“Sorry, we can’t purchase this note. Our underwriting committee does not like your payor’s credit and the appraisal’s comparables are poor.”
How many times have you heard this from a large institutional investor?
This is not an article that bashes institutional money. McKinley Mortgage Co., where I am Chief Operating Officer, brokers notes to institutional investors every day, and we value them greatly for the notes they do purchase. This article is about the notes that don’t fit the institutional underwriting box but do fit another investor’s box. This is where private investors come in. A private investor is an individual who buys notes for a retirement account, a trust account or in their own name.
On a cold, rainy day in 1991 (it’s cold 345 days a year up here in Alaska, and it rains the other 20), Tobias Preston, founder and CEO of McKinley Mortgage, heard “Sorry, I can’t purchase this note” four times in a row. That may not be a problem when you have 30 to 40 notes in your pipeline. When you only have four, it becomes a serious challenge. A solution had to be found, or McKinley would have been just another mountain in the Alaska Range.
Tobias decided to show one of the turned-down notes to his business mentor and ask for his thoughts. The mentor knew the area around the property and in fact knew the payor personally. He liked the risk and the return, so he called Tobias back and bought the note.
From that point on, McKinley was off and running with a solid base of private investors. That base has helped us close more deals and close them faster, and it has given us greater profits both today and for the future.
Why broker to private investors at all
A couple of thoughts before we get into the details.
Turn earned income into passive income
Most small businesses fail for one of two reasons: lack of money or lack of energy from the owner. Brokering notes to private investors creates more money for you today, with much less energy than brokering to institutions.
Remind yourself why you are in this business: to invest as an insider by buying notes, not to broker every note away. As Robert Kiyosaki, author of Rich Dad Poor Dad, put it, “brokers die broke.” Working for your broker fee is fine. But if you want a pipeline of cash flow, you must turn that earned income into passive income as quickly as possible by buying notes as an insider.
Yes, private investors carry risk
I know what you’re thinking: “Working with private investors is risky business.” Sure, there are risks. But isn’t there also a risk of going out of business? Isn’t there risk in not giving the market, both note sellers and private investors, what it wants: cash in hand today or cash flow in the future?
I believe a private investor down the block from a property is a better judge of the collateral than someone in a suit and tie 2,500 miles away. (The suit might be closer to where you are, but the point stands.)
There are notes out there that could and should be funded and brokered to private investors. The key is to manage the risk: know what you are doing and be 100% honest.
Not every broker should use private investors. The more experience and financial intelligence you have, the more money you will make and the safer you will be. Used well, private investors are an additional money source that complements the big institutional buyers.
Benefits of working with private investors
- More notes to close. Savvy private investors are outstanding judges of local properties in their areas. The key word is local.
- More flexibility and control. We like to buy the tails, or back ends, of notes. We have full control of the closing process and of which portions of the note we keep.
- Faster closings. Two words: no appraisal. The time and money appraisals take kills deals and eats into profits. A simple broker’s opinion of value (BOV) or broker’s price opinion (BPO) is enough, and it usually takes 3 to 5 days with photos and comparables.
- Lower closing costs. Again, no appraisal. When this was written, a BOV usually ran around $100, compared to $400 for an appraisal.
- Real relationships. Solid friendships form naturally. I’ve flown over the Alaska Range, fished for 50-pound king salmon from an investor’s deck and been invited over for Christmas dinner.
- More profit. More notes to close plus quicker fundings equals larger profits.
Risks and drawbacks to manage
- Getting sued. The law favors the less sophisticated party. Qualify new private investors properly (more on that below), and do not broker notes to just anyone. Fully disclose all information about the property, the payor and the paperwork, and be completely honest at all times. Do not guarantee or manage your private investors’ notes.
- Unpredictability. It’s a fact of life with private investors. Stay in contact before, during and after closing. Have a backup plan: we keep a credit line and a personal line of credit for quick fundings, because now and then a private investor walks away from the closing table.
- Different underwriting standards. This cuts both ways. One of my investors flinches at a misplaced period on the deed of trust, but he didn’t get where he is without being detailed. Which is why he doesn’t have a problem with the next drawback.
- Limited capital. If you find a large private investor, keep them happy. They will make your job easy.
- Investors need to be educated. My simple rule: investors who haven’t been educated on the process, both the risks and the rewards, are not yet qualified to invest.
- Investors who start competing with you. This rarely happens. Our investors respect the marketing we do to find notes. Finding notes is costly and time-consuming, and our investors value their time more than their money. If one begins competing directly with McKinley, they are cut off from our preferred list.
How we place a note with a private investor
This assumes two things: you can find notes to buy, and you have the experience to process and underwrite them and tell the good notes from the bad. Here is how we place notes at McKinley once we have found and qualified them.
