Ask anyone who has been in the note business for several years how to become wealthy in it. They’ll tell you two things: you don’t do it overnight, and you do it by becoming an investor yourself. This lesson follows one real transaction to show the choice every broker faces: take a fee now, or keep a piece of the note and let it ride.
Building wealth by keeping a back end
A real advantage of this business is that we can use our knowledge of the product to build net worth. As we develop expert knowledge, we see investment opportunities in deals that few others notice.
At American Funding Group, we look at every deal to see how we can carve out an equity position that will grow over time. A straightforward way to do this is to buy a full mortgage and sell a partial to an investor. The broker keeps a number of payments on the back end. After the investor receives his contracted number of payments, the broker receives the rest. If the note pays off early, the broker receives the present value of the cash flow he kept.
This strategy doesn’t require the broker to put up any funds. It’s a way to invest with no starting capital.
The deal: a builder’s $225,000 note
Our note seller was taking back a note on the sale of his single-family home, which the buyer would occupy. He came to us before the real estate closing, with authorization to pull the buyers’ credit. It was excellent.
The house was selling for $250,000 with $25,000 down. The $225,000 first mortgage was amortized over 360 months. The first 18 months were at 8% interest. Then a $25,000 principal payment was due, and the rate changed to 9%. Worked out, the payment stream looked like this:
| Payments | Amount | What it covers |
|---|---|---|
| 1–17 | $1,650 | 8% interest on $225,000 |
| 18 | $26,650 | $1,650 plus the $25,000 principal payment |
| 19–360 (342 payments) | $1,603.05 | 9% on the remaining balance |
Turning rejection into a workable price
Negotiations went on for about a month. The seller was a small custom home builder who didn’t need to sell, but could use cash to work on several building projects at once instead of one. We made offers based on our standard yield for new notes.
He was a good negotiator and pushed hard. He wouldn’t accept our offers at 10% to 11% yields. But that apparent problem led to a talk about his real needs. He said he needed $50,000 to build a house on land he owned, but he could use $100,000. So we worked out partial purchase options.
He turned down both partial options, also based on 10% to 11% yields, because in his words “the cost was too high.” But that rejection led him to say he would sell the whole note for $200,000, a discount of 11% from the $225,000 principal. We told him that if we could come close, we’d get back to him.
A few days later we told him we couldn’t pay $200,000, but we could pay $187,550 and let him keep the first three payments. His total cash in three months would have been $192,500: $187,550 at closing plus $4,950 (three payments of $1,650). He rejected this, but said he would take $195,000 for a full purchase, $5,000 less than his last asking price. That $195,000, a discount of about 13%, moved the deal from “undoable” to “doable.”
Two investors, two choices
We had to get to work to secure the deal. We had two investors with very aggressive positions.
- Investor 1 would pay $195,000 for 213 payments, including the $25,000 principal payment, at slightly under a 9% yield. If we bought the full note and sold him that partial, we would keep the last 147 payments for ourselves. Because we had gotten the note seller to pay for a full appraisal and a lender’s title policy early in the negotiation, our profit would be that back end of 147 payments.
- Investor 2 would buy the entire note at a 9.5% yield for $211,835, an 84.73% investment-to-value ratio ($211,835 divided by the $250,000 price). Since we were paying the seller $195,000, a full sale would leave us $16,835 in cash, with no interest kept in the note.
So the choice was to take $16,835 now and run, or let it ride and wait 214 months to start receiving $1,603.05 a month. What would you do?
