Investing in notes can be rewarding, but it can be an intimidating space to get into. In this episode, we go back to basics as we look into notes. Katie Berlin of Labrador Lending interviews Jamie Bateman about the basics and the ins and outs of notes from a newbie’s perspective in notes. They look at the differences between partials, performing and non-performing loans, and talk about passive and active investments. What is more, they also discuss the key members you need in your team, the capital you can expect to part with, and the types of notes to invest in depending on your risk tolerance. Tune in for more great info on note investing as you prepare to take on this space.
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Notes For Newbies: Jamie Bateman Goes Back To Basics With Katie Berlin
I’m going to be flipping seats here and I’ll be the guest on the show. We have Katie Berlin as the temporary host. Katie joined our team at Labrador Lending. She helps us with some marketing and branding. Who knows where that’ll go? We’re happy to have Katie as part of our team at Labrador Lending. We take the opportunity for Katie, who’s a little bit less familiar with note investing than many of us are for her to ask me questions from a newbie’s perspective. Some back to basic questions, if you will. Katie, how are you doing?
I’m doing well. Thank you for the intro. Yes, I am a newbie in this space. Even though I’ve started working with Jamie, I have a lot to learn. I’m a little bit familiar with real estate investing but these questions as a newbie note investor are going to be because I am a newbie. I haven’t invested in notes yet. This is your 101, back to basics.
We don’t have to fake anything here.
Jamie will pour the knowledge out and we will consume it because I will be learning right along with everyone else.
Katie is out in California. I’m in Ireland. It’s not overly early for you but it’s still earlier for you than it is for me.
I do wake up before 12:00 PM, contrary to what some people may believe about us out here in LA.
I’ll be quiet until you ask me questions. You’re now the host. We don’t need Chris anymore. He’s frolicking around in the US Virgin Islands or something.
Let’s begin with going back to the basics of what a note is. How would you explain this to someone who has never even heard this term before or maybe is familiar with something like a note but doesn’t understand it in the world of real estate investing?In its most basic form, a note is a promise to pay, and this can take on many other forms. Click To Tweet
In its most basic form, a note is a promise to pay. This can take on many other forms. We’ll try to keep it focused on real estate. Most people are familiar with a mortgage, taking out a loan to buy a house. In our world, when we say note or note investing, it’s first position. It could be second position. A note is a promise to pay. I go into a bank, I get a mortgage to buy a house, the bank gives me $250,000 and I promise to pay that back over time. Typically, it’s in monthly installments with interest. That’s the promise to pay.
The note is a document. It’s pretty simple. It’s normally 2 to 4 pages. There’s not much to it. It spells out the terms of the promise to pay. That note itself in our world is attached to collateral, which is the real estate and that’s where people argue, “Is note investing part of real estate investing? Is it a separate niche?” It doesn’t matter. It is but its own little niche. The note is attached to the property by a mortgage or deed of trust depending on the state. To more specifically answer your question, a note is a promise to pay. In the real estate space, a note is backed by hard real estate. If I don’t pay the bank back, the bank can take that property from me.
I want to get into acronyms as well. You mentioned a couple of terms that some people may not be familiar with. You said first position or second position. What do those mean and how do they relate in very simplistic terms?
The first position is also referred to as first lien and second position is second lien. When the bank lends me money as a borrower to buy a house, they take on first position if there are no other mortgages or liens on the property. That means that the bank has a right to collect their money. If not, they have a right up to that amount that I owe them. The first lien or first position means that mortgage or that note, if you will, has the first right to all of their money back. Normally, that’s dictated by the order that the note was recorded.
Let’s keep it simple. I walk into a bank, a $250,000 loan from the bank to buy my new home. That bank will then record that mortgage or deed of trust that shows that they are in the first position. If I then go and take out a HELOC or a second mortgage, another loan on that property that I live in, that new lender could be the same bank. That second loan is now in the second position. There’s more risk there. Let’s say the house is worth $300,000. I took out a first position mortgage for $250,000.
Let’s say I go get another small line of credit for $20,000. That line of credit is going to have a higher interest rate most likely because there’s a higher risk for that second lender. They don’t have a strong position as that first lender. That first lender has the right to collect their whole $250,000 before the second lender gets anything. It’s normally dictated by how the order that the loans were recorded. In somewhat simplistic terms, that’s what a first and second position mortgage or deed of trust is.
In a way then, if you are a note investor, you’re almost acting like the bank.
Correct. You’ll hear or see people disagree over whether you’re a lender if you are originating the loan or not. You can get into all kinds of semantics in this space. You are acting as the bank or the lender when you purchase a note that was already originated. That’s the world that we operate in. We don’t originate notes. I’m not underwriting a new borrower to see if I will lend them money. Someone else has already done that and that’s typically a bank. It could be a seller financed transaction or lender. That’s the nuance where some people would argue. We’re not the bank because we didn’t underwrite them. We didn’t originate this loan and lent them the money. That was already done. In many ways, we take on all the rights that the original lender or bank had at that time.
How does that work? When you think about a bank or you think about a typical lender, they’re usually FDIC insured or have some other means to back up their license. There could be these other factors that allow them to do that. If you’re a note investor, is there anything special that you have to do to be able to take on that risk?
There are state-by-state requirements to be a note investor. In general, it’s a largely unregulated space. Frankly, I don’t think most people anticipated as many note investors as there are. Before 2008, 2009, I don’t think there had been such an influx of nonperforming loans. I don’t know that too many people foresaw this situation where we have all these note investors. Oftentimes, the law and legislation are behind reality or the free market. I’m not a bank. I don’t have to follow certain banking regulations.
