Part 1 – Investing in Real Estate Notes from A-Z
When you read or hear about real estate note investing, you usually get the 30,000 foot overview of the process.
It’s necessary to see the big picture and have an understanding of what investing in real estate notes is all about but how about some details, please?
What are the actual steps that you have to take?
A lot of the information out there is opaque, glosses over, or just completely omits the actual details of buying real estate notes for sale.
If you’re considering investing in one of our funds, this will give you insight into how we conduct our business. If you’re doing it yourself, this e-book can help guide you in your current business or give you the information you need to get started.
Let’s take a look at the process in more detail.
First, what’s your strategy?
Investing in notes is not a one size fits all. Just as in real estate, there are lots of different niches, each requiring a different expertise. Do you want to buy institutional, residential, first position non performing notes like we do? What about non performing loans in second position? There are also performing, re-performing, sub performing, scratch and dent, seller financed, and commercial notes to invest in.
Once you pick your specialty, you’ll also have to pick your strategies to make money in your particular niche or niches. Each niche will have its own nuances and will require you to learn specific strategies.
Here, I’ll explain how my niche works in detail, which will give you some guidance and a place to start with your own chosen specialty.
Who are you buying investor notes from?
I’ve talked about buying real estates briefly in How to Invest in Notes (and 5 other FAQ). It’s important to understand that the note buying process differs from buying “regular” real estate in the order or sequence of events. Buying notes can also vary between different types of whole loan sellers.
I buy notes for sale from hedgefunds or trusted and established note brokers. The following details describe how I buy notes from hedgefunds. You can use this as a guide to understand the note buying process and adjust if your note seller does things differently. (I also wrote article that goes into more detail.)
Get a Tape
When we’re ready to buy real estate notes, we contact the trusted note sellers that we’ve spent years building relationships with. We ask them to put together a tape and give them our criteria.
A tape is an excel spreadsheet that lists one loan per row and about 25-75 columns of pertinent data about the loan, including property address, principal balance, interest rate, term, delinquency, etc.
Our criteria are the states we like to buy in and foreclosure status of the loans. We like to look at loans that are more than 120 days late or are in some stage of the foreclosure process.
This ability isn’t typical and you have to spend a lot of time and effort to establish relationships where you can do this. For a lot of note investors out there, you don’t get special access to tapes. If you come across a tape, whatever loans are on the tape are the only notes for sale. If you’re buying from on online marketplace such as Paperstac.com, you can find individual notes for sale but not pools.
Once we receive a tape, our sellers will expect to get our first bid within about a week. To evaluate the tape, we look at property locations and do some research on property values. We go through a culling process to narrow down the list of non performing notes to decide on the best potential buys.
(We get to cherry pick from the tapes our sellers send to us; this is not always possible with other sellers. For many of them, it’s all or nothing.)
Then, we input the information from the tape into our proprietary financial model (fancy for “excel spreadsheet with a bunch of formulas, specifically designed for us”), which calculates projected returns using our assumptions about the market and timelines to liquidations (important when dealing with non performing notes).
Most of the time, we can get servicing comments and pay histories for the non performing loans from our sellers. If you’re buying directly from a seller or through Paperstac.com, you can try to get this information as well. The more details you have of the loan, the more accurately you can predict performance and timelines.
For some tapes, especially the ones that get “daisy chained,” meaning they’re passed on from note broker to note broker where the end broker has no real connection to the seller, this isn’t possible. (“Daisy chained” tapes are a waste of time; you have to have a legitimate relationship directly with the seller or the note broker who controls the deal.)
Unless you’re a medium to large fund ($100M+) where it doesn’t matter as much, not having access to servicing notes and pay histories ahead of time puts you at a serious informational disadvantage. Try your best to get these before bidding on notes, if possible.
3 Considerations to Give you an Edge
Informational Advantage on Price
Do research to determine property values. Are the seller’s valuations outdated? If your research determines that the value is much higher than what the seller is showing, you have an advantage.
