1980 Commonwealth Letter Vol 2 No 4

I just sat through Jay Turner and Pete Fortunato’s course “Profits in Paper” for the 2nd time in as many years. In the event you are not yet in the paper market, now is an excellent time to buy. Similar to bonds, when interest rates available in competitive investments are high and cash is hard to come by, paper can be purchased at major discounts. This same paper can be used again when rates come down to acquire other paper, real estate, or other personal assets, at full face value.

For example, in today’s market, most professional investors in well secured short term instruments are demanding and receiving a yield of at least 30% on their invested dollar. The investor who put chases an existing note for less than the balance due, receives a return greater than the stated amount on the note. When the note is paid off prior to the due date, the investor who buys the note at a discount will realize a profit even greater than the yield he negotiated for when he purchased the note.

For example, a $10,000 note bearing interest of 12% and amortizing over ten years would have payments of $142.05 per month. Assuming that this note is new or has 120 payments remaining to be collected, an investor demanding a 30% return would pay $5, 523 in cash today for that series of payments.

In the event you are the investor in the above situation.and you purchased the note as described, you now have the choice of holding it to maturity, or using it to acquire another asset. If held to maturity, you will realize the 30% before tax return on your invest­ment, however, if you can acquire another asset sooner, your yield will increase.

The disadvantage of holding any paper in your portfolio is the de-valuation of the dollars you will receive in the future. It makes sense then to try to cash in your future profits in the paper you have acquired and invest the profits in an asset which will appre­ciate, ergo – houses. Many sellers of houses, especially in the buyers’ markets which most areas are now experiencing, will accept the note you acquired at a discount at full face value for their equity. When you buy an apparent house equity of $10,000 or more with a note like the one described above which you acquired at a discount, you in effect realize your profit immediately. Many owners of houses which have high payments and relatively low equities are experiencing a cash flow squeeze which forces them to sell even though they would prefer to continue to occupy the property.

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By acquiring the property equity with a discounted note which will give them cash flow and agreeing to lease the house back to the owners for the mortgage payments, you have allowed the home owner to “cash in” on his appreciated equity and still enjoy the use of his home. This is similar to the owner of a whole life policy who borrows out the cash value of the policy, and takes advantage of the accrued profits.

Suppose a home owner owed $60, 000 on a 10% VA^–loan on a house he has owned a_, little over a year. Because the house is in an area of high demand and therefore is appreciating faster than inflation, it is now worth in excess of $70,000. In the event the owner sold, hewould net after the expenses of the sale only a couple of thousand dollars, much of which would be devoured by the costs of relocating. Because of inflated house prices and high interest rates, the home owner may not be able to qualify for another loan on a similarly sized house and may decide to rent to help his cash flow problems. The problem is that he must move down a few notches in life style because the houses for rent are not as nice as his home and the neighborhoods are older.

By allowing the home owner to remain in place, the cash expenses of moving are avoided plus, more importantly, the trauma of relocating the family is escaped. When we assign the home owner the $10,000 note with payments of $142 in exchange for him deeding us the pro­perty, we ‘have effectively subsidized his-payments by that amount. The payments on a $60,000.00, thirty year, ten percent loan would be $526.24 (principal and interest). This gives the home owner effec­tive rent of $380 per month, far below the market rent for a $70, 000 plus home. When we sign a five year agreement with the home owner/ tenant to allow him to rent the home for the payments and all ex­penses (taxes, insurance and maintenance), we have created a “hands-off” investment. In order to guarantee that the tenant will not leave early, we take a collateral assignment of the note for the ‘security on the lease. We act as the collection agent on the note and collect only the difference of $380 from the tenant.

The above offer “gives” the home owner something tangible, the note, of value. In the event you can show the home owner the value of a prepaid lease, you can accomplish a similar result by giving the owner a lease at the rate of $380 per month for the term of the note. Your. cash flow would be the same and you would benefit from the appreciation in the property value, but would lose as the rent which should increase substantially would be frozen for the term of the note. As you are still stuck with the note, your yield will never exceed 30%. The tax ramifications are basically the same, as the in­terest income you would receive from the note which would offset the increase in rent received in the first case above.

I just returned from Salt Lake City where the market is mixed and many smaller builders and developers are losing: ground fast. It is a common practice for developers to sell a builder a lot with 50% subordination. A builder can then acquire a $20,000 lot for $10,000 in cash and a $10,000 note which will record against the property behind the new construction loan obtained by the builder to build the house. Often, the developer will in turn sell his interest in the subordinated note to a third party investor who is interested in a passive, relatively safe, short term investment at higher than available investment yields.

When the builder gets in trouble, he will typically pocket all the cash he can from the construction loan and stop paying everybody; his subcontractors, the second and finally the first. Now all the subs will file liens and judgments will abound from the injured parties.

Here lies an excellent opportunity for the astute investor. The holder of the 2nd is in a precarious position as his interests in that property will be extinguished should the 1st foreclose. In the event you can acquire this 2nd at a discount or even for your note which would be better secured, you are in an excellent position to now acquire the house from the builder for no additional investment.

If the builder is still in town, ask him for a quit claim deed which he should gladly tender to attempt to remove his name from the records. In the event you cannot locate him, bring the payments on the 1st current and proceed to foreclose on the 2nd. This will typically take 90 days or less.

Obviously, this is not a game for amateurs. First of all, make sure there is some solid equity over the 2nd. Remember,  you will have holding and legal costs during the foreclosure period. Secondly,assess the amount of work, if any, which needs to be done to com­plete or repair any damage which has occurred due to vacancy and vandalism.

In the event there has been vandalism, you may be able to make a claim under the insurance which would be connected with the comstruction loan.

Just because the house looks complete, don’t assume the plumbing and electrical work is complete. Often the water and sewer are connected last and that alone may cost several thousand dollars. It’s wise to engage a competent contractor to bid on completing the job. You may be able to save by subbing the work yourself but you will have an outside price to work on.

The business of buying distressed notes is complementary to invest­ing in SFH. Often as a result of negotiating and acquiring the note, you will gain title to the underlying security, or at least part interest in it.

Many owners of title companies and attorneys who specialize in real estate closings have specialized in buying these notes and may be a source of opportunities. Like all investors, they will perio­dically run short of cash or come across situations they do not or cannot become involved in.

They often prefer to remain passive. Typically, they purchase the note at a deep discount and then resell to another investor at a profit. When they buy a note which will require foreclosure, or some physical work like finishing a house, they may resell it for, a nominal profit.

 
Find out who are the owners of the aggressive title and closing companies in your area and offer to “help” them when they bite off more than they want. These people are pro’s in a lucrative business and are much easier to strike a deal with than a frightened builder or home owner.