Banks also are able to do other things. They can get into fractional-reserve lending, where they can lend money that they don’t have, which is crazy if you think about it. I can’t lend money that I don’t have. They have to follow certain regulations that we don’t have to follow. The NMLS is a site to check out if you want to research licensing for note investors. In most states, you can operate without any debt collector license.
I do recommend people use a licensed servicer if they’re buying notes that are for owner-occupied property. When you get into Dodd-Frank and CFPB requirements, there are more strings attached when you’re operating in the owner-occupied space, which is where we operate primarily. If you’re dealing with fix and flip notes, credit card loans, auto loans or something like that, that’s a whole separate animal. In general, there aren’t too many requirements as far as licensing goes or red tape if you will.
If it’s just me and I’m like Joe Schmo over here, I don’t know anything, I could log on to the NMLS and try to find a note. If I have capital, I can be like, “I’m going to purchase this.”
Yes. Always seek legal advice. I’m not an attorney. Katie is not an attorney. Check the NMLS. That’s not a source for notes but that will give you state-by-state requirements. It does vary. One thing that a lot of new note investors underestimate is how much being a note investor can vary based on the state. Another thing that people ask often is, “I’m in California. What requirements are there for me?” It isn’t about where you are. It’s about where that house, that property or that note is located.
If I’m going to buy a loan in Georgia, you need a lender licensed in Georgia to buy a note. You will get varying opinions on this. Based on the legal feedback I’ve gotten, I’ve been told, “Don’t purchase any notes in Georgia on owner-occupied properties without a lender license.” We went and got our lender license, which did require a good chunk of change. It’s not cheap but it does separate us. Chris has his lender license as well in Georgia. To me, it makes more sense. There aren’t that many legal requirements in this space. Why not comply with the ones that do exist?
If you are brand new, you don’t necessarily know where to begin. You’re interested in, “How do I begin to research?” You mentioned owner-occupied versus non-owner-occupied. If you’re a newbie and you’re trying to figure out, “Where do I even begin? What would be right for me?” Is there a place that you recommend? It’s like, “Start here. Think about yourself and what your goals are and begin to look at it from this lens.”
You should go to our website, LabradorLending.com. We do have a free eBook and a lot of other resources. Chris has a ton of resources on his site. Go back and read all of our previous episodes. This note space is all about networking and asking questions. It’s not a clearly laid out path for you. One of the things I love about it is you can make it what you want. At least in the note space that we run in, most people operate in the owner-occupied world. We have had some guests on our show that buy more fix and flip loans and do commercial loans and things like that. Those tend to be lumpier and more active.There are state-by-state requirements to be a note investor, but in general, it's a largely unregulated space. Click To Tweet
A fix and flip loan, if you think about it, a normal rehabber is trying to get this property fixed up within six months let’s say. An owner-occupied property, the average time that people refinance or move is closer to seven years or something like that. Whether you should play in the owner-occupied space or not, some of it will come down to deal flow as well. Right now, deal flow has been challenging for a lot of people. There aren’t as many notes floating around as maybe there were years ago.
You might think, “I’ll get into the fix and flip space as a note investor.” If there are more owner-occupied notes available, you might go that route. Normally speaking, most people end up going down the owner-occupied space. Another key difference between the owner-occupied and fix and flip or commercial space is that you have a much better chance of working out. If you’re buying nonperforming loans, you have a much better chance of exiting through the borrower on the owner-occupied side. Oftentimes, they want to keep their home. They don’t want to be kicked out of their home.
If you’re operating in the fix and flip note space, you have a higher chance of exiting through the property, meaning you’re going to get that property back. That’s for nonperforming owner-occupied versus nonperforming fix and flip. If you’re somebody who’s trying to work with borrowers and you want to keep them in their homes and you prefer to exit through the borrower versus the property, the owner-occupied side is probably more for you. There are all kinds of strategies, performing versus nonperforming partials, joint ventures, and things like that. I’m trying to keep it somewhat basic here. Hopefully, that answered that question.
I also want to talk about the strategy piece. If you think about investments, in general, many people think about, “I want to invest in something.” Their considerations are, “How much money will that take? How much time will that take? How much knowledge will that take?” For example, I’ll use the stock market as an example. Let’s say that you have your 401(k) and you’re going to invest in the stock market and you are not familiar with individual stocks. You choose an index fund that’s close to when you’ll retire. It’s passive. You’re not in there every day like, “Let me leverage each of these little pieces of this puzzle to try to get ahead of where the market is performing.” You’re like, “I’m at my job every day. I don’t know what I’m doing. I’m sticking my money in an index fund.”
When it comes to note investing, you could probably look at it in the same way. Do you want to be “active?” Do you want to be “passive?” If you’re a newbie, if you were someone like me and I’m trying to think about my strategy, “I have my day job. I’m part-time real estate investing. How do I even begin this?” Do I think about my strategy of maybe I need to partner up with someone who knows more about this than I do? Can I leverage that person as a resource to learn this? How do I know if I should be active or passive? I’d love for you to put some framework around that for someone who’s like, “Where do I even begin?”
