Notebuying is a very good business. Done well, notebuying can generate both significant lump sums of cash as well as passive income. You don't have to rehab properties, you don't have to deal with tenants (usually) and you can do all your share of the "work" without leaving your La Z Boy recliner (that's a big deal for me). Sounds great!
Many of my colleagues in our local REIA's who are/were veteran real estate investors supplement their rentals and flips with notebuying and some gave up rentals and flips altogether and switched to notebuying. These are smart, talented and skilled investors, so there must be something about notebuying that is better than real estate investing.
If you don't know much about notebuying and do know about real estate investing, you are probably interested to learn about the attractive results notebuying delivers and I'm not surprised that you will continue reading this article to learn a little about notebuying and see some typical notebuying scenarios.
If you are nearing “retirement age” and already know about notebuying, you may want to skip to the end of the article to the section “Why Don’t I Invest in Notes?”
First, a disclaimer. While I am a successful part-time real estate investor, I am not a notebuyer. The reason I am comfortable discussing this topic is that I analyzed and studied in significant detail the portfolios and performance of two notebuyers in my sphere of influence. The performance was impressive in both cases with ROI's north of 40% when looking at an entire portfolio, including notes in the portfolio that don't pay out a penny. Yes, that's impressive to just about everyone.
In short, the reason to learn notebuying is that when done well, the return on investment is high and you can generate passive income, lump sum payments or both!
Therefore, I encourage you to learn more about notebuying from highly skilled and highly reputable notebuying experts. I strongly recommend that you read material and/or listen to lectures/training by Donna Bauer, "The Original Notebuyer," and Dave Van Horn of PPR. I know Donna and Dave well and not only do they have successful very extensive real-world experience with notebuying, they have high personal integrity. There is so much hype in the investment world, that it is very important to listen to experts who can be trusted. Donna Bauer and Dave Van Horn are such experts.
In other words, everything written below is not qualified information about notebuying, it is just my novice understanding. It's just food for thought so you can learn the reality from the experts and maybe this article will serve as a basis for clarifying questions you can ask of the experts.
In this article, I will not attempt to explain the details of notebuying comprehensively. I recommend you get Donna’s and Dave’s materials for the correct details and comprehensive training. I will non-comprehensively describe a very limited number of notebuying scenarios as I understand them.
In the broadest of terms, notebuying is based on buying promissory notes at a discount relative to the unpaid principal balance (UPB) of each note. The value for the investor is created from that discount.
Promissory notes are IOU’s that people sign to borrow money to buy homes, cars, student loans and more. When the people who borrowed the money stop paying the payments on the loans, the lenders have a problem and are sometimes willing to sell the loans to notebuyers for less money than is owed on the loan.
According to my very novice understanding, two of the broad categories of notebuying are “performing notes” and “non-performing notes” (NPN’s). I'll start by explaining my understanding of just one of many non-performing notes scenarios, which is non-performing second notes. The concepts are also valid for non-performing first mortgage notes.
Let's say that a homeowner bought a house at the top of the seller's market using a large first mortgage loan and a small second mortgage loan. Let's assume that the remaining unpaid balance (“UPB”) on the first mortgage loan is $160,000, the remaining UPB on the second mortgage loan is $40,000 and the home is currently worth about $180,000 after the ups and downs of the market cycles. Let's further assume that the homeowner loves the house, loves the neighborhood, is paying his first mortgage loan on time but due to some hardship (e.g., job loss, medical situation, divorce, etc.), they just don't have the money to pay on the second mortgage loan.
In this scenario, the lender of the second mortgage loan has a problem since there is only $180,000 of collateral for the two mortgage loans, leaving only $20,000 of collateral (= $180,000 minus $160,000 UPB on the first mortgage loan) to cover the $40,000 of UPB on the second mortgage loan.
Moreover, if the lender of the second mortgage loan were to file for foreclosure in attempt to get the borrower to pay off the second mortgage loan, the lender would have all kinds of legal expenses that would further erode any value that was left in the reduced collateral they could possibly recover.
The lender of the second mortgage loan is now a motivated seller for that non-performing promissory note with a UPB of $40,000, of which they can recover only a fraction at best, and they would still have to invest resources of money, time and effort. This is not a good situation for the lender of the non-performing second note.
What can a notebuyer do in this case?
A notebuyer may be able to buy the $40,000 UPB non-performing note at a discount, for say $8,000. [Lenders of non-performing notes periodically sell their NPN’s in big lots into markets created for this purpose. Companies like Dave Van Horn’s PPR buy chunks of these NPN’s and resell them, sometimes individually and sometimes through a bidding process.] Why would a notebuyer be willing to buy such damaged goods, even at that discount?
The mom-and-pop notebuyers, who often buy pools of 10 or more NPN’s at a time, all at significant discount to the UPB’s, buy these NPN’s with the intent and hope that they can “work out” some type of payoff arrangement with the borrowers who are currently not paying, for some percentage of the NPN’s. The notebuyers understand that not all NPN’s can be worked out and some will be absolutely worthless. The notebuyers are looking at the overall performance of the complete portfolio of the NPN’s they bought and in the cases that I have analyzed, their returns on entire portfolios exceed 40%.
