Gary,

Picking the meth lab situation as a focus.

How does a landlord have control over the setting up of the lab
compared to the lender? I would expect in both cases the resident who
sets up the lab does so without permission. Both the owner
(borrower/landlord) and the lender have a risk in this case.

Both the owner/landlord and the lender can walk from the problem and
try to write off their investment while limiting their liability. The
landlord/borrower/owner has a lot of exposure here while the lender has
almost no legal liability if they walk. I am not sure who actually has
the greater exposure and who can be forced to pay for the clean up. It
would vary by state in some cases. The EPA takes the view that a
contaminated site is not something a lender can be held liable for
while most of the time the past owner can be (past owner -> owner who
lost the property to the lender in a foreclosure).

So, why is the owner's position superior to the lender's when a meth
lab is involved? This was you example.

At a higher level many of the points you cite (junk yard, etc) are
either addressed by the terms of the loan agreement or are covered by
local government rules. The lender tends to have less interest than the
landlord as the lender has someone in the middle (the landlord) to deal
with the situations. There is little legal liability as a lender when
it comes to the items you have cited.

If the owner occupant is the problem why will the lender care about a
junk yard if the mortgage is paid on time? If the mortgage is not being
paid then the equity in the property is the main buffer. Any waste is
either a default in itself (as per the agreement) or can be chased up
by notifying the city, etc.

I agree that people can be dumb or do things that are not fun. I
question how some of the things you cite are an issue for a lender or
why the landlord's position is so superior. If the lender only made
loans to investors then the lender always has someone between the
occupant and the lender to chase up the junk yard, etc. Hence the
lender has many of the benefits of the landlord but without the need to
directly address the issues. For that extra benefit the lender lets the
landlord/borrower/owner keep the possible appreciation.

We can debate the merits in specific cases. What is more useful is to
agree that the two position are rather different. Apples to oranges.
Many of the things you cite are red herrings rather than practical
issues in that you have taken an extreme view for the lender but not
really address how the issue impacts the landlord when faced with the
same situation.

John Corey

Hugh,

As we have no numbers to view concerning default risks of pooled
sub-prime loans lets not even go there. Obviously we are not discussing
buying a large pool by someone on this list. If someone wants a share
of a pool they would be best to focus on an REIT that buys such pools.

Focusing on individual notes...

Lets be specific about the loan to value. If the loan is at 70% LTV
(30% of equity or junior liens above the loan) would you be as
concerned about default risk? Even if there is a default would you
expect the lender to be made hole at the end?


On the property management and 1031 'no management deals'...

On your other point you are correct that people are using the 1031 tax
code to sell and buy a TIC as a replacement. The TIC structure appeals
to many as it is very passive and produces yields of 7%. There is a
large question about liquidation. As the TIC owner has a fractional
interest in a large property with professional management who will buy
such a stake in the future? How will the person eventually liquidate
(death or not before)? Where can such a partial interest be listed for
sale and who is likely to be in the pool of potential buyers? At some
level the value of an asset is a function of the size of the pool of
buyers (liquidity). There is very little history so far of TIC
interests being resold and what sort of values were placed on such
interests.

I am in theory a fan of TICs but I am not sure that there will be a
balanced market when people want to exit. As the TIC will legally fall
foul of the 1031 code is there is a pre-existing agreement concerning
liquidation buyers are going in blind. It could be better for them to
pay the tax now (15% long term capital gains plus the rate on
recapture) rather than push off the tax bill.

John Corey

Ron,

Picking up on the default question...

- quote -

Think for a minute about if you were to stop paying on a mortgage/trust
deed that you owed on. What would happen.

Lets assume the note is secured and in 1st position. Little came come a
head of the lender's note. Property taxes would be the most common.

If the borrower fails to pay the property taxes, fails to maintain fire
insurance or some other minor items the lender can pay the cost (pay
the taxes, buy fire insurance) and add the cost to the outstanding
balance. Stepping in like this is a default on the terms of the
security.

If the person fails to pay the note as agreed then we also have a
default.

Foreclosure is where a lender is taking action to seize property that
was pledged as collateral for a note. The specifics depend on what is
in the security agreement (mortgage or trust deed) and based on the
laws of the state where the property is located.

Practically what happens is the lender hires a lawyer. The lawyer
manages the process. All costs of the lawyer are funded by the lender
up front and then added to the debt that has to be paid. The borrower
generally has two options. First is to bring current the loan by paying
all costs, fees, interest outstanding and then making payments going
forward. The second option is to pay off the loan including all costs.

If the borrower fails to bring things current then the property is sold
at auction. The lender submits the first bid and that bid is the amount
owed by the borrower including all costs, etc. If someone bids higher
the lender is paid off. If no one bids higher then the lender 'wins'
the auction and takes the property back. If the loan was made at a
conservative LTV the lender will have an asset that is still worth more
than the full costs.

In some states the borrower can have a specific right to redeem the
property after the auction. No all states do this and the time line
varies by the type of ownership occasionally (primary residence vs.
investment, etc).