I did a short YouTube video, 5 Key Decisions for New Note Investors. This is one of them. In one of our blog post that we have on our website, Steven Burke wrote it and I helped edit it. It’s the most thorough and most informative blog post we have. It may seem like I’m taking a cop-out here but by pointing people to that instead of answering the question, they will go into the weeds a lot more than I’m about to. I want to let people know about that. It’s this whole passive-active thing. First of all, you may not have everything figured out, most people don’t. Let’s be real. You don’t know what your life is going to look like in a few years.
On some level, you do need to roll up your sleeves, test the waters and then pivot. If you buy a couple of notes and then you realized, “This isn’t for me,” that’s fine, too. Don’t approach it by thinking, “I’m locked in for the next decade on whatever I decide today.” It’s my two cents on that. With all of that said, there’s a spectrum of passive to active in the note investing space. A lot of the gurus out there will sell the idea, “Note investing is passive. You sit back and collect mailbox money. It’s easy.” It’s not that easy.
Chris and I try to keep it real on the podcast. There are ways to be more passive. You’re talking about the index fund like I have in my TSP, which is the government version of 401(k). I’ve got the lifecycle fund and it automatically adjusts from stocks to more bonds as I get older. It’s extremely passive. I don’t know that you’re ever going to be quite that passive as a note investor. There are note funds out there. Chris and I have a note fund. Probably the most passive way to go is if you can get into a note fund or maybe buy partials. We’re touching on some weeds here but we’re not in the weeds yet.
If you want to be passive, there’s a scale of passive to active note funds. It’s super passive, relatively speaking. Performing loans are more passive than nonperforming loans. Buying partials are probably even more passive than buying a performing loan yourself. Getting into the nonperforming space gets more active. When we say active, you’re mostly sitting at a desk with your computer and your phone. There’s a lot going on, especially if you decide to scale and buy more than a handful of notes. It’s not physically active. It comes down to how do you define active, how do you define passive, and what your goals are.
Some people do find that there’s too much paperwork. You’re like a conductor of an orchestra where if you’re scaling on any level and you get into nonperforming notes, there are a lot of moving parts. You’re dealing with attorneys, servicers, vendors, property preservation companies, and borrowers. You got to make sure you’ve got force-placed insurance, other vendors, property taxes, the county, and city personnel. That doesn’t sound all that passive.
I’ve rambled a little bit on that answer but you can make it what you want. You can buy a performing loan or invest in a note fund through your self-directed IRA, for example, and be pretty darn passive. I have more than one note but one of the notes I have in my self-directed IRA pays every month. I don’t give it much attention. That’s slightly more active than buying an index fund but not much. You can be passive if you want to but if you decide to scale or get into nonperforming loans, forget the whole passive thing because it’s active.
If you decide that this is a direction that you wanted to go as an investor and you want to begin to dabble in the space, you’ve mentioned partials. I would love for you to explain what that is. Do you feel like that’s a good gateway in for many people that are getting their feet wet?
Yes. You can structure your partials in different ways. Consult with your attorney. Let’s say I bought a performing loan. Partials work better with performing loans to be clear. A performing loan is where the borrower is paying. They’re in their home and they pay their monthly mortgage payment on time like most people do. That’s what a performing loan is. It’s where the borrower is making payments pretty much on time. I want to clarify that. I would not sell a partial loan and a nonperforming loan.
To walk through a basic example of a partial, let’s say Labrador Lending owns a whole note that has a principal balance of $100,000. Let’s say the borrower is making on-time payments of $300 a month. I’m making this up. If I would prefer to take a lump sum of cash and reinvest that into another note, I could sell you a partial and then you would collect those $300 per month payments for the next X number of payments. Let’s say I sell you a partial loan for three years. I bought this note that has a principal balance of $100,000. It’s performing.
Let’s say I bought it for $75,000. I can sell you a partial for the next few years and you would collect those payments. I would take that lump sum of cash that you paid me for those payments. I could go reinvest that elsewhere. It’s a business decision. Buying a partial can be more passive than buying even a performing loan. Yes, it is a good way for a newer note investor to partner up with the note holder, the note owner, and approach note investing in a more passive way than buying a whole loan themselves. There are many ways you can create these. Some people involve their servicer in the partial payments and some people do not. That’s in the weeds.
You can get into Note Partials vs. Hypothecation, which we have on our site as well. It’s a good place to start. Let’s say you don’t have a whole lot of money or you’re not maybe an accredited investor and you can’t find a good note fund for non-accredited investors. A partial can be a great way to go. Get exposure to the note world. Buying a partial can be a great way to get into the world of note investing without being 100% responsible for everything you’re familiar with how things work.There aren't that many legal requirements in the note space. So why not just comply with the ones that do exist? Click To Tweet
If it was me and let’s say that I was like, “This is something that I want to dabble in.” We’re using your example of the $100,000 note that you paid $75,000 for. If it was me and I was like, “Jamie, I am interested in this. I want to invest.” From my point of view, I would be looking to pay a certain amount of money out of my pocket. Let’s say it’s $20,000. I would put that $20,000 into this note and it would be going to you. You’re then giving me partial ownership over that note.
Every month, I’m collecting an agreed-upon dollar amount because this note is “performing” where there’s somebody paying that. I’m receiving that dollar benefit every month for the lump sum of cash that I provided to you in exchange. I’m then able to use your knowledge and your resources. If I come up against this situation or we collectively are in this situation where maybe I wouldn’t know how to proceed on my own if I was out there trying to figure this out from the start. You might be able to give a little bit of guidance because you have skin in the game.
