% (don't try to do the numbers in your head you need a financial calculator like a HP10BII or this cool app which I use everyday http://www.inadaydevelopment.com/app

So what happens if the borrower doesn't pay you ask? Well, you start a foreclosure action to enforce your rights as a lien holder (the procedures vary depending on the state the property is located) If the borrower doesn't make up all missed payments & late fees etc. The property is auctioned to the highest bidder who will pay off your remaining loan balance plus fees you are owed. If no one bids on your loan, you will get title to the property, YOU OWN a property worth $200,000 for what you invested in the loan ($85,000) plus expenses minus any payments you received.. Once you get possession you can fix it, flip it, rent it out, live in it etc. Not too bad.

Ok, now let's talk about (the borrower is not paying the lender). Because there haven't been any payments coming in typically these notes are sold with more of a discount.

So let's look at the numbers.

$100,000 property value (the property was bought at the top of the bubble & lost $50,000 in value in 5 years)

$150,000 loan balance

$1,000 monthly payments that they aren't paying but it's in the contract.

300 payments left (they paid 60 payments then stopped paying)

You acquire the loan & the right to the remaining payments for $50,000.

Now here is where many things are possible:

1) The borrowers say they can't make $1,000 monthly payments but they can make $600/month

so now your return on your investment is 14.4% approximately ($600/month x 12 months =$7,200/50,000)

But wait there's more! What is after 10 years they decide to sell & now the value of the property is up to $100,000. You are entitled to $100,000 as a payoff. Now your return is closer to 18% (don't do this in your head, you will just get a headache, get the calculator or app I mentioned above). I like to show this to my banker & stockbroker who try to sell me CD's at 1% or Bonds at 4% ( I don't think they find it amusing and somewhat irritating when I do this).

2) So say scenario #1 doesn't work so now you come to an agreement that the borrower just wants to sell & live somewhere else. They agree to work with you on a short sale. The property is sold for $100,000 you are entitled to the entire amount. You just made a profit of $50,000 from your $50,000 investment that's 100% return ( my stockbroker & banker hate that as well)

3) Ok, the borrower won't cooperate with you on #1 or #2 so now you foreclose & send it to auction. It sells for $75,000 net to an investor after all expenses so now you made $25,000 profit from your $50,000 investment (I can live with a 50% return, can you?)

4) The borrowers don't want a short sale, don't want a payment plan, and don't want a foreclosure on their credit record. So they agree just to give you the property.

You can sell it, rent it, live in it. You have a $100,000 property for $50,000 (half-price) You didn't have to battle with other investors trying to buy from agents & brokers or what I call "REO & Short Sale MADNESS!"

5) there are more scenarios that I won't cover in detail because it's time for me to take my kid's too lunch, summer is almost over.

a) Payment plan reduce payment & help them refinance later

b) Payment plan & reduce their loan balance

c) Do nothing & just let the payments & late fees owed accumulate & wait for refi, sale, etc. And get a BIG PAYOFF later.

d) Keep payments the same in exchange for reducing loan balance

e) reduce number of payments in exchange for lower or higher monthly payments

There are many more possible combinations, the bottom line is that it has to work for both the borrower & our investors. We want to help them stay in their homes as long as our investors receive a fair return on their investment.

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