Over lunch with a group of investors in Hollywood, from beginners to battle-scarred veterans, one of them described a strategy I’ve used myself and had clients use in markets like this one. It’s simple, almost boring, and very profitable. I won’t go into all the number crunching here, just the concept.
He’s buying notes at a discount. If you’re a flipper buying properties for cash, or even (maybe especially) if your strategies are longer term, buying notes can be far more profitable, and less sweaty too.
Lower the rate, raise the payment, increase the value
He’d bought a note at a healthy discount. He then approached the property owner and offered to reduce the interest rate from 8% to 6% if the owner agreed to raise the monthly payment from $750 to $1,000. That increased the note’s value, which sounds like the basis for a bar bet.
How is it possible to lower the interest rate and increase the note’s value?
The note was fully amortized from the start. The bigger payments, combined with the lower rate, sharply shortened the time until it would be paid in full. That let the investor flip the note quickly for a $12,000 to $15,000 profit. It took him just over a week.
None of this is new. It’s just not widely practiced.
Options when you buy a note in default
Now, what if instead of buying the note for its own sake, you bought a note that’s about to go into default, or already has? Look at all the upside-down homes in your area. How many local lenders, a few of them private, would gladly take a discount to get out?
Here’s the example we used at lunch, with a couple of changes: a house worth $400,000, a note balance of $380,000, and you buy the defaulting note for $240,000.
| Item | Amount |
|---|---|
| House value | $400,000 |
| Note balance | $380,000 |
| Your price for the note | $240,000 |
First, go ahead with the foreclosure. In the process, approach the homeowner with an attractive plan to get them out: pay for their move and remove the dings on their credit report. That last one can sometimes be done completely, sometimes not, but as the note owner you can certainly remove anything you reported yourself.
You’ve now created several options.
Option A: sell to a flipper
Sell to a flipper for, say, $300,000. Even after some expenses, you’ve made somewhere around $50,000, relatively quickly.
Option B: fix it and sell to an owner-occupant
Make the property perfect yourself, then sell it to the end user. Even if you sell slightly below market value, maybe $385,000, and pay a Realtor, your net profit would be in the range of $70,000 to $90,000.
Option C: keep it as a rental and refinance
Keep the home, rent it at market value of $2,000 a month, and refinance it for roughly $235,000. At prevailing non-owner-occupied rates, that leaves plenty of room for it to pay for itself. You’re now playing with “house money,” because you’ve almost completely recouped your original capital. Then you do it again.
Option D: sell and exchange into income property
This is my personal favorite. After spending maybe $10,000 sprucing things up (it was never a fixer), you sell it for market value. While in escrow, you convert the sale into a tax-deferred exchange. Your net equity would be roughly $360,000, possibly a bit more.
In my illustration, that equity could buy about $1.25 million (possibly $1.5 million) of well-located small income properties in a solid growth region. In roughly eight to 13 years, those properties could produce $90,000 to $100,000 or more in annual cash flow, assuming no increase in net operating income. Your original note purchase would have cost less than three times that annual cash flow, and your capital, even with no appreciation at all, would have grown to $1.25 million to $1.5 million.
Options when the note is still performing
If the note isn’t in default and you want the monthly income, you can do what the first investor did: get a higher payment in exchange for a lower interest rate. Besides raising your income, you usually increase the note’s market value (not always, but most of the time if it’s structured correctly), and you move up the date the note is paid in full.
When going this route, many experienced investors convert the note from fully amortized to interest-only or partially amortized, so they get a lump-sum payoff at a time that suits their plans.
Borrowing against a note with hypothecation
Finally, consider hypothecation. Put simply, you pledge the note as collateral for a loan.
Say you own a note with interest-only payments at a decent rate, all due and payable in five years. A lender may loan you 30% to 60% of the note’s face value, at roughly the same payment as the note. The note payments still come to you, and you hand them over to your lender.
If your note is $100,000 and you borrow $40,000, you make the payments for five years. Because your loan was fully amortized, it’s paid off by then. Then the original note comes due and you’re paid the full $100,000.
This maneuver isn’t a taxable event. It gets you quick cash when you need it, without coming out of pocket, and it preserves the lump-sum payoff, all of which comes to you. Meanwhile, you had the use of the money, which should have earned you more.
There are many more ways to use notes in real estate investing. It’s one of the most productive methods I’ve ever used. If you’re buying homes for cash, this approach belongs in your toolkit.