People do it differently. I sell my partials where I am still active. I have skin in the game. I don’t want to sell you the next three years of payments and then you have no idea what you’re doing. You can screw things up and then all of a sudden, the loan is mine after that three-year period. I still have an interest in this borrower performing and this loan paying. You’re right. I still have skin in the game. The way I do my partials, I’m still active as a partial seller.
Yes, you could rely on the partial seller for information. You’re not going to be calling every day, “Let’s go over this deal together.” In reality, the way I do it is we use Podio. I’ll give the partial buyer access to that particular asset so they can see what’s going on every day with it. Someone else might do more of a true transfer where they’re like, “Katie, this is up to you now. Good luck. I’ll talk to you in three years.” We don’t do it that way.
You can also get into joint ventures, which is a separate topic. Joint ventures are a little more together, meaning the big decisions are made together. The way our partial agreement is written, if the note does go nonperforming, there are different exits that you and I could agree on as to how we want to exit that partial deal. If the loan pays off, sometimes the borrower pays off the loan and it’s like, “Now what?” That’s all written into the agreement ahead of time. As a partial buyer, you are backed up. You still have that same collateral in the sense that I, as the note holder, had originally.
One thing about notes is people say, “Real estate is risky. Note investing is risky.” Stocks have no collateral. We assume that you go get a job and everybody signs you up, “You have to opt-out of the 401(k).” It’s almost forced upon you because that’s what you’re supposed to do. I’ve heard that the guy that created the 401(k) never intended it to be this massive tool or the only tool for retirement. That’s a whole rant that I could go on. We have money in stocks. I have a TSP. I’m not an anti-stock market. Because you’re unfamiliar with notes, it doesn’t make it risky. You need to learn about it like we’re doing here and then understand it. You can invest in what you know. You can approach it while you mitigate some of that risk.
That’s why it can seem a little bit nebulous to people. It seems like, “What exactly am I investing in with real estate you understand?” I could purchase this house and I can take a hammer, some nails, fix it up, paint it, and rip out the carpet. I beautify this location. I’ve created equity in it. A lot of people understand that entire process. When it comes to a note, it seems a little bit more like, “How do you create that?” I’d love for you to talk through the example that we gave where you’re saying you bought a mortgage that’s $100,000 and you bought the note for $75,000. How exactly that process works? You’ve mentioned owner-occupied. How are they involved in making those payments so that the end receiver, which is you and I, are making money off of this and it is an investment? Break that down.
The way I do try to help people think about it in that vein is that a performing loan is truly more like a buy-and-hold rental property. You buy a performing loan for cashflow. Hopefully, you can get it at a nice discount when you purchase it. $75,000 for a true performing loan is a pretty good price right now, assuming a lot of factors. Although it doesn’t come with note investing, that has no inherent tax benefits. Chris and I have done one episode on ten reasons to invest in notes and another episode on ten reasons not to invest in notes because there’s no perfect asset class. I encourage the readers to go back and read those.
Buying this performing loan is more like a buy-and-hold rental property. You’re looking for cashflow. Leaving the partial out of it for now. I’m buying this $100,000 loan. Originally it was $120,000 but now we’ve already paid down that principal balance to $100,000. I might be able to purchase that for $75,000. I’m collecting those $300 per month payments. It’s for cashflow. You’re not going to be able to add a whole lot of value to that deal itself like a rental property that you buy on the retail market through a realtor or on the MLS. You’re probably not going to be able to turn around and sell it in six months for way more because what value did you add there?
A performing loan is more like a buy-and-hold rental property. There are certain tax benefits to rentals that notes don’t have. A nonperforming loan is more like a fix and flip property. There are multiple ways you can exit the deal. As a new note investor, I would assume that any nonperforming loan is going to take you 6 months to 2 to 3 years to exit. It’s not quite as quick as a fix and flip maybe. In that example, you’re buying it at a larger discount, a greater discount, and you’re able to add value to the asset itself and then exit at a profit, hopefully. A performing loan is more like a buy-and-hold rental. A nonperforming loan is more like a fix and flip property.
When you’re buying the note, you’re buying the debt. You’re becoming a lender and becoming the bank. You still have that hard real estate as collateral. It’s backing up the loan. People who are unfamiliar with note investing that have a real estate background, whether that’s as a realtor, a real estate investor, fix and flipper, that helps, for sure. That’s where it’s a niche within real estate investing. You can be a software engineer and be good with Excel and running numbers and be somewhat unfamiliar with real estate and be a successful note investor. Everybody has strengths and weaknesses.
Marketers are also living in Excel.
You’ve told me that before.
When I think about the actual exchange of money in this situation, this is what I want to go back to touch on. If you have a mortgage and every month you’re paying your mortgage, you have your principal balance and then you have the interest that you’re paying. For our example, we’re using $300 a month in this situation. The $300 is covering this principal balance plus the interest.
It might be a little low but that’s the number we went with.
These are not relative to real life, the numbers we’re talking about here. In that situation, the note investor, you and I, we’re receiving that benefit every month. Just like in a mortgage, over time, your principal balance is paid down and the interest is less of that payment. It works the same way for note investors. How does it stay profitable for you to be a note investor with a performing loan over a long period of time? How long do I keep this thing?A performing loan is more like a buy-and-hold rental property. There are certain tax benefits to rentals that notes don't have. Click To Tweet
Some note investors will not buy loans that have less than 100 payments left or something like that. You’re right, a higher percentage of that payment each month is principal. You’re, in a sense, getting your money back slowly. Why not hold that in the beginning and not buy that note? If you’re a note investor and you buy performing notes or even if you buy both but you’re targeting a performer right now, you have a particular yield that you will accept. Your performing note calculator should adjust based on the factors we talked about.