To short circuit the foreclosure process the lender and borrower can
agree that the borrower will just sign over the title to the property
and walk away. It saves the borrower's credit compared to a
foreclosure. There is some risk to the lender when doing this if there
are junior liens as they transfer when the property is signed over. A
title search and title insurance will remove that risk.

John Corey

John wrote:
- quote -

The return looks good. Where do you buy them? What happens if the
property owner can no longer make payments?

--
Ron

John:

You are correct, the regulations I refer to are for mortgage
origination only. However, as you are most likely aware of, the
secondary market can be very risky when dealing with sub prime loans
that come with a high default rate and usually can only be profitable
in the long run when one buys a package of notes for a discount high
enough to offset the non payers. Almost all national firm sub-prime
lenders sell off these notes, mostly to foreign investors in bundles of
hundreds of millions.

I guess you can liken it to credit card lenders who choose to have a
very high rate of interest mixed with a mixed credit bag of clients or
to the holder of one junk bond versus a junk bond mutual fund holder.

You mention people fed up with property management etc and I find that
many real estate investors in that category are doing 1031 exchanges
for property that has no management responsibilities but offers the
same type of rewards of ownership with, at the very least, a delay in
tax consequence.

Good Luck

Hugh

Hugh,

Are the items you noted about Vermont's regulations specific to when
the loan is originated? Assuming that the loan was correctly handled
when it was set up (license, etc), what would stop you from buying a
note after the fact that was in excess of $40K? I am mostly focused on
the legal points you reference as opposed to business preferences you
might have.

You are correct about the insurance and taxes needing to be maintained
or the lender can step in and cure the situation plus tack the cost to
the loan when they collect.

No argument about which strategy is better for growth of ones wealth
vs. what strategy might be used after achieving a certain level of
wealth. Most note investors I know are RE investors who have gotten to
a stage in their life where they are less concerned about the capital
growth than the hassle associated with property management. Not all but
most. One exception is when someone is in a low appreciation area (much
of the Midwest). Some note investments will produce superior results
compared to property that is averaging 0% to 5% appreciation with flat
cash flow.

John Corey

John:

I am involved in real estate notes in the State of Vermont only and
only when they meet the following criteria. Only a first mortgage and
No more than $40,000 loaned and at 50% or less of appraised value and
for a 13 to 15% interest rate. This criteria is because Vermont has
some peculiar laws such as any mortgage over $40,000 must be
accomplished by a licensed mortgage broker but loans of $40,000 or
below don't and that in the event of foreclosure you must wait 12
months from filing BUT you receive the property (no auction) and the
owner loses it with no payments to compensate for their previous
equity. Needless to say the property normally is sold and you receive
the balance PLUS any accrued interest prior to actual foreclosure.
Good rate of interest and MINIMAL risk. As Gary states insurance must
be purchased by owner and maintained and taxes promptly paid and if not
this becomes grounds for foreclosure as is non or late payments. Have
been a mortgage broker in Vt and NH in the past.

Have only made two loans thus far but keep my eyes open.

I also own rental real estate and agree with Gary that I have made much
more equity gain and income in that area. HOWEVER I am a firm believer
of having as complete a circle of investments as possible with the
highest potential income with as little risk that is prudent.
Sometimes it works better than other times.

Good Luck on your investments.

Hugh

Regarding the math, the difference between landlording and note
investing is leverage. Say I have $50,000 to invest -- either in notes
or in real property. If I invest in real property by putting $500 down
on each of ten properties then I could generate an after tax after
expense cashflow of $250 per month per house, for a total of $30,000
annual positive cash flow. Thus, my $50,000 returned $30,000 in year
one, it does the same in year two, etc., etc., etc. Then the mortgages
are actually paid off and the cash flow would increase to $500 per
month per house, for a $60,000 per year of postive cash flow.

On the other hand I could invest in a note that, even if sold at a
steep discount, paid, say, 20% interest. You can do the math. At the
end of the day, I would have nowhere near what I had if I had invested
in the above described real estate and this ignores the equity built up
in the property.

As for risks of landlording, that can easily be managed by using legal
entities and other structures (such as IRAs and HSAs). Even then it is
very easy to pay a manager 4-7% of the profits and push nearly all of
the liabilities off on them. Thus, the risks can be reduced to nearly
nothing.

The reason why notes sell at a discount is the risk inherent in them.
What if the homeowner decides to set up a meth lab on the property?
You, as a note holder, have no say over that. The homeowner may even
call you and tell you how good the meth business is. What would you
do? I am guessing you wouldn't call the cops as your investment would
be devistated. You will probably not know that it is occurring and
even if you do, you cannot evict them. So what if the meth lab is
busted and the homewoner goes to prision? What do you get? A meth lab
house that you cannot sell w/o disclosing, that you have to either have
demolished or pay for the environmental clean up, and a note that no
one will buy. The same holds true for a homeowner that starts a junk
yard in their front yard, that burns or tears down the only structure
on the property, a property that has led paint, asbestos, mold, or
other problems, etc., etc., etc. What happesn if the homeowner doesn't
insure the property and the house is destroyed by a fire, hurricane,
flood, etc, etc., etc.? What are you going to do about that? Note
might have an acceleration clause, but by the time you find out it will
probably be too late... That is just too risky in my book. I like the
contol afforded to me with rentals, my ability to nose around things
(or have the manager do it, and have a manger to sue if he doesn't),
and my ability to nip problems in the bud...

