(Part 2 of the 2-part Note-Investing Series. Click here for Part 1.)
Eddie Speed, an expert on note investing who has bought and/or sold nearly 40,000 notes during his three-decade career, has story upon story about students he’s mentored who have reaped big profits from the note-buying business. He shared many of those stories at his half-day workshop on a bonus day at the 2012 Equity University Networking Conference.
One of the main points Speed reiterated was that it doesn’t take a huge pile of cash to get into note buying. He added that self-directed investors have a cash source that others don’t: their IRA. They can tap into their retirement account to fund investments and the profits go back into the account tax-free.
Here’s an example of one of his students’ transactions involving the note for a residential property:
Stone Mountain, Georgia
1,800 square feet
The investor paid $9,500 for the note.
Possible property value:
A house down street was on sale for $150,000, and there are other properties in the neighborhood valued around the same amount.
Income from the property:
The investor could collect rent at $1,000 a month to create cash flow, Speed said.
“Through all the objections, I have found one incredible motivator: When you can buy notes that cheap, it gets you over all the other objections,” Speed said.
Here are, according to Speed, the 4 steps to success in note investing:
1. Find the deals
– The obvious first step is to find the inventory of notes to start purchasing them. Investors might think of starting at a bank, but Speed said that’s not the way to go.
“Banks generally don’t sell notes on a one-off basis because it’s not efficient,” he said. “Banks tend to bundle loans 500 to 2,000 at a time and sell them to a hedge fund investor who buys a big box of these loans. Many hedge funds then re-aggregate and sell them.”
Speed mentioned that several of his successful students have never bought a note from a bank. Instead, they often work from recommendations from mortgage service companies who do servicing for mortgage hedge funds, or they deal directly with hedge funds.
It’s best to know the process of obtaining the notes going in, Speed said.
“There’s certain etiquette or protocol the investor needs to understand,” he said. “But it’s not brain surgery.”
Keep in mind that the note seller is in a quick-turn business, he added.
In addition, notes often carry with them liens or delinquent payments or taxes, so it’s important to have general knowledge about titling and foreclosure law. “You have to verify taxes and know what you’re doing,” he said. “I’m not trying to make you an attorney. Just know a business man’s level of the law.”
You can then hire an attorney and understand what the attorney is saying, he said.
2. Price the inventory of these notes correctly
The most common question Speed receives is “How do you value a note?” Here are the factors that go into deciding the value of a note, according to Speed:
The guy who owes the money: “If I had a note, and Warren Buffett personally guaranteed the note, would I even care about property?” Speed asked hypothetically. “If I’ve got a strong enough buyer, nothing else matters.”
3. Source the money
If the note in question is delinquent, the real estate issue becomes a lot more relevant. “You’re going to pay a lot more attention because I’m basically ‘pawn shop lending’ at that point. I could be buying a foreclosure in incubation,” he said.
The collateral: Speed warned to pay attention to the borrower: Are they paying, or can they start paying? What kind of credit do they have? “This isn’t a wink and a nod deal. We’re talking about successful modifications – quality people that can pay you back.” If you’re not getting the payments, you’re going to pay a lot more attention to collateral, Speed said.
In this case, first calculate the value of the underlying collateral, he said. While this might sound daunting to some investors, Speed said even if your calculations end up a little off, there’s still room for profit from the deal – especially when the notes are cheap to being with, he said.
Most of the property price points Speed deals in are in the under-$125,000 fair market value range. He bases this value on a real estate agent’s broker price opinion (BPO). That, according to Speed, is the range in which the profit margin is highest. “I have not found super cheap notes that were non-performing in these higher-price bands,” he said.
Other factors to pay attention to: The financeability of the property, the location and condition of the property, the local laws and the area’s economy.
Equity – Speed is observant of the buyer’s “skin in the game,” or equity, which can be measured by their loan-to-value ratio.
“A lot of times I buy these loans and they’re under water,” Speed said. “I’m always going to modify these loans and try to take the balance back down to where the customer can generate a comfortable payment. Sometimes that’s the rate, sometimes it’s the principal balance, sometimes it’s both. We learn how to do things that make sense and help the borrower.”
Terms of the note – If you buy a note that’s performing, you’re going to pay attention to the terms, Speed said, adding there’s a lot of difference between a 5-year and a 30-year note.
History of the note – (How long it’s paid, how well it’s paid). Look at the pay history of the note, Speed said. While some notes have a good pay history or appear to be being paid on again recently, others have zero activity in the last 12 months. All of that is taken into account in pricing the note.
Paperwork – Certain circumstances that require administrative costs can make notes less attractive, Speed said. He passes on a lot of properties if he decides it’s not worth the cost of foreclosure and all the related expenses. “Build in a budget just like when you’re rehabbing house,” he said.
– Some investors don’t think they can pull together enough money to close a deal. But Speed pointed out to Networking Conference attendees that based on demographics of his past presentation audiences, the room was full of potential investors.
“There are going to be some substantial investors in the room,” he said.
Retirement accounts are one of the most-used sources of funding in the note investing business, Speed said. It’s no wonder: Retirement accounts currently provide a pool of at least $4.2 trillion* for investment opportunities. Self-directed IRAs allow investors with fewer resources to tap into that money for bigger and better deals that might not have been possible otherwise.
“There’s going to be people who are more like me when I started. They’re going to start out with more energy than they have capital,” he added.
The right combination of savvy investors and funding sources could be a very profitable partnership, Speed said.
He provided an example of such a transaction. A student of Speed’s negotiated with a hedge fund and bought a reperforming note for a property valued at $205,000 for $86,000. He then sold it to another investor who funded it with his self-directed retirement account for $95,000.
The first student made the $9,000 fee for doing the work and putting the deal together. “Some people want to do (investments) but don’t have the time. The second guy gladly paid the fee. He was able to put up the capital with his self-directed IRA,” Speed pointed out.
His return in the first year of owning the note was $10,283. The property could easily sell for $150,000 to 170,000, Speed added.
The investor uses a third-party service to manage the investment. He gets a check in his retirement account every month, which isn’t taxed. He doesn’t have to touch it, and he doesn’t have to monitor taxes or insurance. In addition, he doesn’t have to make collection calls.
“It’s a pretty passive investment,” Speed said.
4. Close the deals and get the profits.
Speed provided several examples to illustrate the profitability that notes investing can achieve. By making these deals in your self-directed IRA, you’ll get to keep more of any profits made because it goes back into your retirement savings account, tax-free.
*Investment Company Institute
Learn more about investing in notes with a self-directed IRA
For details on purchasing the full recording of Speed’s workshop and the rest of the recordings from the 40-plus sessions at the Networking Conference, call KT Hartman at 888-382-4727 x393 or email email@example.com