The best deals often come from situations that look impossible, the ones nobody else wants.
The key is having the knowledge and creativity to restructure the transaction to your standards while giving the note seller an acceptable solution to his problem. Often you’re the only one who can solve it, because everyone else has declined to buy. When a seller faces that, he’s often very flexible on price, terms or both.
Here are a few transactions that show creative solutions for making these deals work.
Splitting one note into two
The first case was a note on an industrial building in Mississippi. (How many brokers would hear “industrial building” and give up right there? Many.) The property and business had sold 7 months earlier for $125,000 with only $5,000 down, which scares off most of the rest. The buyer was a long-time senior employee of the company.
The property had been appraised for $92,500. My investor refused the deal because the value of the business had been factored into the note amount on the property, even though the note didn’t say so.
After wrestling with the problem for several days, I asked the investor: “If we restructure the existing note into two notes, one a first on the property and the other a second on the property and the business, would you do the deal? And how would you structure the note so you could buy the first?” Notice that I always try to find out what the customer needs.
He proposed making the first $82,860, and he would pay $61,500 for the remaining 173 payments. The original note of $120,000 at 11% for 15 years had been paid down to $118,379. Here’s how the restructure looked:
| Note | Balance | Rate | Monthly payment |
|---|---|---|---|
| New first (on the property) | $82,860 | 11% | $956.93 |
| New second (property and business) | $35,241 | 11% | $407 |
The two notes carry the remaining balance of the original note, and the combined payments are exactly the same as the payment on the original note.
Protecting your position when you restructure
This deal differed from the usual transaction in two ways. First, we had to get the payor to agree in writing to the amended setup. Second, we added one clause to the new second that wasn’t in the first: “In the event of default on the first, the second is also automatically in default.”
That clause protects us but does no real harm to the payor. He would have been in default for the total amount anyway if the original first had gone into default.
One caveat: we always modify the terms of the original note. We do not tear it up, re-issue it or create a new first. Creating a new first would mean canceling the current first and re-recording it. That would lose our place in line and let any other recorded junior obligations move ahead of us. We could end up in second or third position, or worse. Modifying the note leaves our position unchanged.
This has to be done very carefully. You don’t want to restructure the note directly with the payor before you buy it, because that’s a loan.
Getting the second note for free
Here’s what we did. Our contract to buy the note was $52,000, the amount the seller needed to pay off another balloon at closing. We paid a $3,000 finder’s fee and split the difference between our $55,000 cost and the $61,500 sale price. Not a bad little profit.
But what happens to that $35,241 second with payments of $407 a month? Who gets it? We do. And our cost for it is zero. The second is far out on the risk curve, but it’s over $400 a month for 173 months, and it’s free.
Not a bad day’s work for a note that had been offered to several others who couldn’t figure out how to do the deal.
Split funding when the seller wants it all
The second strategy involved a blanket mortgage on six properties in Louisville, Kentucky. It was originated on January 10, 1990, with a face amount of $118,000, an 8% rate and payments of $840.16. When I bought it, 316 payments were left and the balance was $115,275.12.
The note holder was leaving the area and didn’t want to sell part of the note. He wanted to cut all ties and would take $60,000. One of my investors would pay about $59,000, which left no profit for us.
My proposal was a “split funding”: we pay him $29,199 now and $29,199 at the end of five years. That gives him $58,398 and gives us a profit.
The seller was happy to lock in almost his full asking price. We were happy because we bought 60 payments up front and deferred the purchase of the remaining balance.
Offering the seller a buy-back option
It’s often hard to get people to accept the large cash discount that comes with selling a note. Here’s another strategy that can sometimes close an “impossible” deal.
Suppose the seller has a $50,000 note at 12% for 30 years and we offer $25,694 for the entire note. He objects, and we’ve used up our other strategies. Then we ask: “How long do you need the money for?”
Sellers usually say a year or less. If so, we can offer him the right to buy the note back from us at the same price we paid, any time during that period.
If he accepts, we collect payments at our yield while we hold the note. In this case the yield was 24% (we did this one a few years ago, when 24% was more common than it is today). If he exercises the option, we get our money back and keep the payments we collected.
More likely, he won’t be able to raise the money within the option period. A one-year option is best, since we don’t want the note tied up for long; the option limits what we can do with it. The net effect is that we can get the whole note at a good discount, because the seller thinks he’s giving the discount only temporarily.
Here’s how it looks on the calculator. The “?” in each row is the value you solve for, shown in bold.
| Step | N | I | PMT | PV | FV |
|---|---|---|---|---|---|
| Basic note | 360 | 12% | $514.31 | $50,000 | $0 |
| Purchase | 360 | 24% | $514.31 | $25,694 | $0 |
| Sell back after 1 year | 12 | 24% | $514.31 | $25,694 | $25,694 |
| Sell back after 2 years | 24 | 24% | $514.31 | $25,694 | $25,694 |
Your yield stays the same for any length of option, up to the end of the loan term or until the note pays off. Your contract will ordinarily require the note seller to bear the cost of reassigning the note to him if he exercises the option.
Rules for using the buy-back option safely
- Carefully document what happens if the note pays off early. Use the approach you would use for buying partials.
- Never offer the note back at any price other than the price you paid. Anything else could be construed as a loan at usurious rates.
- Even at the same price, that interpretation isn’t impossible. Check with a competent attorney who knows your state’s laws before using this approach.
It has worked for me, and I’ve never had an option exercised.