As you can tell, I am a bit biased towards rentals. I do beleive that
notes are better than many other types of investments and the reason
why most people don't invest in them is that their financial adivosrs
do not earn commissions for selling them (another bias of mine).


Gary Brolis
http://www.MechanicsofMoney.com
http://www.MechanicsofMoney.com/blog.php

Gary,

As I tried to note there are differences. I think you did a better job
of highlighting some of the differences.

Check the math on the example you gave (what you invest vs. what you
earn). Either the math is wrong or I just do not get it. Let me know so
I can figure it out if it is me.

As to the interest rate charges vs. the yield produced. When I said
that one note pays 21% I should have clarified that that is the yield
and not the interest rate the borrower is paying. I believe that they
are paying 10% (still not low). The yield is because that note was
purchased for a discount. They could not get conventional financing as
the property price was low and it needed work from what I understand (I
bought the note after the fact). Lenders do not like to lend below $25K
when writing a mortgage in 1st position.

On the flip side of the benefits of ownership comes the legal and
financial liability for the property. Assume great tenants. You still
have costs and changes that reduce the income. Hence the income is not
that different and might be lower when you own the property as a
landlord.

The upside for being a landlord definitely relates to possible
appreciation and tax benefits compared to a note. If you are buying
your notes at a discount you could be exceeding the appreciation from
the ownership.

So, this is very much a comparison of two alternatives that have some
aspects that are similar and many aspects that are different at some
level.

Just wondering what others are seeing in the market, how it works for
them and why they choose to invest the way they do when it comes to
sometime involving RE.

John Corey

Gary,

One more thing...

You wrote:

"I don't really think that you can compare holding a note with holding
a
rental property"

I was not trying to compare the two in any direct way. That was an
assumption you might have made but not one that I intended. I do think
there is a lot of domain knowledge or skills that cross over between
the two.

Ultimately people do choose between different things when allocating
their capital. Hence there is a comparison at some level between any
investment no matter how different the asset or asset class might be.

So, we can focus in on notes without trying to say if hold a note is
somehow superior or inferior to being a landlord and owning RE
directly. Or we can discuss how the two are alternative ways to get
exposure to the RE sector and how to leverage domain knowledge
concerning RE. I was mostly interested in hearing from other note
investors as to what they see or do when investing. That was my bias in
posting the topic.

John Corey

John,

I don't really think that you can compare holding a note with holding a
rental property, as the risks, tax consequences, and reward are too
different.

These days in most states it is relatively easy to evict nonpaying
tenants under the terms of a lease (expidited and informal eviction
proceedures). Whereas, it is often difficult to foreclose on person
who does not pay on their note. In the later case, you will probably
be negatively impacted by the imposition of the automatic stay in
bankruptcy. With my rentals, I can often find very credit worthy
tenants who opt not to buy a house (either because their family is
growing, they are saving for other personal goals, or they just don't
want to deal with home ownership); whereas, the person that takes a 21%
note almost undoubtedly has bad credit and a poor track record in
paying their debts timely. I much prefer the good credit person to pay
off my property over time than receiving a less certain income stream
(perhaps, just a personal preference. I also like the control that I
have in that I am not locked into a 10 or longer year relationship).

Morover, note holders do not get the full benefit of tax attributes
that landlords get (such as larger depreciation, etc.). The ability to
generate tax-free income is the real allure of rental property
investors. I invest $500 which generates a $3000 annual tax free
postive cash flow. I do that for ten properties, getting $30,000 earch
year in positive cash flow. That is much much more than the interest I
would get from a $50,000 mortgage note.

In addition, note holders do not typically get to benefit from the
future appreciation of the underlying real estate. If you assume that
real estate will appreciate over time, then it can be more profitable
to hold the house and not just the note. Taking a historical look at
rates of return (even on high risk notes) versus the appreciation on
real estate, the real estate investor wins hands down.

Thats my two sheckles.



Gary Brolis
http://www.MechanicsofMoney.com
http://www.MechanicsofMoney.com/blog.php

I hold some notes secured by real estate. A few that I bought. I few
that I created when doing a RE deal.

I earn anywhere from 11.5% to 21% if memory serves me correctly.

All but 1 (special case that one) are 1st position liens secured by
trust deeds or mortgages depending on the state. Some are held directly
and in other cases my IRA is actually the owner.

I collect a check each month and have no legal liability or hassle like
a landlord. Based on most people's rentals my income is the same or
higher though there is no upside from appreciation.

The notes range in size from (approximately) $15,000 to $40,000.

Anyone else investing in notes? Care to trade tips and observations?

John Corey