The short answer is you’re buying that loan at a greater discount than you would for the same loan earlier in the amortization schedule. With that said, that loan also has a stronger pay history, most likely. If there was a note that was originated two months ago, yes, those payments are almost all interest but there’s not much of a pay history there. There’s a greater risk there because you don’t know what this borrower is going to do. Even if there’s equity in the property, you don’t have a strong pay history.
At least when you’re buying more seasoned loans that have fewer payments remaining, you have a stronger pay history. We’re assuming that. There’s more of a history of payments having been made. We don’t know what that looks like and it’s hypothetical. You’re right, more principal is coming back. You build that into your numbers going in. You should be able to get a loan that’s closer to maturity at a greater discount because it’s largely your own money coming back to you. Hopefully, that answers that one.
How would someone who has a mortgage ever have their mortgage or this note not be held with the bank? How could that even happen? I think about my home and my mortgage and it’s like, “How would my mortgage ever not be with the bank that it is right now?” Why would someone find themselves in that situation? Does that inherently mean that it’s not safe to invest?
There’s been a growing sector of borrowers that can’t qualify for a traditional loan. Even though interest rates are super low, lending institutions make their own underwriting guidelines for the most part. They don’t have to lend you money. If you are deemed an unsafe borrower or too risky for their guidelines, they’re not going to lend you money. You may be a self-employed individual who has poor bookkeeping habits or you have a good accountant. You’re not able to show on your books that you make as much money as you do. There’s a downside to that. Everybody wants to pay less in taxes. It’s like, “From the bank, show me that you’re able to afford this loan. Where’s your income?” “I don’t have any income.” “You’re not getting a loan.” Maybe they fell on hard times. Bad things happen to good people.
Also, another whole sector of this is mom-and-pop landlords. One thing that I underestimated years ago when we got into rentals is how challenging it could be to get a loan through an LLC. It’s not super challenging but it’s harder and the terms aren’t as good as compared to if I walk in even on an investment property that I own personally. You can get better terms and better financing. There’s more financing available for someone that owns a rental in their personal name. It could be mom-and-pop landlords who aren’t able to qualify for a bank loan.
The whole world of non-institutional lending is seller-financed and owner-finance. As an example, we have a condo that is a rental. We’ve had the same tenant in for over eleven years. He’s awesome. He used to come to our house and drop off six months of checks twice a year and pretty much, we’d never hear from him. We were considering selling that to him as an owner finance transaction. He’s getting up in age and it probably doesn’t make sense for him to own at this point. He’s happy remaining a tenant. We could have or we still could sell him this condo and then create a loan, whether it’s ourselves or through an actual originator. We become the bank in that sense. I wouldn’t have nearly the same underwriting guidelines as a bank. I know him and I know he’s good for it.
We released the Justin Bogard episode. Justin plays in the owner finance space. He doesn’t even buy bank-originated loans. The whole at Eddie Speed world, owner finance, seller finance, that’s a whole niche that is growing, frankly. If you want to be a note investor, you’re probably going to get a greater discount. To circle back to a part of your question, it’s because the underwriting wasn’t quite as strong as a bank would be. Maybe the paperwork is screwed up a little bit. Even if it was written through an attorney, that doesn’t mean it’s perfect. You probably should get a greater discount if you’re buying a performing seller finance note versus a banknote that is theoretically stronger.
Are there certain dollar amounts that you normally see notes for related to mortgages? Do you see notes for mortgages that are $500,000 or $1 million? If someone has a $1 million mortgage, could you ever purchase a note on a $1 million mortgage? Are there more notes available for mortgages that are $500,000 and less?
I don’t target your state for any mortgages. It’s too expensive. You don’t see them. You can buy a decent house in the Midwest for $100,000 still even with property values going crazy. I’m talking principal balance, not purchase price per se. $25,000 to $250,000 is a good range. Honestly, $25,000 to $100,000 is probably the majority of the notes that we buy. The interest rates are higher. There are potentially more issues with them. It makes that niche a little less passive.
You can buy loans that are $500,000 or more but there are fewer of them and the discount is probably going to not be as good. You’re going to have to pay more for that loan relative to the principal balance. The interest rate is going to be lower, most likely. What bank is lending millions of dollars to a risky borrower? There are hedge funds and people out there who want a 5% return on their money. It’s a pretty safe way to go but it’s not the world that we run in as note investors.
When you’re looking at notes that are in that standard $25,000 to $100,000, that means that as a note investor, that would be my potential out-of-pocket that I’m paying to acquire that note if it was me and we’re not doing any partial or split. From an investment standpoint, if you’re like, “I want to get into investing but I don’t want to purchase a mortgage on a home that’s $200,000. Maybe I could put $20,000 into a note and have a higher interest rate there and start to receive that benefit.”
One of the downsides to note investing is it’s pretty capital intensive, at least initially. You do need money from somewhere. In the beginning and if you’re going to scale, you need to find more money. That’s why a lot of note investors decided to go the fund route where they raise capital. It’s difficult to walk into a bank and say, “I want to buy this mortgage. Can you give me a loan to buy this loan?” It’s challenging. You can sell a partial or hypothecate, which is a loan against that loan. They’re similar but that’s after you’ve purchased the note. You need that capital upfront to buy the note.
