The seller-financed mortgage industry is again at a crossroad. Brokers who only pass deals along are under pressure, and the ones who will last are those who can find and fund their own deals. Here is how the industry got here, followed by practical tips for thinking and working like an investor.
How the business got to this point
Fifteen years earlier, the business was a cottage industry dominated by broker-investors with real estate backgrounds, working from home offices. John Behle taught how to run a profitable mortgage business using private investor money. A few years later, as some people were unknowingly violating securities and lending laws, Bill Mencarow offered classes on how to avoid that and still use private investors. Brokers frequently “stayed in the deal,” either investing some of their own money or taking their profit as ever-compounding payment streams.
Money was tight in those days. There was not much of it available for investment, and what there was commanded rates in the upper teens and higher. Markets that are taken for granted now didn’t exist then. For example, it was virtually impossible to sell a note on a commercial building.
The first crossroad: big money arrives
As rates eased and the money supply grew, long-time investor Michael Morrongiello warned me that the industry would not look the same in five years. He was right, and private investors faced their first significant crossroad.
Insurance companies and investment houses took an interest, so to speak, in seller financing. Broker business multiplied thanks to quick money and the ease of passing a deal to large investment companies such as Metropolitan Mortgage and The Associates. Investors had a harder time securing quality deals because they were competing with brokers anxious to pay today’s bills by selling tomorrow’s payments.
Successful industries always go through a period of consolidation. Just as McDonald’s consolidated the hamburger business and Blockbuster consolidated video rental, investment companies were consolidating ours. The largest corporate investors began advertising directly to the public, which put them in competition with the same brokers who had been channeling them profitable notes for ten years.
The second crossroad: brokers squeezed
Brokers are now at another crossroad. Their growing numbers increase competition with each other for a fixed number of deals, and they may be at the mercy of corporate buyers advertising in their own back yard. As this trend continues, watch for the extinction of the independent broker. The entrepreneur who succeeds over the next 15 years will be the one who can find and fund his or her own deals.
Investors have a fixed floor under their income and are immune to corporate politics, restructuring and downsizing. The rest of this lesson lists points for fine-tuning your investor skills. If you are strictly a broker, you should find a few tips for easing into the investor role, balancing the risk in your business plan and getting past the next crossroad.
Fund your business wisely
Hypothecate, don’t sell. When you sell a note, you finance your business at the investor’s yield. That’s fine for a high-risk internet startup, but too expensive when the security is a quality first mortgage. You also face an immediate tax consequence when you sell a note, and you give away the windfall when the note pays off early.
Cut it thin, you never win. When you invest with other people’s money and your name is on the documents, we estimate it takes 2 yield points to stay profitable. If you need a financial calculator to analyze your spread, it’s too thin. Hypothecate profitably.
Borrow long and lend short. The banks tried it the other way around some years ago, and we all paid for it. Controlling a portfolio of 10-year mortgages with an adjustable-rate line of credit is risky. Add a short-term call provision and it’s suicide. When rates are low, watch the fallout when they creep up a point or two. Have your money come back to you faster than you pay it out, and you can always pay your debt off early if rates move against you. Low and flat rate environments are very forgiving; protect yourself against rising rates and short-term calls.
Compare the quality of the debt you give to the quality of the debt you receive. When you sign for a line of credit, you are guaranteeing the payment, and you know you will make it. That is high-quality debt. Use that money to buy a note of similar or better quality, so you can be sure the cash flow is there to make your payment. Peter Fortunato teaches this in detail.
The best investment of all may be paying down your own debt. The debt you pay is the highest-quality debt you manage, and it often carries some of the highest interest rates. Pay it off early. Think how reassuring your future will be when you are not continually borrowing against it to pay today’s bills.
Choose and treat investors well
Disclose everything to an investor, and make sure they disclose to you. You don’t want to take a widow’s $10,000 only to find out it was her last $10,000. You do want to pledge second mortgages to investors who have held seconds before. Our investors include CPAs and attorneys we met in mortgage seminars who had the same knowledge we have. It would be hard for them to claim we took advantage.
Disdain partnerships. Partnerships fail because of the perceived inequity of what each partner brings to the table. Set up your deals so that each party is independent. If investors insist on buying into your deal, give them the paperwork, assign them the entire note, let them do the servicing and be done with it.
Nothing should come between you and your payor, least of all an investor. If you pledge your notes instead of selling them, stay in the middle of the deal where you know exactly what is going on. Payments should come directly to you so you can track the payor’s history, then forward the investor’s portion. Large principal payments and long delinquencies are significant events you need to know about, and you can only be sure if every payment comes through you first.
Good paperwork doesn’t make a good deal; good people do. No matter how many clauses and contingencies, if the payor won’t pay, the payor won’t pay. Over the years we have systematically improved the quality of our portfolio to the point where we hold only IRA-quality notes: good seasoning, low LTV and above-average credit. The same rule holds for your choice of investor.
