Note Investing 101: The Hands-Off Way to Cash Flow in Real Estate

0:00To me, one of the biggest pros is one of the biggest cons is is that I don't own the property. And to me, that's a huge bonus. And that means that I don't have to set aside money every month for eventual repairs. I never get the call in the middle of the night to say, "Hey, the toilet's broken." You know, I'm not dealing with tenants. I'm dealing with homeowners. So, to me, that's one of the greatest advantages. On the flip side, that's actually one of the greatest drawbacks because the appreciation that you get by owning that property, I don't get.

0:31Mine is a depreciating asset over time. Whereas if you own the property, that's going to appreciate over time. So, it's a trade-off. We've debated it, my wife and I, many times and we've gone back and forth and ultimately I would rather not deal with the headaches and I I'm fine having something that's going to pay me over time and then I knowing that I'm going to have to replace that note at some point in the future. The interesting thing with that actually is last year I actually went and took a course from a a guy that I consider to be one of the one of the greats in the industry and he was talking about different strategies in with seller financing and things like that.

1:10And as part of his presentation at one point he's older now he's he's up into his 80s and has been doing this for 40 years. And at one point he talked about how he wished that he had some rental properties too. And I and that totally set off alarm bells in my head. And I'm like, "What do you mean? This is the golden goose. Like why would we do that?" You know, then we have to deal with stuff. And so I went and talked to him. I said, "So tell me about that." And it was really interesting at this stage in his life. He's got COPD.

1:40Like he's he's dealing with, you know, health challenges and things. And he's saying that that appreciation would really come in handy when all of a sudden one year he had to go into the hospital and stay in the hospital for a week three times in one year. That adds up a lot, you know, and that that monthly income that he's getting from the notes is great. However, when he has a large expense like that, it's much easier to depend on that property that he might own and then he can pull out some of the equity or he can sell the property and realize the equity gain there and that can help take care of some of those things.

2:17So, it got me thinking. So, I think maybe it's more of a balanced approach where you want a little bit of — Yeah. Yeah, that makes a lot of sense. I was going to ask you that if you think maybe a mix of both because, — what came to mind for me when you were talking about the cons is is the tax ramifications, you know, like — we just as rental property investors, I've just over the years been so used to — not really paying much in taxes because you just can write off so much. — but what do what do you I mean, how do you strategize for your your taxes and to minimize your tax liability?

2:55Well, we do a number of things. So, first of all, we it's mostly interest income that we're receiving. So, that's different than than, you know, regular income. So that makes a difference there. And and you've got to get your accountant to be able to report it that way because they may or may not understand that. And and so that's finding the right person and or educating your your accountant to make sure that you guys are on the same page. That's a big one. Other than that, again, one of the tradeoffs is, you know, if I, let's say I buy an out and then at some point I sell it, at no point did I own that property.

3:34Therefore, I don't have a capital gain that I need to report. And so that that offsets that just in terms of, you know, comparing the two. — So, yeah, it's a little bit different and there's pros and cons. You got to weigh it out. — Yeah. Yeah, that makes sense. So I guess there's a lot of different types of real estate deals out there obviously. When you say note investing, do you specifically specialize in doing notes on a specific type of deal or are you open to to any type of of deal?

4:07— Yeah, good question. So, I actually focus on residential first lean mortgages. That's that's my niche. And in fact, it goes further than that where for myself, I like balances under $250,000. So there can be and there's plenty of them out there that are all shapes and sizes. You can get commercial notes, you can get, you know, second or third lean notes, all kinds of things, land notes, whatever. All kinds of different things. And that's what I've chosen to focus on because that's what I've been doing for years and I understand it well.

4:39And it just works. But there's there's all kinds of options depending on what you're looking for. — Okay. And and so I would imagine those are probably some of the most stable. So maybe less returns. What what type of returns do you anticipate from a a loan like that? — Right. So if I'm buying a note for myself, different than so I've got an investment fund and so we pay off our investors. We pay them 8%. Okay. Minimum that I buy is a 12% yield. So currently in the in the fund I think we're right around 13 and a half% yield which is a little bit different than the 8% we pay them but but just to give you an idea like that's not unrealistic somewhere between 12 and 15 typically.

5:26— How so how does that work if you know like most people they go to the bank they get a a 30-year mortgage right now it's 6 and a half%. So how are you as the note holder then earning 13.5%. Yeah, I'm buying at a discount. That that's what it boils down to. So currently, so when I first got started in 20, you know, 2009, 2010, I was all about non-performing notes. There were thousands and thousands and thousands of those. So at the time with the non-performing note, that's a that's a different animal altogether and returns much higher, but obviously much more work and more risk.

6:02With those ones, most of those came from the bank. Most of those were institutional lenders that had created loans and now they've gone bad and now they're trying to just clear out their books. Today I'm buying mostly performing loans. Those tend to be because banks are doing like 6 and a half 7%. Most of the loans that I'm buying today are seller finance notes. So those tend to be higher interest rates, you know, 8 n 10%. And those make it easier for a deal to get done.