It is one of those hurdles that people have to overcome if they want to become a note investor. I know the whole no money down stuff. It’s still a good idea to have some skin in the game. If you can BRRRR it and get all your capital back out, great. If you’re talking about investing, that means you have the capital to work with whatever asset class we’re talking about. The same thing with stocks, you need money to invest in stocks. You do need some capital to buy that note.
If you’re going to begin and let’s say you have the capital, many times when you think about other investments, you think about the key players that would be on your team to make this investment successful. For example, if you’re going to invest in the stock market, maybe you have a trusted advisor that you work with. You have your contact at Fidelity or wherever your money is parked that you could work with. If you’re a note investor, who are some of those key players that make up your team?
The first one is a marketing rep.
We are the most important piece of the little puzzle here.Buying a partial can be more passive than buying even a performing loan. Click To Tweet
There are note investors who don’t market at all and they like it that way and they’re successful. A brand new note investor should certainly give this thought. It’s a great question. That said, don’t use it as an excuse not to get started because things will change anyway. Your team is not set permanently. Much of this varies by state. It does depend on where you’re going to be buying your notes oftentimes, especially on the attorney side.
One other caveat is once you buy a note, it normally takes 4 to 6 weeks for that to transfer to you. This is not like a stock where it’s overnight. You don’t need all the answers right away. Brandon Turner uses the analogy of driving in fog. You don’t see the entire road the whole time but as you drive further, you see more of the road than you did twenty yards prior. My caveats are out on the way now. You need a licensed servicer. This gets back to your question you touched on a couple of times. The servicer collects your payments and that’s their primary function. They can do a lot of other things. Many servicers do many other things besides collect payments and send the payments to the lender or the note investor. That’s their primary function. You need a servicer.
The servicer is the intermediary between the person that’s making the payments and you.
It’s between the borrower and the lender.
They’re not knocking on your door every day and saying, “Here’s your monthly payment.”
They also prepare your tax forms. Hopefully, their books are in order so that they can give you accurate accounting records. They are critical. Chris, me, and Shante have our new servicing company. BIFI Loan Servicing. We’re not fully licensed in all states or even the states we’re planning to be licensed in. I recommend people check us out. We’re not fully functional yet. We’re excited about the future. There are many other good services out there as well. You do need a loan servicer.
I recommend having a bookkeeper. We use Debbie Mullins. Some people do their books, that’s fine. You should know what you’re doing. It can be yourself initially. You should be thinking, “If I’m going to scale, I should probably find a bookkeeper,” or at least a CPA who’s familiar with this because note investing is different than other niches. I would say a servicer, a bookkeeper, and an attorney. It’s good to have a business attorney in your state that you reside in or that your business functions out of.
Also, start thinking about which attorney you might want to use, especially if you’re dealing with nonperforming loans where you think you’re going to be heading to foreclosure or even sending a demand letter. Starting legal on that particular note, you’re going to want a qualified and competent attorney in that particular state. This is where it varies. An attorney who’s great in Georgia might not be great or might stop practicing next year. Be ready to tweak your team members. That’s a key one as well, a servicer, a bookkeeper and an attorney. You have all kinds of other vendors as well like property preservation companies and things like that.
Do they have to be a real estate attorney?
Yes, they should be.
You mentioned this a couple of times but do you recommend that newbies invest as themselves? Do you recommend that they start some business like they become an LLC or a corporation before they begin investing?
I started LLCs in an hour online. I don’t think it’s that challenging. It does add some complexity to your tax filings and things like that. I don’t mean that I’m smart or something. We’ve got a bunch of LLCs, some for rentals and some for notes. Why not take that extra step and open your bank account with your LLC? You need your EIM. It’s not that many steps. To me, you’ll see these arguments about insurance versus LLC. It’s like CPAs versus attorneys. I don’t know why you can’t do both.
If you’re going to get into this, especially if you’re buying land contracts, we can save that for another episode. CFD is a whole separate animal. Especially if you’re buying CFDs, your name is on the deed. I don’t want my personal name on the deed for protection purposes. It’s smart. It depends on how many assets you’re going to buy. It depends on what your risk tolerance is. To me, the only assets we own that are not in LLC or some business entities are owned in self-directed IRAs. I don’t know to own any notes in my personal name.
It seems like it would be not just more protection but a little bit of a cleaner process as you want to scale and grow because then you don’t have to backtrack to try to move any of your investments into it eventually if you’re like, “I want to treat this as a business now.” It’s like, “How do I move everything that I had before now into this?”
You could do an assignment. The other thing is I don’t want borrowers calling me personally. It’s creating that separation not only from a lawsuit standpoint but also day-to-day anonymity standpoint. I personally feel more comfortable operating out of an LLC. Other people use trusts and they’re different. It’s not just LLCs but I do recommend getting an attorney. I recommend some firewall there. Also, are you professional or not? Do you want to be receiving statements as a borrower from your servicer with Katie Berlin as my lender? No offense.
Something about this corporation seems a little fishy.You need capital upfront to buy a note. It's one of the challenges that people have to overcome if they want to become note investors. Click To Tweet
I know California is more expensive. As a quick aside, I’ve sold partials to someone in California. Eric Smith was on our podcast. Hopefully, he doesn’t mind me sharing this. He got advice from his CPA that because he was going such the passive route, he makes good money from his job. He’s not an active note investor. He buys partials and things like that. It didn’t make sense for him to continually file and pay $800-plus a year in California for this LLC fee. It didn’t make any sense. He switched it over to his personal name. It’s an example. If you’re going to get active in any way, shape, or form in this business, why not use an actual business entity?
