Why 2nd Liens Are 1st!

While property investors are paying higher prices due to low inventories nationwide, buyers of defaulted mortgage paper are having a hey-day. The rumors of a coming shadow inventory have become a faded memory as banks choose not to complete the foreclosure process on millions of homes and instead sell off the mortgage paper to large buyers and individual investors who then clean up the foreclosure mess while profiting handsomely as well. This is the back-story for what is happening with defaulted 1st liens and has been reported extensively by Smart Money Vision Update. 

But what about 2nd liens? Remember when banks were approving HELOCs for millions of home owners who wanted to use their home equity like an ATM machine to pay for vacations, home improvements, and big screen TVs? Well, the chicken has come home to roost and banks do not want to deal with these 2nd liens either. Let’s take a look at how 2nd liens can benefit you in your wealth creation and preservation strategies.

Although similar in some ways, investment strategies for 2nds do have unique features that make them worth considering for your investment portfolio. Here are some key differences of how each asset investment is unique:
 
The Opportunity

You buy 1sts to either acquire property or get monthly cash flow from loan modifications. You buy 2nds to get paid off or monthly cash flow from loan modifications. It is safest to only buy 2nds on homes with performing 1sts. 

     
Collateral Type   

The largest quantity of available 1sts to buy is on homes valued at under $100,000. More than half of the notes available are on homes that are in “challenged” areas, e.g. high crime, rural, foreclosure ridden. The largest quantity of available 2nds are on homes valued at over $100,000. The majority of the homes are in the best neighborhoods of the country, e.g. low crime, highest rated schools.

      
Due Diligence

The buyer of 1st liens is most focused on the property quality and value.    The buyers of 2nds liens focuses equally in the value of the property and the borrower’s credit report 

   
Price Points

1st liens are priced from 30-65% of the BPO value of the property    2nd liens are priced from 10-25% of the unpaid principal balance

     
Sellers

Banks, hedge funds, family offices.

        
Pricing Trend

1st liens are getting more expensive in some markets. 2nd liens are still a good bargain if you have a direct source

      
Time Frame

The time period from acquisition to disposition for 1sts is only limited by the speed of foreclosure in the worst case scenario. 6-18 months. The time period from acquisition to return of investment of 2nds may have to wait for the house to appreciate to begin collecting. 6-60 months.

      
Return on Investment

Acquiring a property through the 1st note at  30-65% of market value can lead to cash on cash returns of 50-100% in one year. Buying a 2nd lien at 10% of UPB and then getting a settlement of the entire amount can lead to cash on cash returns of 500-1000% in 6 months to 5 years.

     
Exit Strategies

Deed in lieu, approving a short sale, loan modification, foreclosure    Deed in lieu, accepting a pay-off (settlement), loan modification, foreclosure

      
Tax-Free Advantage

You can use your self-directed IRA    You can use your self-directed IRA       
Investment Amount    1sts are available from $1000 each to $100,000. 2nds are available from $1000 to $50,000

      
Risks to Consider

About 10% of the time, a home owner will refuse to give up the deed or agree to a loan modification. The investor must then foreclose.  If a home owner goes into bankruptcy, the 2nd lien can be “stripped” off if there is no equity in the home. Mitigation: Wait until the house has appreciated before collecting.

      
Legal Issues

1sts have come under attack especially in California and Nevada which have passed recent legislation making it increasingly difficult to foreclose on a first lien for owner occupied property. See http://www.responsiblelending.org/   2nds are safe from the consumer finance laws but one must watch statutes of limitations laws state by state which govern how long a note holder can force collections.

      
Value of Asset

As the market improves, 1sts become more valuable as a way to acquire property and collect monthly payments.     As the market improves, 2nds are more “covered” by the rising equity in the home and as the 1st gets paid down, thus becoming more valuable as a way to collect monthly payments and get pay-outs from settlements.

      
Supply of Asset

The supply of 1st liens is still plentiful but most say it will last 3-5 more years    The supply of 2nd liens is plentiful but as the market improves they will likely become more expensive as they are more secured by the equity in the home.

   
Outsourcing

Servicing companies help call the home owner and comply with RESPA laws    Servicing companies will help if desired. Some choose to work with home owners on their own but servicing companies can help you to scale your business.     

If you have taken the time to study this chart, you have a much better grasp of the unique opportunities offered by investing in 2nd liens.

We are personally cultivating sources for 2nd liens and including them in our longer term investment strategy since they usually take between 6 months and 2 years to pay out. But the wait is well worth it because the profits are so generous. When we can acquire a portfolio of ten 2nd liens for the price of  one house in the central valley (here in California) that hold the potential for 10 times our investment , it is a very exciting investment vehicle that we would be remiss to pass up.  
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Brian Netzel has been a real estate and note investor since 1982 when he bought his first rental property on his public school teacher salary. He is now focusing on turn-around projects using distressed assets nationwide.
Brian Netzel is the acquisition manager for the private equity firm Inspired Capital Partners and the founder of SmartMoneyVision.com and RealEstateNoteInvestor.com which train investors to apply smart strategies that work in today’s real estate market.