There are a variety of ways that workouts can be arranged with the borrowers. Following are some examples. This is not a comprehensive list of workout methods.
Lump Sum Payoff
The borrower who stopped paying the payments on the mortgage loan, knows he is not paying and the notebuyer “reminds” the borrower of the $40,000 amount of the unpaid principal balance. The notebuyer might offer the borrower to payoff the loan in a lump sum for $20,000 which might be attractive to the borrower since they know they owe $40,000! The borrower may be willing to break a 401k at work to do this or come up with the money some other way because he is getting a great deal while getting this burden off his back.
If the notebuyer invested $3,500 in legal fees and other costs on top of the $8,000 purchase price for the note, then the notebuyer makes $8,500 on this note = $20,000 payoff minus $8,000 purchase price minus $3,500 in processing costs.
Even though the return on investment for this one note is 74%, there are other notes in the pool of 10 notes bought by the notebuyer that will not yield a penny. That is why the notebuyer is OK with ‘win some, lose some.’
Passive Income Payments
Another workout arrangement is to offer the borrower a payment plan to payoff the UPB at a lower monthly payment than what they were paying the original lender. This can be done in a variety of ways.
For example, if the original loan had a 15-year term, the notebuyer can offer a 30-year term. That would reduce the monthly payment amount very significantly, perhaps low enough to be affordable by the borrower. In this scenario, the notebuyer can generate a long-term passive income stream that pays off $40,000 over 30 years for an investment of only $8,000 plus processing costs! The borrower loves this because he gets to stay in the home where his family lives, works and goes to school and they can now afford to pay their mortgage loans.
Notebuyers love to say “it’s great to be the bank!” Of course, it’s great when you generate passive income streams from buying discounted non-performing notes that you convert into performing notes. You need some negotiating skills and understanding the needs of people who are behind on their payments, but acquiring these skills is really worth it.
Remember, that these borrowers are not your tenants! They still own the home and they are responsible for repairs and maintenance since it is still their home. You don’t get calls at 3:00 am about sewer backups. What you do get is monthly payments. It’s great to be the bank.
A more common way of generating passive income payments is to offer the borrower a discount with payments. For example, the notebuyer may offer the borrower to pay $30,000 instead of $40,000 and split that into 100 payments of $300 each. The borrower may find that very attractive since he is getting both a $10,000 discount AND an affordable $300 per month payment (close to a car payment). If the notebuyer invested $8,000 to buy the note and $3,500 in processing costs, the notebuyer gets all of her money back in just over three years and the rest is profit in the form of passive income.
Performing Notes
Some investors don’t like the idea of buying a pool of notes (some of which will fail), dealing with non-paying borrowers, dealing with attorneys, negotiating, etc. Some investors just want to get a 15% return on their investment and get their passive income deposited into their bank accounts. Those investors are tired of having all their investments in mutual funds that go up and down in a non-predictable manner and would have some peace of mind with at least a portion of their investments reliably generating 15%, but they don’t want to manage tenants and they don’t want to negotiate with non-paying borrowers. These investors are happy to buy performing notes (actually “re-performing notes”) from notebuyer-investors who did the heavy lifting of doing the workouts and managing risk.
Some investors who buy non-performing notes and “rehabilitate” them into performing notes with a 70% return on that specific note, are happy to sell that re-performing note to another investor who is willing to buy it at a price that yields a 15% return. Those notes are typically “seasoned” for a year to establish to the performing note buyer that the borrower is paying as agreed.
“Partials”
The term “partials” is a hybrid between lump sum and passive income. For example, if the notebuyer achieved a workout of 100 payments of $300 each, that notebuyer may sell 70 of those payments to another investor at a handsome profit and keep the cash flow of the other 30 payments. The incentive for the investor who buys the 70 payments is an attractive return.
Yes, there are many ways to skin the cat after the value is created by buying discounted notes relative their UPB.
While there are other creative ways to make money by doing workouts for non-performing notes (for example, foreclosing on a home with equity as a real estate acquisition strategy for high cash-on-cash return rentals) these methods described above are certainly enough for many investors to get excited, even when realizing that many notes bought by the notebuyer will never be worth a penny.
Why Don’t I Invest in Notes?
If all this sounds pretty attractive (even though I left out a lot of details that you can learn from Donna and Dave), why am I not personally investing in notes right now?
The answer when choosing investments is that they should ALWAYS meet your CUSTOMIZED personal situation.
I view most notebuying strategies as falling into one of two broad categories that are nearly analogous to two real estate investing strategies and they are “buy-fix-sell” and “buy-fix-hold.”
"Buy-Fix-Hold"
This is the note equivalent of holding rental real estate with one huge difference.
If one of the goals of the notebuyer-investor is to generate passive income, then the investor holds the notes that were worked out with a payment plan (as opposed to lump sum work out) and collects passive income payments for the term agreed. For this scenario, I assume that the investor does not sell off partials.