Non performing notes sell in a small range that represents the market. If there’s sufficient equity, you bid on a percentage of principal balance. If the property is underwater i.e the debt is more than what the property is worth, you bid on a percentage of property value. If you think the property is worth more, your bid will be far more competitive because it will be higher percentage-wise in the seller’s view.
Assume that non performing loans in a certain state are selling at 72-74% of value
The seller knows that the market will only get him 72-74% of property value with an underwater loan. If he needs or wants to sell, your bid of 75% is very attractive since yours is slightly above market. For you, it’s a great deal at 50% of value.
CAUTION: You should be very certain of your value before bidding. If your value turns out to be less than what you think but more than what the seller thinks, you are still committed to buy unless you find something wrong with the loan, which would give you a reason to back out.
In the above example, if the seller’s value was correct at $100,000, your percentage of value will be 75% instead of 50%. You would be paying market value and be committed to buying if there were no issues with the loan.
Informational Advantage of Title Issues
This one comes with time and experience. When you discover title issues from your review of the servicing comments, you’ll be able to quantify time and cost to deal with that obstacle. The seller might not know or want to deal with the issue and be willing to discount the loan because of it.
For example, you know that a Quiet Title Action will most likely cost $5,000-$10,000 and take 6-12 months to complete. Factor these costs into your bid, add a little bit more cushion, and explain your bid to the seller. If he’s tried to sell the note before, he will probably run into this issue before and might give you the $15,000 to $25,000 discount that you’re asking for. (Read this blog post for a thorough example of a Quiet Title Action.)
Different Business Model
This one comes with experience as well. Note investors are willing to pay different amounts for loans depending on their niche. Note sellers are also willing to sell notes for less when the loan doesn’t fit their business model.
This is especially true when the seller bought a pool of notes where it was “all or nothing.” The seller had to take loans he didn’t necessarily want. Many times, sellers like these will keep the loans that they want and sell the rest.
The “tail end” of a tape refers to the last, lingering loans of a previous buy. They may be the leftover junk that the note holder is finally getting around to dealing with. They might not be junk at all. The note holder might have already made his profits from the “front end” of the tape and might not want to spend time on the last ones.
Some note investors only want non performing notes (like us). Some only deal in seconds or re-performing loans. Try to find the situations where you’re buying other people’s “junk” when it’s not “junk” for you.
Once we have our financial model crunch some numbers, we do a final evaluation of the notes that we like the best. This process is more of an art and is based on our experience, what we see in the servicing comments and pay histories, and our knowledge of the marketplace. We come up with our initial bid and send it off to our seller.
Now, it’s a matter of each party making multiple counter bids until we reach a consensus on the final loans that make it. Our sellers sometimes will indicate an acceptable range for a bid but mostly we are bidding blind without any idea of what’s acceptable to the seller. Once a party receives a counter, the expectation is that you’ll immediately acknowledge receipt of the counter and provide an answer in 24-72 hours, unless you give a specific reason why it might take longer.
We will have no idea what the seller’s cost basis is for any particular non performing loan nor will we have an idea of what their returns need to look like in order for them to sell to us. Just as our note evaluation process remains unseen behind a curtain, our seller’s ultimate decision making process remains a mystery as well.
If the seller’s cost basis is $76,000 and they can’t take a loss, there is no way we can make a deal happen because we won’t go above our max and there’s no way they’ll take less than $76,000.
If the seller’s cost basis is $65,000, he will counter with whatever effort level is consistent with his performance requirements.
If he’s ok to take a smaller profit, he might accept our bid where it’s at. Depending on how aggressive the seller needs to be on profit, will dictate how high his counter will be above our $70,000 bid.
Again, we will not know what the seller’s basis is, what his motivation level is, or what profit level he needs to reach in order to sell.
The best we can do is make the bids that fit our buying criteria and hope that our numbers are close enough to the seller’s selling criteria to get a deal done. In this example, we’d be happy to buy at $75,000, knowing that we’re projecting an acceptable profit, regardless of what the seller’s profit will be.
During this phase, some or many loans will get kicked out because we can’t agree on price. Once we get to the final cut, both parties acknowledge the agreed upon prices for the non performing loans in an e-mail and we go to the next phase: