When I was young and just starting in the note buying business, I went to a lawyer for advice. The first thing he told me was: “Always remember, Lorelei, every note seller is a liar and a crook.”
I was shocked. I couldn’t believe he’d say such a thing.
Trust the seller, verify the note
Then I read the same advice in George Coats’ excellent book Smart Trust Deed Investment in California:
“Experienced TD [trust deed] investors often claim that the best approach to the investigation of any TD is to assume the other fellow is a crook, and then work backward from there. Depressing as it may sound, there is considerable justification for this attitude.”
After nearly thirty years in the note buying business, I understand exactly what my lawyer and George Coats meant. They weren’t saying to treat your note seller like a crook. They were saying not to trust anything the seller says without backup documents.
I treat my note sellers as if they were perfectly honest. But I keep them honest by carefully checking everything they tell me about the note. So if you shouldn’t treat a seller like a crook, why think of them as a potential one?
The two reasons people sell notes
There are only two reasons anyone sells you a note:
- To get cash.
- To get rid of a problem.
Let’s look at how each one could affect you.
When the seller needs cash
Think about the note seller’s situation. They want cash as fast as possible, and they’re willing to take a discount, to lose money, to get it. That tells you something right away.
A note seller is under pressure. It could be something simple and innocent, like buying a new car or sending a kid to college. It could be something serious, like a gambling debt or delinquent taxes. Either way the pressure is there, and the seller may not volunteer any bad features of the note for fear that each one will lower its value.
This is the seller who tells you the payor has never been late, and then you find the payments are always at least three weeks overdue. This is the seller who says the payor keeps the property picture-perfect, and when you drive by you find junk cars, garbage and broken toys all over the yard. Point out the discrepancy and there’s always a justification ready:
“Well, they do pay, eventually.”
“Well, I haven’t seen the place since just after I sold it, and it looked good then.”
It could be an honest mistake. Maybe they really haven’t seen the property in a long time. Maybe a month late is fine with them. The cash-hungry seller may not be lying on purpose, but they’re likely to look at things through rose-colored glasses in hopes of getting more for the note. As we’ve said in our office for many years, “people are funny with money.”
When the seller wants to unload a problem
Second, the seller may want to get rid of a problem. The payor may have found defects in the property and want expensive repairs. The payor may have just lost his job and can’t pay anymore. The payor may have threatened to sue the seller for failing to dig a promised new well. It could be any of dozens of problems, and the seller isn’t likely to tell you about any of them.
The worst part is that the seller doesn’t think there’s anything wrong with holding back bad news. They rationalize it in weird and wonderful ways: you’re in the business, you know there are risks, and after all, you are getting a discount. If there weren’t problems, why would they sell at a discount anyway?
Your answer to this all-too-human condition is to be a good detective and check out every feature of the note before you buy it.