On the idea of seeing your loan through all the way to the end, regardless if you’re active or passive, we talked about exit strategies a little bit. Let’s say that you finally get your funds and you’re like, “I’m going to do this.” You buy a partial. You’re in it now. Let’s say it’s me. I’m buying a partial. I put $20,000 into this $75,000 note that we had. What happens next? I’m receiving my monthly payments but then I’m like, “Does this go on forever? When does this end?”
You’re buying a partial as a set number of payments. For my partials, it’s pretty boring. From your standpoint, ideally, you’re getting a payment every month and that’s it. That’s the whole point. It’s not like you’re a joint venture or you’re buying your note. It’s all set ahead of time on a partial as far as the end date for you. From my perspective, the person who bought the performing loan initially, because it’s performing, your only exit strategy is to sell it to another note investor or wait for it to be paid off.
A nonperforming loan is a whole separate animal. You try to guess what your exit strategy is going to be when you purchase the loan, an educated guess, but you don’t know how it’s going to turn out. That’s okay because you’re comfortable with whatever exit you have to take. Ideally, you’ve mitigated the risk upfront and purchased this at a decent price where you can still profit whether it goes through the borrower or the property or if you end up selling it. It’s a whole mix of different exit strategies but it’s more complicated on the nonperforming side.
I want to talk about that a little bit with the performing to close this loop. At the end of the day, the loan eventually gets paid off, and then there’s no more loan in an ideal world. In that situation, we made the equivalency here of a fix and flip as almost like a nonperforming if you’re thinking about the real estate world versus the note investing world. If you have not a nonperforming loan and you’re maybe a newbie and you have a passion for risk and you want something that maybe keeps you up at night and you’re like, “Let’s add more spice to my life. Maybe this is the direction I want to go.” If you decide to go that route and let’s say that you are well-versed in this area but you’re like, “This is my first forte into nonperforming.” What are some of the tools and tactics that you use to determine, “How do I know if this is going to be a successful investment? How do I know what my exit strategies are?”
One thing I will say is performing loans aren’t always less risky than nonperforming because of the discount you’re getting on these nonperforming loans. In our $100,000 principal balance example, I might be able to buy that for $40,000 versus $75,000 or $90,000 on a performing. Right there, you’ve mitigated a good bit of risk because you paid a lot less for this deal. When you’re approaching a nonperforming loan, almost all of this comes down to what the borrower is going to do. You can help educate them or work with them.
One of the things I like about this is trying to make these exits a win-win all the way around, a win for the borrower, a win for the lender, a win if you’re selling the loan for that person as well. Once you’ve done this for a little bit, you realize there are only so many exits that the deal could take and you have to be comfortable with that. The key piece is communication, whether there’s actual communication with the borrower or not.
When you’re purchasing a loan, you should be able to get access to the pay history as well as the loan servicing comments. You can see the communication between the servicer and the borrower. If there hasn’t been any, it’s more likely that you’re going to exit through the property. We have some loans in New York where I cannot get a response from the borrowers. We’ll serve them with different options as far as the short payoff. This would be a whole separate episode as far as exit strategies for nonperforming loans.
Cash for keys is another one. Many people are familiar with that on the rental side. I’m paying you $1,000 to give me the property. Give me access to the property or give me the property back and we’re good. Even though you owe me a lot more, we’re good. We’ve done that. We did cash for keys in Jacksonville, Florida, and now we have a strong rental property there. You don’t know how it’s going to exit but you can get a sense that there’s communication. They lost their job and now they have a job again.
You can see from the communication trail between the borrower and the servicer or the borrower and the previous lender where you think it might go. Has the person filed for bankruptcy multiple times? Is there equity in the property? If there’s a lot of equity in the property, the borrower knows that as well. There’s a good chance they might file for bankruptcy. Nowadays, with market conditions, you’re not seeing a lot of short sales and things like that because most people have equity in their homes right now. It’s a different set of circumstances but you can get a feel based on the history of the note itself.
There is another tool that you use on nonperforming as well.
I do approach performing loans with a performing calculator as far as creating a bid on that note itself. I use the IPA by Revival Brothers. It’s the ideal project analyzer to run our numbers for nonperformers. There are other products out there but that’s the one that I like. It’s Excel-based. You can run calculations through multiple exit strategies. It’s up to six different exit strategies in one calculator.
As soon as you put your numbers in, it’s wrong. To be clear, you cannot predict exactly how this is going to go. You have to be okay with that. If this goes to foreclosure, how’s that going to look numbers-wise? It costs money to buy this calculator but you can save yourself a lot of money and heartache in the future if you’re not overpaying for it. Part of your pre-bid due diligence is running your numbers and researching that property as best you can. I use CIPA. I also enjoy doing IPA sometimes. We use the IPA calculator by Revival Brothers.
It would seem like if you are unsure of the direction you want to go, not to analysis-paralysis level but being able to review them and have that gut check gives you the extra courage. If you’re having an IPA at the same time, it can give you liquid courage plus financial courage to say, “I’m going to venture into this space.”
If you get into the arena where you’re running a fund and you’re bidding on 100, 200 loans at a time, I’m not going to sit here and say that I’ve run everyone every single bit through that calculator every time. If you’re a new note investor, I would not recommend bidding on nonperforming assets without some financial calculator. I’ve seen this where people are bidding on 10 to 20 loans. They’ve never bought a note before and they’re not running any numbers.