If was 30-50 years old, I wouldn't mind doing this because the yields are high when considering the initial investment, the workout costs and adjusting for the % of notes that prove to be worthless (i.e., never get a workout).
My reality is that I am 63 years old and my goal, for passive income has a term of my entire lifetime, that I am assuming is beyond 90 years old (my father is almost 93). That means that I need an investment that will not expire when I'm in my 80's and 90's.
There are very few notes that have workouts with payments that last more than 15 years. I need payments that will last at least 30 years.
The problem for my life stage is that when buying notes, the value of the underlying asset decreases with time, ALL THE WAY DOWN TO ZERO (!), and it hits zero when I'm old, can't work and need it the most.
In great contrast, when investing in rental real estate, the value of the underlying asset does not deteriorate to zero, BY DESIGN, and cash flow continues forever. In fact, over the next 20-30 years, the value of the underlying asset of real estate typically APPRECIATES (not depreciates by design as with notes), though I don't care about that much since I'm looking for the endless cash flow into my golden years when I can no longer work or choose not to work.
The classic argument notebuyers tell me when I bring up this objection is to sell the remaining payments of the workout and buy a new pool of notes, achieve another high yield in the process, then rinse and repeat.
The problem with that is two-fold.
The first problem is that means that I get a lump sum of money instead of endless payments and then I must rely on the requirement that the rate and method of distribution I choose for that money does not expire before I expire.
The second problem is that means that I must then buy another pool of notes. I don’ know that I will have the health to buy and fix notes, rinse and repeat in my late 80’s and 90’s. My father had a stroke in his late 80’s and lost his ability of speech. Not being able to talk is more than a small problem when trying to workout notes.
As you can see, my goal is not to build a pile of cash that I must manage into my 90's. I want passive income in my 90's and rental real estate with a property manager will give me that.
"Buy-Fix-Sell"
Buying non-performing notes, rehabbing them and selling the re-performing notes is the notebuying equivalent of buying distressed houses, rehabbing them then flipping the renovated houses.
The ROI's are excellent, but no better than the excellent yields I get when I flip houses that I already know how to do. So, there is not much incentive for experienced rehabbers to make the effort to learn a new skill set to achieve the same returns.
In addition, for some of us advanced investors, buy-fix-sell notes is equivalent to buy-fix-sell houses with one crucial difference which is the questionable nature in the eyes of the IRS to use self-directed Roth funds to flip notes vs flips houses.
I built a significant nest egg in my SD Roth 401k in which I flip no more than one house per year and buy free and clear tax-free rentals in that Roth. Other people do 100% of the work.
The IRS does not allow conducting a business on a "regular" basis AND the IRS does not allow the beneficiary of a retirement plan to do any of the compensatable work him/herself.
One day the IRS is likely to take cases to tax court that show that SDIRA beneficiaries are doing too much work themselves and in the cases of wholesaling in a Roth, notebuying in a Roth and flipping more than a couple properties per year in a Roth, these activities will likely be considered to be performed on a "regular" basis.
I speculate that the IRS may win these cases and, if so, some of these activities in SDIRA's may come to an end.
Rental real estate has different characteristics than notebuying and can be managed properly by independent third parties from beginning to end. Notebuying can be passive and managed by independent third parties after the workout, but the workout activities themselves may one day be deemed to be active and/or they may be deemed to be performed on a regular basis. If either of those determinations is made, that will spell trouble for notebuying in a self-directed retirement plan and workouts performed by the beneficiary.
For all these reasons that are specific to my life stage and my prior work to build my SD Roth 401k, I focus on rental real estate, with the occasional "non-regular" flip, both in my SD Roth 401k, to meet my long term goals for passive income (tax-free!!!) and tax-free free & clear net worth.
However, if I was 20 years younger and I didn’t have most of my net worth residing in retirement plans, I would definitely be a notebuying investor.
You need to determine your personal life stage and take an inventory of your skills, net worth, income, time available and everything else to evaluate if notebuying or other investment strategy is optimal for you.
If you need help assessing your current situation and developing your customized strategic plan going forward, you may want to consider conducting a half-day or full-day coaching session. If interested, now contact me directly by E-mail to inquire about coaching.
In order to get the most benefit from reading this article, complete the following sentences in writing:
“The top three reasons I should learn about notebuying are [1] ____ [2] ____ [3] ___.”
“The #1 reasons that I should NOT engage in notebuying is ____.”
Now figure out if the #1 reason that you should not engage in notebuying is an excuse or a valid reason.
Happy investing!
Biography: Marc Halpern is a successful part-time investor who has achieved financial freedom in terms of passive income and net worth mostly through rentals and flips using “regular” money and self-directed 401(k) funds.
E-mail Marc Halpern directly if you want to learn more about part-time investing or improve your profits through coaching by a local expert in South Jersey/Philadelphia with track record.
Do not take any action or make any decisions based in whole or in part on the content of this article. ALWAYS consult with licensed professionals in YOUR state before making any investment.