6:33A a note at a six and a half percent interest rate, my discount is going to be a lot larger. I'm gonna pay much less for that note than if than if it was written at a 10% interest rate. So, that's the number one reason why I'm looking more at the seller finance stuff these days. — Got it. Okay. And and how do you find a seller financed note? Because that's typically just an agreement between a seller and a buyer, right? And so, how do you how do you know it's even out there? It's a lot of the networking. The the conference makes a big difference where we attract a lot of people who are doing that and looking for an outlet.

7:09And a lot of people that are creating notes like that don't know that there's an outlet. They don't know that there's a way that they can resell that. And so I we do a podcast, a partner and I we do this separate businesses, but we've we've been doing this for three years. And lately that's been a big push for us is is trying to reach out to those seller finance people and educating them that there is a back door. There is a way for you to cash out of this if you so choose. And so a lot of education, a lot of networking. — Okay. Got it. Interesting.

7:39And so can you give an example of like what that would look like? So if somebody did a seller finance note for a buyer, — what would they sell it to you for? Like what typically would the interest rate be and what would they sell it to you for? What would you be looking for? — so it's that's all part of the education that we're trying to do. So first things first, if a bank, let's say right now is 6 and a half%. — Mhm. — If a bank is 6 and a half% and you're doing a seller finance deal, you have to number one realize that your product is a premium.

8:11They're not going to the bank for a reason. Therefore, you can and should be charging more. So if the bank is going six and a half, you're at least eight and a half or nine. That's that's just standard. First thing, first things first. And part of the reason you want to do that is because if you so choose to sell that note at some point in the future, a 9 or a 10% interest rate is going to be a lot easier to get a deal done, and you're going to make a lot more money off of that. — so that that's like the number one thing. Make sure you're doing as high as an interest rate as you can.

8:45Of course, while you're working with the borrower, it has to make sense and they have to be able to continue to make payments. Things like have they gone through a a registered mortgage loan originator, an RMLLO, and that's somebody who's gone through and has qualified the borrower to make sure it's all compliant with DoddFrank rules that got passed back in 2013 and all those things. That's another big part of it. The length of the term is is important. I I look at either really short notes, so like fix and flip loans that are six months to maybe 18 months, or really long notes that are 25 or 30 years.

9:24The the in between ones for me because of because I run everything most everything through the fund. Those are the ones that make the most sense. They either have to be really short or really long. And because the short ones are going to pay off really soon and I can turn around that capital or the really long ones I can hold on to for a little longer before I have to resell it to get capital back and go out and do it again. So there's a number of things. So it's it's hard to give a number just like off the top. If you've done all those things, like let's say you read wrote it at 10% over 30 years and it's in Texas, it's not in New York or something like that where if I have to foreclose, it's going to take me forever.

10:06Texas is the opposite. That's much much quicker. So, if all those things line up, yeah, it's going to be really good. I can probably pay you 80 85% of whatever the balance is, but it it there's a lot of factors, so it's hard to just say off the top like this much. — I see. Okay, got it. So So it's a way So it's kind of a a win-win for everybody because it gets the buyer into a deal that they couldn't qualify for with bank financing. — Yeah. The seller gets to sell their property typically at a premium.

10:40— and then they can turn around and still use that money that they use that that equity that they use to finance the the buyer by selling to you and and getting that 85% or 80 85% of their money up front, right? — to where they can turn around and reinvest that then and not have to wait 30 years to get paid back. — Yeah, exactly. Yeah. — Yeah, that makes a lot of sense. Okay. And then you you mentioned some of the qualifications you look at, you know, if it's if the interest rate is right, if it's in the right state, if they used a a what was the acronym for it?

11:15— it's RML. So, it's either registered or residential mortgage loan originator. — Okay. Yeah. To set that up the right way. So, beyond that, what's the evaluation process like? How do you know that that that borrower is going to continue to pay back after you you've taken over the loan? — Yeah, part of what I look at is the history. So, if they've been making regular on-time payments for the last 6 months, very likely they're going to continue to do that.

11:46If if we look back and it's been a year and they you know miss a month and they make it up the next month or they instead of paying on the 1st they pay on the 20th or whatever people are pretty habitual. They're going to continue to do what they've been doing for a long time. So that plays into it as well. And not to say that those are deal breakers, but it may adjust my pricing where I say, "Look, your borrower is not fantastic. Like, let's be honest. Let's just look at the history and see what's been going on. I I need this is something that I'm going to have for the next, you know, 25, 30 years." So, I want to make sure that I can get paid.

12:23I'm going to have to adjust my pricing a little bit just to make it make sense for me. So, that goes into it. Another point is if it's if the servicing the one who's collecting the payments, there are third party servicesers that'll do that for you. If the reporting that I'm getting is from that third party serer rather than the note creator, the one who maybe has a little bit more vested interest to possibly fudge those numbers or dates, something like that. And not to say I don't trust you, but but it's in your best interest to kind of maybe not be quite as polished on your reporting as a third party serer who's detached and they're just going to report whatever's been happening.

