In the first of our 8-part series with “noted” note expert Jack Sternberg – the man who brings us the Noteworthy Newsletter – we gave you the skinny on what’s up with the note industry, and why you should seriously think about jumping on the note bandwagon in your own business. In case you missed The Paper Broker, you can read it here.
Now, armed with more than 40 years of in-the-trenches note experience, Jack has been kind enough to sit down with us and share more from his broad repertoire of expertise.
In today’s lesson, we’ll dig-into the second segment of our 8-part series with note guru himself, who has generated millions of dollars in real wealth creating notes.
Today’s lesson is what we call “The Paper Wrapper”, and as a Mogulite, you’re getting it for free as part of your membership!
The Paper Wrapper
JP Moses: What is The Paper Wrapper and why should our readers care?
Jack Sternberg: The Paper Wrapper is a deal where you buy a house on good terms and you sell it on better terms. You stay in the middle of the deal (as facilitator) and you collect a down payment from the new buyer.
This is in your hand cash now, along with multi-year cash flow that lets you make money for a longer term. And that is really what we've coined The Paper Wrapper. Some of your students might know it as a wrap-around mortgage.
In simple terms, let’s say you buy a $100,000 home from a seller and they agree to finance it at 10% (just an example) and the payments are $1,000 a month. Again, just for a number, and they've agreed to finance it for “X” amount of time, at which point the note will have to be paid-off with a balloon payment.
JP: Jack, can you break this down to the least common denominator for any students who might not understand… a good, “living in the real world” example?
Jack: Let’s say you buy a property with a ten-year balloon, then take that house you’ve paid $100,000 for (just an example) and sell it for $110,000. The new buyer (who you locate) makes a $5,000 down payment and wraps the existing $100,000 loan with your $105,000 loan.
Here’s how it might look on paper: You owe $100,000 to the former seller at 10% interest with payments of $1,000 a month. The new buyer owes you $110,000 less $5,000 down, which is $105,000, maybe at “X%” interest, which could break down to $1,200 a month.
The difference between what you’re paying the seller and what your buyer is paying you is $200 ($1,200-$1,000) plus a $5,000 down payment. If you write the deal with your buyer for seven years instead of ten years, they will pay you out in seven years with a balloon payment when they get new financing, and you're wrapping around the existing mortgage.
JP: This sounds like a phenomenal strategy, Jack, but we all learn as real estate investing newbies that it’s extremely rare to find an assumable mortgage, and that all new paper written in these United States includes a Due On Sale clause.
(For students unfamiliar with Due On Sale, it’s a mortgage provision that first popped up in the 1980s which basically says any transfer of ownership – including things like wraparound mortgages, owner financing, contract for deed, even lease options, etc. – can technically allow the mortgage lender to call the note due and payable in full.)
So how do you get around this challenge?
Jack: It would, if you were wrapping a mortgage being held by a major bank like Bank of America. What many people don’t know is that lots of banks, credit unions and finance companies (hometown banks, community lenders, etc.) hold onto all of their own paper. Due On Sale clauses are inserted into Fannie Mae and Freddie Mac loans, and almost all of the loans from the great big banks, but not in many of these smaller financial institutions’ loans because many of them don’t use the government-issued contract.
JP: I actually assumed a mortgage from the 1980's early on in my real estate investing career; it was one of my first deals. I happened to stumble upon one that was still left and that was nice, back when you could still find those leftover assumable deals.
Since the big banks, along with Fannie and Freddie, control the lion’s share of the residential mortgage market, where exactly can students find these cherry deals – if any of them still exist?
Jack: You can find them in several places. Many credit unions don't sell their paper. (Most credit unions aren’t in business to turn a profit, so many hold onto their own paper.) Another good source for these kinds of deals are local finance companies, even local S&L's (now Savings Banks) who don't sell their own paper.
Here’s an example from my own area – an S&L here in town that actually brags about not selling their mortgages. Their marketing gimmick is to say they keep all of their mortgages in-house. They don't sell it. They don't use a Fanny Mae form with the ‘due on sale’ clause it.
