Jack Sternberg – the man who brings us The Noteworthy Newsletter – has been kind enough to rip back the veil shrouding the note business, helping Mogul readers get a full-on immersion into one of the hottest, least-known profit centers in real estate today.
During the last few months, Jack has told us about a variety of his favorite creative dealmaking strategies (each with its own creative name), including:
In today’s main event, Jack introduces a creative process he likes to call “The About Face.”
If you need a refresher course on any of Jack’s previously-discussed strategies, then this is the perfect time to pause and revisit his last few lessons. And if you share our fascination with clever tricks-of-the-trade, then today’s lesson will be perfect for you!
The About Face
JP: Thanks again, Jack, for walking through all these creative dealmaking tricks for those of us at Real Estate Mogul. The first four have been very helpful!
Jack: My pleasure.
JP: Shall we move on to Creative Deal #5?
Jack: Let’s do it! The next one is called “The About Face” (or “Rehabbing the Note”). It’s all about turning “bad paper” into “good paper” – so let me tell you what that means…
If you buy a defaulted note, you can rehab that note by getting the mortgage to perform appropriately once again, and then you can resell the note. There are several ways to do this:
For example, let’s say you are able to buy a note with face value of $100,000 for a purchase price of $50,000. And let’s imagine that the tenants in this house have not provided their $1,000 monthly payments for two years – thereby representing $24,000 of past-due payments. Understand that these $24,000 of past-due payments will also combine with up to $50,000 of late fees, legal fees and delinquent interest charges – thereby representing an even larger sum of “supplemental indebtedness” to you.
You can offer to waive the tenants’ large sum of “supplemental indebtedness” and reinstate their loan in exchange for a relatively modest payment of $20,000. If the tenants agree to this arrangement, then your purchase price for the $100,000 note is essentially reduced by $20,000 – from $50,000 to $30,000. Additionally, you can negotiate with the tenants to reduce their monthly interest rate, in exchange for an accelerated repayment schedule of your choice.
It’s all a big negotiation, and this is a purely hypothetical example with purely hypothetical numbers, but what you have essentially done is this: In this example, you have reduced your initial investment from $50,000 to $30,000 and purchased a $100,000 note which pays you reliably each month (according to the tenants’ new reduced interest rate). Now, after 6-12 months of receiving steady payments from the tenants, you can sell that note for significantly more than the $30,000 you initially invested!
JP: It’s kind of like creating new notes, right?
Jack: Absolutely. When you waive the tenant’s “supplemental indebtedness” in exchange for the hypothetical lump sum of $20,000, you are also going to invite them into your office to transform their stinky old $100,000 note into two fresh new notes – a second mortgage for $30,000 (the balance of your initial investment) and a first mortgage for $70,000 (the balance of the original note’s face value). You could give them a 2% interest rate on their second mortgage and an 8% interest rate on their first mortgage.
JP: And that’s called “The About Face”, or turning “bad paper” into “good paper”.
Jack: Yup. And remember, in this hypothetical example, after you sell the first mortgage for a profit, you get to keep the $30,000 second mortgage for additional cash flow!
And the way to find a deal like that is by looking at the borrower’s credit on a delinquent note. If your analysis reveals that the borrower is successfully paying his car note, credit cards and/or other debts, then you can deduce that the delinquency on his mortgage payments is a result of being underwater on his mortgage – and he’s probably not inclined to pay the original mortgage. This circumstance would open the door for you to introduce yourself and negotiate a deal.
Does that make sense?
JP: Yes, it definitely does! And I’m going to guess that you probably don’t look at this approach as a surefire strategy when you are going in. You probably don’t say, “I’m going to buy some delinquent notes and then rehab them.” Instead, you probably consider this to simply be one option for the investor who buys bad paper. Since the you don’t know all of the tenant’s circumstances when purchasing a delinquent note, you probably consider this strategy to be one of several possibilities, right?
Jack: Right. This approach assumes that the tenant wants to stay in their home, and they are willing to “have another go at it” – which is not always the case.
Buy A Delinquent Note – Buy a delinquent note.
Research – The research the tenants’ underlying credit quality.
Renegotiate New Terms – Negotiate new lending terms with certain underwater tenants, using two new notes.
Sell the First Mortgage – After collecting payments for 6-12 months, sell the first mortgage for a profit.
Keep the Second Mortgage – After selling the first mortgage for a profit, keep the second mortgage for future cash flow.
Jack Sternberg
is a nationally recognized expert on real estate investment. He's been a full time real estate investor for 40+ years, and has done about every kind of real estate deal that exists, many times over. Jack has bought and sold over 2,000 single family houses and over 4,000 apartment units, totaling over $750 million when he stopped counting. He also owns The Noteworthy Newsletter - the note industry's oldest and most respected publication. Think of Jack as the "Obi Wan" of real estate who's forgotten more about real estate investing than most folks will ever know.