You get into this disagreement or split in the note space where you bid on a percentage of unpaid principal balance versus yield. This is in the weeds. Performing loans, you should bid based on yield. Meaning, what’s your projected return going to be? You should also see what percentage of your principal balance your bid is. On the nonperforming side, the calculator does both. It shows how much of a percentage of UPB as well as yield. It’s harder to quantify that yield on nonperformer payments.Performing loans aren't always less risky than non-performing loans. Click To Tweet
One more caveat I’ll throw in there is, a lot of notes do not fit in this bucket neatly. A lot of notes are self-performers. They’re performing but not really. There’s a lot of grays in this space. Having a strong calculator gives you that confidence. The math doesn’t lie. It is what it is. The thing with that particular calculator that I enjoy is you can save it as a one-page PDF and send it to someone that may be a joint venture partner or someone that you’re potentially buying this loan with. It gives you a quick synopsis of the deal with a picture of the property and things like that. It’s not just numbers on a spreadsheet, it’s pretty as well.
It’s helpful for those who maybe do not live in Excel all day long.
We covered a lot of ground. It’s helpful to understand the differences between performing and nonperforming. We touched on the team that is helpful to have in place, the potential out-of-pocket that you’re spending when you first dive in, and how best to work with someone potentially. If you want to get your feet wet and if you need to have a business to go for this, can you maybe try one in your personal name if you’re doing a partial like your reference, Eric? That was his process. As a newbie, it seems less scary when you break it down. As a newbie for myself, having tools like the calculator, understanding who I need on my team, and then partnering with someone would be the hand-holding that I need to jump in. It’s hard to part with a decent amount of money. It’s scary.
You also need workflow management and an asset management system. We use NoteRules, which is Podio-based. There are many other systems out there. If you’re going to buy more than a handful of notes, you’re also going to need a system for tracking that. We didn’t touch on that too much. Along with a calculator, which is more pre-bid due diligence, you’re going to need some asset management or tracking system to track all this if you’re going to scale.
I want to throw that in there as well. Chris also has a lot of resources on his 7Einvestments.com website. I’m not the only one with resources out there. We have a link to the NoteRules as well as the IPA calculator and a lot of other free stuff, blog posts, YouTube channel, and all kinds of stuff on LabradorLending.com. Hopefully, people can find some value there.
Can you leave a newbie with a note and bolt?
The one thing that comes to mind is there’s always a tension between the one extreme where it’s paralysis by analysis and then the other extreme where you’re throwing caution to the wind and not mitigating risk and not learning from others. It never goes away entirely. You have to find the right balance for yourself. When you feel comfortable moving forward, neither extreme is a good way to go. If you want to be a note investor but you never get in the game, there’s a lot of risks there because there’s opportunity cost. You might have a risk of regret. I never tried it. The other extreme is not safe either.
My note and bolt is to find that happy medium where you feel comfortable moving forward. Know that you’ll never have it all figured out. For me, the fact that other people are doing it, maybe I can do parts of that better in my mind anyway. I don’t have to reinvent the wheel, “This person over here is doing this well. I can do that, too.” I don’t need to have it all figured out initially. I don’t know how many notes and bolts are in there.
As Brandon Turner says, “You start driving and you see that’s 5 feet. Don’t let the entire process overwhelm you. One little step at a time.” Jamie, thank you for allowing me to sit in this seat to interview you. I appreciate it. Hopefully, we brought some knowledge to the audience if there are newbies out there like me that needed this little intro.
We covered a lot of ground. There’s a ton of rabbit trails we could go down off of this episode but we covered a lot. Thanks for filling in. Thanks for the good questions.
We’ll save all of those rabbit trails for future episodes. Once I take the plunge and I invest in my first note, then I’ll be like, “Let’s have a go with it.” It will be the story that we follow along with.
It sounds like a plan. To the readers out there, don’t forget to go out and do some good deeds. Take care everyone.
- Labrador Lending
- 5 Key Decisions for New Note Investors – YouTube
- Blog – How Passive is Note Investing?
- Note Partials vs. Hypothecation
- Episode – Top Ten Reasons To Invest In Mortgage Notes With James Bateman
- Episode – Why You Should Not Invest In Notes Today With Jamie Bateman
- Justin Bogard – Previous episode
- Debbie Mullins
- Eric Smith – Previous episode
- Revival Brothers
- YouTube – Labrador Lending
About Jamie Bateman
Founder Jamie Bateman has been an active real estate investor since 2010. Jamie is an experienced real estate investor and business owner who has been actively buying and selling mortgage notes since early 2018. During this time, he has acquired over 40 notes with principal balances in excess of $1.7M across 12 states. Jamie manages several small businesses and a multi-state rental portfolio worth over $2M. He has hands-on experience overseeing construction projects and managing properties. Jamie also has work experience in both the title and mortgage industries, having worked for years as a real-estate settlement officer, notary, and mortgage funding manager. Jamie served as a Captain in the United States Army, has held numerous leadership roles professionally, and maintains a high-level security clearance with the U.S. Department of Defense.
Jamie values integrity, consistency, and transparency. He takes pride in assisting those who are motivated to incorporate non-traditional investing strategies into their wealth-building plan. He also recognizes that sometimes homeowners come across challenging circumstances that necessitate creative solutions to help them stay in their homes.
Jamie loves to spend time with his family. A former collegiate lacrosse player, he also enjoys learning, leadership, faith, fitness, bourbon, fantasy football, and coaching youth lacrosse.