- Match the note with the right investor. This usually happens within a day of a “written accepted,” McKinley’s option agreement giving us the right, but not the obligation, to buy the note. A typical private-investor note has a principal balance between $15,000 and $50,000; the average is $25,000. We broker most notes over $50,000 to an institution and keep most notes under $15,000 in-house.
- Look at the property’s location. If the property is along the Kenai River (world famous for king salmon), we have one set of investors. If it’s in Fairbanks, we have a different set. Location is everything to our private investors. They like knowing that if something goes wrong, they can drive or even walk over to check on the property.
- Send a note profile. This is a one-page summary of the note that we send to the investors we think will be interested. It has five sections that answer 90% of a private investor’s questions.
- Follow up quickly. If no one calls within an hour or two, I call each investor, starting with the one most likely to want the note, and ask whether they have questions or would like to go ahead.
The five sections of a note profile
- Property: Location? Sale date? Down payment? Acreage? Map? Tax-assessed value? Broker’s opinion of value with photos?
- Payor: Name? Employment? Address? Are payments current? Credit scores?
- Paperwork: Full or partial purchase? Balance being purchased? Original note balance? Monthly payment? Interest rate? Number of payments being purchased? First payment due to the investor? Holdback in the escrow account? Investment amount? Discount to yield?
- Comments: Investment-to-value? Where is the note being collected? Any unusual facts about the note?
- Enclosures: Every item in the note portfolio, from the broker’s opinion of value to the amortization schedules and the discount-to-yield figures.
Finding good private investors
We grow our private investor program in three stages: generating leads, converting leads and nurturing the investors we convert. It starts with knowing who makes a good private investor.
The best private investor is one who comes to you. They already trust you, and they already know what they will be investing in. You can still look for new investors, but the more public you become, the higher your risk. Investors who come to you tend to be more sophisticated and more experienced than the ones you go looking for.
Our 150-plus private investors show a clear pattern: most are frugal and live well below their means. A great book on this type of person is The Millionaire Next Door by Thomas J. Stanley and William D. Danko, and Stanley’s follow-up, The Millionaire Mind, goes deeper into how they think.
What our private investors have in common
- They have made and lost money in real estate
- They have experience with notes and have made money with them
- They have excess cash
- They are between 50 and 70 years old and married
- They live well within their means and don’t show off their wealth
- They worked, or still work, very hard for their money
- They are mostly male (90% to 95%)
- They are or were business owners
- They made their money over 20 to 30 years
- They seek value, not price
- They are family oriented and extremely down to earth
- They like to be treated as special
Seek versus ask: the subtle difference
Seek out many people and you will find much trouble; ask one investor and you will find good cash flow. If you go out seeking private investors, some could view it as issuing securities, which can break the law. The best way to generate leads is to run your private investor program with complete honesty and trust. That attracts more investors than you will know what to do with, and they will share your standards.
It’s the chicken and the egg, of course. You have to attract one investor before one leads to two. We started our base with a simple ad, but I’m not suggesting you begin that way; it’s another land mine. Our best source of leads is our current investors and their referrals.
Ways to generate leads
- Referrals from current investors. These are the best. Simply ask: “We’ve found that when our current investors help us find more investors, we can spend more time on our investors’ needs and less time looking for business. Who do you know who might benefit from investing in notes?”
- Risk reversal. Offer new investors a loss leader, such as a one-point bump in discount on their second note.
- Direct mail to your mortgagee list. “So you don’t want to sell your note? That’s great! Do you want to own more notes?” Be extremely careful with your state’s laws, and do not mail to other states. Big land mine.
- Buying qualified lists. Plenty of companies will sell or trade you a list with the demographics you want. Another land mine.
- Networking. Join a club like Lions, Toastmasters or Rotary, but not to find private investors. That’s the wrong motive. Join to get out, expose yourself and your business, and learn from others.
- A business and personal elevator speech. If you can’t say what you do in under 30 seconds, it’s too long. Our private investor slogan is “The Safest and Most Profitable Way to Invest in Real Estate!” My personal version: “Hello, I’m Jason Preston, Chief Operating Officer with McKinley Mortgage. We purchase real estate secured mortgage notes. I help all types of investors increase their monthly cash flow by purchasing mortgage notes through McKinley.”
- Raise the perceived value of your notes. How much would you pay for a Pepsi in a Styrofoam cup? Put together a sharp investor portfolio with every document related to the note your investor is considering.
Qualify every investor up front
Qualifying is the key to higher profits and long-term safety. Without it, you are just spreading land mines until one day you step on one.
“The quality of your life and your business is directly proportionate to the quality of positive questions you ask yourself and ask others.” – Jay Abraham
Great questions position you better and greatly reduce your risk. A couple of years back I failed to ask a new investor whether they had ever bought notes at a discount. Big mistake. A few months after the investor took assignment and was enjoying a nice cash flow, I got a call: “Why doesn’t your amortization sheet match the payment record from the collection company?”