JP: But Due On Sale clauses have been the modus operandi of the mortgage industry for more than 20 years. What’s the reason so many of these lenders don’t incorporate Due On Sale into their contracts?
Jack: The simple answer? They just don't use the form. Many of these institutions are independent in their policies, so they don’t use the standardized, government-issued forms. They have a local marketing gimmick that works for them. They’ll advertise wide and far that they don’t sell their mortgages. And that’s why your students have a great opportunity here.
JP: Are there other classes of deals haven’t you mentioned yet – where our students can tap into The Paper Wrapper? Or is that about it?
Jack: How about big houses – jumbo mortgages? Most lenders who write great big mortgages (say $500K and up) keep their own loans. They hold onto their own paper, which ordinarily are written on their own contracts. These contracts don’t have Due On Sale Clauses. There are a couple of classes of homes that these kinds of lenders won’t touch, mainly charter homes or anything that fits into a box.
They sell a big house (and I'm talking $500K and up). They keep that loan. As for the finance companies, they absolutely use different paperwork. They do not use Fanny Mae forms; they do their own deals. They are out there. And I'll tell you one other thing a lot of people don't know: many times, investor-financed homes that were financed for investment purposes don’t have ‘due on sale’ clauses on them.
JP: What about commercial paper? I’m talking here primarily about investor-owner, lender financed commercial properties. Multifamily properties, even down to 4 or 5 units? These loans usually have Due On Sale clauses, don’t they?
Jack: Actually, these kinds of properties are ideal for Paper Wrapper deals. Many, many of these mortgages do not have Due On Sale clauses in them. Banks anticipate that investors might at some point need to sell these properties, and because of the higher associated risk (and the fact that most don’t have Due On Sale clauses), the banks charge a higher interest rate to compensate for the increased risk of loss – including renting the property for the long term.
I actually know of a lender in Houston, TX who made lots and lots of investor loans, and not one of those loans had a Due On Sale clause in it. This wasn’t “Back in the Day” – this was within the last three years.
JP: Jack, I want to run through this really quickly with you just one more time to make sure I have the essence of the Paper Wrapper. If I mess this up, feel free to step in and correct me…
With the classic Paper Wrapper, you find a motivated seller who needs to sell their house. We’re talking truly motivated, not someone who wants to sell their house and has the time, money and patience to wait for an at- or close-to-market price.
Because the seller is truly motivated, they're willing to sell to you on terms, so you negotiate terms that are favorable to you, below market terms, maybe nothing down plus a very favorable interest rate and length – as much as you can get.
You know that you’re going to connect with a pool of buyers who are having a hard time buying houses (credit, down payment trouble, time on job, etc.). Once you have your buyer, you'll create an additional note and mortgage to sell that property. Your buyer will pay you a higher interest rate than you’re paying to the seller, in addition to a down payment that is higher than any down payment you give the seller (if you give the seller a down payment at all).
In short, you’ll get cash now (from the down payment), plus a spread (the difference between the amount of your payment to the seller and your buyer’s payment to you). In addition, you’ll probably charge your buyer a higher price for the house than you pay the seller for it. Then, when your buyer pays off their balloon payment, you get a final payday and walk away from the deal with cash in your pocket. Is that about right?
Jack: You’re on the money, JP. Simple, isn’t it?
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Find truly motivated sellers, those who need to sell (as opposed to folks who have the time, patience and money to wait for full market price).
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Negotiate favorable terms with the seller, offering them a price, interest rate and monthly payment terms that will make the deal profitable to you.
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Locate buyers with down payment money, and charge them a higher interest rate and larger monthly payments than you are paying to the seller, with a balloon payment that is shorter than your balloon payment to the seller.
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Find properties with existing mortgages with Due On Sale clauses built into them. These deals can be found through many hometown-type lenders – credit unions, Savings Banks, Savings & Loans, finance companies, etc.
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Don’t overlook the opportunities in jumbo mortgages and commercial real estate loans for single family properties. (If you’re truly ambitious, apartment complexes and commercial properties are also good targets for your investing activities.)
So you’ve got it? You’re sure? Then what are you waiting for? Go get it!