Protect the notes you hold
No paperwork, no money. The days of handshake deals ended long ago.
Watch the down payment. The best predictor of foreclosure is a small down payment. So says the FHA, and isn’t that ironic? Our late friend Earl Woodell told us that every note he bought behind a $1,000 down payment eventually defaulted.
Bunch up your note holdings geographically so you can give an attorney repeat business. You’ll get much better service if you ever need legal help. Trade out any note that is the only one you hold in a state, unless you plan to grow your portfolio there. At the same time, spread your risk by holding notes in more than one state.
Check your collateral after the closing. Few deals close without an appraisal, but do a quick follow-up every few years. Inspect the property if the payor files bankruptcy; your attorney can then petition the court for relief if the collateral is being wasted. We had a payor go into bankruptcy who never missed a payment, until he came out of it! When we took the property back, its only value was the land. Fortunately that was enough, but we didn’t get the windfall we expected. A cheap, quick market analysis by a local Realtor would have alerted us much earlier.
Don’t sue anyone for less than $10,000. The legal fees, combined with the uncertainty of collecting your judgment, make anything less uneconomical. Unfortunately, the reverse is also true: it’s not worth defending yourself over less than $10,000. A sad commentary on the American legal system. You can be right or you can be happy.
Earn more from the deals you already have
Restructure for profit. Large investment corporations buy a note and immediately go to work on the payor, encouraging an early payoff to earn a higher yield. Offer to halve the interest rate on the note if the payor will double the payment. Try it on a financial calculator and see whether it doesn’t raise the investor’s yield by 4% or more. That’s just one trick; there are many others.
Find additional profit centers in your existing deals. It takes about $10 per note per month to make a profit as a loan servicing company. If you service payments your own contacts receive, however, you can be profitable in the $2 to $7 range while keeping your name in front of them. We recommend you do not service the same notes you sell to your investors, to avoid potential securities issues. The servicer keeps all NSF and late fees. Structure the servicing so incoming payments are due, for instance, on the 1st and investor payments go out on the 15th. Get some float, make sure the incoming check clears, and try to bunch outgoing payments so they are due on just one day each month.
Make it easy for people to pay you. Payment coupons, deposit slips, credit card payments, automatic checking debits and prewritten checks can all simplify collections. Offer an interest rate discount to payors who agree to increase their monthly payment; your yield will increase dramatically. Have your attorney draft a note modification agreement, and make sure no junior lienholders would be adversely affected. We once left a bank account open for a year after moving out of state, because two payors preferred making their mortgage payment ten days early every month, the day their Social Security check arrived, and didn’t want to risk mailing it.
Buy a note, then buy the property. One of our best note purchases was in Summit County, Colorado, not exactly the middle of the suburbs. Corporate buyers would not go over 50% investment-to-value at the time, so we outbid the best offer and still got a great yield based on a sizable discount. One day the payors called for a payoff. They sold the house with 35 acres and a commanding 360-degree view of white-capped mountains, and we recaptured the whole discount in only a few years. Later we drove by and it dawned on me that we could have bought the property at a huge cash savings by using their note to cover part of the price. And we might have gotten them to finance the difference!
Habits that build long-term wealth
Don’t spend what you earn; spend what your earnings earn. This is hard to do when you first get started. Read The Richest Man in Babylon for guidance. George Clason says it much better than I can.
Don’t eat your seed corn. Of all the pearls Jimmy Napier has given me, this is the most valuable. Put another way, you can spend your $2,000 paycheck on luscious groceries, or you can eat cheap and invest $1,000 of it toward your future. There is something warming about waking up in the morning and not worrying about where the money is coming from. Eating beans today sure beats eating pet food when your Social Security checks start coming in.
Stay just behind the leading edge of technology and way ahead of the pack. Technology will put the pencil-and-paper crowd out of business. Use tools to reduce your grunt work and spend more time marketing for the next deal. Picture a Norman Rockwell bookkeeper with a visor and armbands, hunched under a green banker’s lamp reconciling the checkbook. Meanwhile, the techno-investor, whose books are always balanced, just closed another note.
Exceptions will kill you. Make as much of your business routine as possible, and you’ll get 80% of the work done in 20% of your time. Our portfolio contains only high-quality notes. We give up a bit of yield but spend no time managing it. Michael Gerber’s outstanding book The E-Myth has the details.
Float like a butterfly, sting like a bee. Muhammad Ali was talking about boxing, but it applies to any entrepreneur. Profitable opportunities come your way regularly, and you need to jump on them. When we moved to Colorado, we found rental houses would generate the same gross return as a mortgage, so we moved some of our investments into real estate. That was just before the California influx into Colorado and a 50% jump in prices.
The more you hoard, the less you have. We really own nothing anyway. We are merely stewards of the property under our control.