13:04So that's another big point. — That makes sense. Yeah. And and then in terms of your repercussions then or or what you know you have available to you. You mentioned you know foreclosure if they stop paying but what else like so if they have you had to go go through a foreclosure process and and what does that look like if you do? — Yeah the foreclosure is our worst case scenario. It's it's our backup plan and it's always you know there in the back pocket if we need it. Most of the time we don't have to and and I had a lot of experience with this through the years with the non-performers.

13:42If there's somebody still living there, if there's somebody still alive, almost always, like 95% of the time, we're going to be able to get some kind of agreement worked out. So, they they, you know, either they lost a job, they had a death in the family, or a divorce. Those are like the top three reasons why they stopped making payments. So then we can have a conversation and say, "Okay, so you're not making payments. What do you want to do? How do you want this to to move forward?" And and like I say, most of the time, almost always, we can work something out.

14:13If if your payment before was 800 bucks a month, first of all, are you back working again? Okay, great. Is it are you making the same amount you were before? Fantastic. Okay, great. — Should we just pick up back on 800 bucks a month and get you back on track? Awesome. Then we'll take those a rears and we can do all kinds of things. We can tack it on to the back of the loan. We can spread it out over the next year. You know, with the payments that you're making, we can do all sorts of things. We can split it up however we want. As long as we can agree between now me as the lender and the borrower, as long as we can come to an agreement, that's now what's going to be happening.

14:50We we modify the terms of the loan. That actually gets recorded with the county. And then off we go. Now we've got this new loan that we can both agree to. — And that's got it. Okay. — Most of the time if we're foreclosing, almost always it's because the house is now vacant and either because they died or they've abandoned the property. — Okay. And do you find that if you have to foreclose there's a big loss there or you can do it and you know take over the property, sell it and you're you're still in good shape.

15:23— Yeah. That's the beautiful thing is is because we bought it at a discount to begin with. And there's going to be some kind of an equity spread in there. I always look for at least a 25% equity spread. — So, it's it's very rare. It happens, don't get me wrong, it happens, but it's very rare that we take back a property and we go, "Oh, shoot." almost always we take it back and and yeah, we're able to resell it either just, you know, on the open market retail or we sell it with seller financing again and create another note. Okay. Yeah.

15:54And I was going to ask you about that, too, because I'm still — I guess like so I do some private lending, you know, from my wife and I's self-directed IAS, you know, typically on fix and flip deals that, — you know, we with people we already have a relationship with, and it works out really well. I'm I guess I'm curious why you don't do more just direct lending as opposed to just buying the notes. I could you know I think it's really just I would I don't know anybody who's doing fix and flip and and I could probably meet some people and we can probably work out some relationships — but this is working.

16:34It's something that we're already doing and and it it works pretty well so we'll keep doing it. — Yeah. Yeah. Yeah, and that's a beautiful thing about real estate investing in general is there's so many different ways to do it. And — and I think like you said, like you have a system around it. I'm the same way with short-term rentals. Like I have a system around buying high cash flowing multi-units in specific areas that — cash flow really well. And it's like — if if you try to do a little bit of everything, it's very difficult to make much traction.

17:06But it sounds like you have an awesome system around owning notes and buying notes that that has been really really great for you. So I guess for someone who wants to build a note building business then — what is that like? It's hard for me to wrap my head around what that looks like. So what how long would it take to build this up? How many notes do you feel like someone would need to have like a a business that they could, you know, like a more of a mom and pop business that would get them potentially to financial freedom?

17:42You know, does that you feel like that would take a massive amount or you could do it in a pretty short period of time or what does that what does that look like? — A lot of it depends on what capital you've got available. One of the one of the gotchas with note investing is that it's a cash business. So, you're not going to be able to get financing from a bank to go out and buy loans. That's not something that they will give you money for. So, if you've got cash on hand, you've got money in your self-directed IRA, that's your number one, you know, that's going to be your bottleneck no matter what is that's you can only spend as much as you have and that's it.

18:15So, so that's going to be the the really the big determining factor. After that, then you can start going out and using other people's money and that works too. That's what I do. That's why I've got this fund. So that's the very first thing. The other thing is because we're talking about like it's real estate related but we're not actually talking about real estate. The real estate is definitely a piece of it and like I say it's backup plan but we're talking about finance. So it's it's important to make that distinction and understand that that's what you're getting into. So the rules are different and you you have to understand how that works.

18:49And I and I don't have a a sales thing on that. I don't have a modules that you can follow anything like that. There are people that teach the business. I'm not one of them, but I'm happy to refer you. But you need to learn the business. It's very important that you understand you know, even just what you're looking at at the very least, but then you're talking about state laws and every state is going to be a little bit different. Sometimes even counties and individual counties will be different and so and you know which states require licensing and which ones don't and like there's a lot that goes into it.

19:23So just understanding what you're getting into is is a an important piece of that. You can learn it absolutely and and like I say I've got friends that that teach it and they do a great job of it. But you need to learn it. So that's going to take, you know, I would say minimum a year just consuming all the material and everything and just — going through different what ifs this, what if that, and just kind of understanding what you're getting into.