I said, “You’re probably looking at the discount amortization sheet.” The next question almost knocked me over: “What’s a discount?” After a couple of internal cuss words (sorry, Mom), I calmly went through the entire note investing process. The investor had thought they were buying the note at face value. It turned out fine, though I kicked myself over the $1,200 in extra profit McKinley could have made selling that note at the coupon rate.
Ask, listen and ask again, so you know they fully understand everything that is happening and will happen. Here are some of our most effective qualifying questions:
- Have you invested in notes before? (Ask this first.)
- How many notes do you have in your portfolio?
- What portion of your net worth is in notes?
- Where did you hear about investing in notes with us?
- What is your investment objective: cash flow, growth or tax shelter?
- How balanced is your current portfolio?
- What would you like your portfolio to look like in 6 months? 1 year? 5 years?
- What rate of return do you expect?
- What part of the state or country would you like to invest in?
- What type of notes do you want: single-family owner-occupied, raw land, commercial, mobile home only, or business notes (much higher yield)?
- Have you bought real estate for investment?
Turning interested investors into buyers
Most potential investors send back the signed investor agreement within one or two days of receiving the portfolio. If not, we call and ask, “Would you like to go ahead with this?” More than 90% say yes. If they say no, we have to move quickly to find another investor; that’s the unpredictable side of private investors.
Every time we talk with a private investor, we follow the same seven steps. Not every conversation leads to a sale, but each one should move us closer.
- Build rapport. Talk about them and their interests. Talk about yourself and your company only to build trust or get the conversation going. Keep a log of every conversation. Our contact database keeps a running history of each one, so when we haven’t spoken to an investor in a month or two, we can review what we discussed.
- Ask questions. Ask open-ended questions that can’t be answered yes or no, then listen. Truly listen.
- Listen to needs. Their needs are your opportunity; otherwise they wouldn’t be calling you.
- Summarize needs. Check in by paraphrasing what they’ve told you they’re looking for. This lets you fully understand their needs and the solutions.
- Ask for commitment. “Should I pencil your name in on this note, pending your final approval of the portfolio?” Most salespeople never ask. This doesn’t mean closing a deal in every conversation. It means your sales process keeps going instead of ending.
- Confirm the commitment. Ask the investor to sign and return the investor agreement. “Would you like to go ahead with this?” is the line I use most.
- Review what went well and improve. A wise man once said, “Don’t focus on your shortcomings; focus on the things you do well.” Stay self-aware throughout the process and get better each time. One question that will challenge your ego every time: “How can we improve this process for you?” Listen, learn and grow.
Keeping your private investors for the long run
This is where the rubber meets the road. There are two things you must do with private investors, or anyone you do business with: keep your promises and provide something of value. That’s it.
Deliver more than they expect
“Always do right. This will gratify some people and astonish the rest.” – Mark Twain
When was the last time you went back to a restaurant that treated you poorly? And why do you keep going back to your favorite one? Because they amaze you every time. You’ll forgive an occasional mistake; that’s human. Private investors, like all of us, love having their expectations met or exceeded.
Take pride in everything you do for them. Take them to your favorite restaurant, send flowers on their anniversary, send Christmas gifts and birthday cards, or simply return their calls quickly. The bottom line is to create a trusted, easy and lucrative way for them to invest their money.
Communicate often
Communication has never been easier. Each of our private investors has a preferred way to hear from us, so we simply ask: “What’s the best way to contact you about notes?” Email is quickly becoming the most popular.
One of my favorite books on this subject is Harvey Mackay’s Swim With the Sharks Without Being Eaten Alive. It includes a list of 66 things his salespeople learn about the people they do business with. Always remember that people do business with people they like. Take a genuine interest in others, not for what they can do for you but for who they are.
As Lou Holtz, then head football coach at the University of South Carolina, said: “You have no idea the impact you can have on others. All life is, all business is, is helping people get what they want. You help enough people get what they want, you will get what you want.”
Don’t quit before the breakthrough
If you’re frustrated and thinking of giving up, ask yourself: “I can always give up, so why quit now?” Most marathoners, marriages and businesses quit right before the breakthrough. Until May 6, 1954, no one had run a mile in under four minutes. In the year after Roger Bannister ran 3:59.4, 34 more runners broke the barrier. It was only mental.
“What lies behind us and what lies before us are tiny matters compared to what lies within us.” – Oliver Wendell Holmes. Believe in yourself and your business, because if you don’t, no one else will.
Treat every investor as if they were worth their weight in gold. And the next time institutional money cuts your deal, expand your box and think about brokering that note to a private investor.
