Cash Flow Notes: Step by Step How to Invest in Performing Notes

Are you tired of real estate ownership? I know I was getting tired of owning real estate earlier this week. I am what you may call a “Night Owl.” I like working late into the night as my brain usually works the best with no distraction around. Hence I usually head to bed in the early morning hours.

This past Wednesday started off as any ordinary Wednesday. I worked from 9am to 1am with breaks in the middle for a run, deal making, managing capital partners, administrative tasks, and juicing (I started the juicing lifestyle nearly 30 days ago now thanks for my girlfriend.) I head to bed by 2am.

5am and my cell goes off. I miss it by sleeping through it

5:15am and my cell starts chirping again. I am thinking “Who in God’s Name is Calling Me at This Hour!?” I decide to ignore the call and stay asleep.

5:45am and I hear my text message bing. I am now up and I am cranky before my first cup of coffee and only 3 hrs of sleep. As I wipe the sleep out of my eye, I see that it is my property manager (god bless him for being a great asset to my firm) and the text message states:

“Call me ASAP. Problem at Armstrong Ave”

I am thinking the worst has happened:the house burned down or something happened to one of the tenants. I quickly scroll to my missed call log and dial him back:

Ring Ring

Manager: Morning boss. We got an issue!

Me: What is the issue? (Still half asleep and crabby; missing my cup of coffee still!)

Manager: The sewer backed up into the basement and tenant is complaining that the house is smelling like $@!#. I need to know if I can call in for a emergency repair as it will cost over $600 to snake and clean up the basement.

Me: Of course, as we cannot let the tenant live in that filth.

(Internal Dialogue) “… I hate this asset and why did not anyone warn me about this when I was getting into landlording!”

This one of the few reasons that I continue my discussion of “No Toilet” Investment Assets with you, the readers. This week we turn our attention to Cash Flow Notes as a potential passive “No Toilet asset class.”

What are Cash Flow Notes?

Cash flow notes are a debt instruments or promissory notes wherein an individual or business borrows money from another individual or business. The note is the proof of the debt . The note can either be secured or unsecured. If the note is secured then it will be accompanied by a mortgage or UCC document. This article will discuss the asset class of Performing 1st Mortgage Notes (hereafter referred to as Performing Notes.)

What are Performing Notes?

Performing notes are mortgage secured debt instruments that are current or where payments are less than 90 days past due. The mortgage, also known as the security instrument, pledges the property as collateral to ensure the performance on the obligation. This allows the note holder to sell the property and re-coop his investment in the event the payer does not pay as agreed.

I had a realization after I owed my first condo for nearly one year. Realization: Notes are sold many times over. In fact during my one year ownership period my note was sold three times which I realized when I was notified that my loan is being serviced by another lending institution.

Why and How to Buy Performing Notes?

Investor who want to earn monthly cash flow can do so by purchasing cash flowing notes without having the headaches of a sewer backup or toilet issues. When you buy cash flow notes, you become the “lender” so the borrower pays you back the principal plus interest. Investors can make money purchasing cash flow notes at a discount and hold out the note to earn money through interest from the repayment of the note from the borrower. Okay so how does an investor purchase Performing Notes?

Below is a simple step by step outline to buying performing notes:

Step 1 – Cash Flow Note Profile

What type of cash flow notes are you interested in purchasing. The following categories can you help you better define your cash flow note profile:

-Risk Profile (Loan to Value, Last Valuation date).

-Type of asset securing the Debt Instrument (Retail, Residential, Multifamily, Industrial etc.)

-Borrower Profile (FICO, Debt to Income, Recourse provision)

Step 2 – Who Can you Buy the Note From?

A. Brokers: You can find local mortgage brokers through an online search and express your interest in buying cash flow notes and see which cash flow notes are available for sale.

B. Banks: You can utilize the county court house or the MLS to locate assets that were financed by local banks or private lenders. Create a list of these banks, lenders and properties. Get on the phone or start sending letters out to them.

C . Loan Sales Platform: Companies like Loan MLS, FCI Exchange, PPR (Dave Van Horn a fellow Biggerpockets member website), and Loan Market who source and provide the notes for you to buy on their platform. If you do not have a geographic limitation on where you want to own notes then these sites can be a huge time saver for the eager No Toilet Investor.

Step 3 – Analyze the Note

Once you get a prospect performing note, grab the terms and conditions for the cash flow note. Find out from the selling source the principal owed on the cash flow note, the interest rate and the term left on the cash flow note. Utilize the following guide posts when analyzing the note prospects:

Risk Underwriting:

Margin of Safety: What is the loan exposure to the current asset value? This will help define the margin of safety utilizing: Loan to Value = (Unpaid Principal Balance/Current Fair Market Value of Asset); The lower the ratio the better.

Debt Service Coverage Ratio= (Total Annual Payments/Net Operating Income or Borrower Gross Income); The higher the number is above 1.0 the better.

Borrower Financial Status: Borrower is your counter party so you want to mitigate this risk by understanding their profile better:

FICO: What is the borrower middle FICO score; The higher the FICO score the better.

Debt to Income: Total Monthly Debts/Gross Monthly Income; The lower the ratio the better.

Return Underwriting: Current Yield: (Current Payment x 12)/Target Investment Price

Debt Yield: Property Net Operating Income / Loan Amount; The Higher the Ratio the Better

The goal to buying performing notes is that you get a in-the-money current yield to compensate you for the foreclosure and the non-payment risk associated with holding a debt instrument.

Step 4 – Buying the Note

You present a offer compensating you for the risk of owning the note and the seller agrees to your price. Now what?

Next you need to hire a lawyer who will help create an assignment of the promissory note to transfer ownership of the lien rights and benefits. When you buy a cash flow note, you are now the lender of the principal amount of that note. In most note transactions typically once you open escrow you are on the fast track to a closing date as you usually provided all the due diligence prior to acceptance of the offer by the note holder. You close on the note by giving the note holder the lump sum cash and you get the note.

Step 5 – Collect that Check Baby

You are now the owner of the cash flow note and due the monthly payments, including principal and interest for the borrower to repay the loan. You need to collect the monthly payments, keep accounting, send out monthly statements, make sure taxes & water are paid. But wait Ankit you said this could be passive no toilet investment asset class? It can be if you decide to hire a servicing company. Hiring a professional servicing company is the key being able to keep Performing Note Investing a passive investment enterprise. There are firms such as Iserve, FCI Exchange who will do the note servicing function for reasonable fees – usually $150 set-up fee and $20 – $35/month per loan.

Performing Notes come with their unique set of risks (which I did not get a chance to highlight in my post so please do further research) but they can be a great Passive, “No Toilet” Cash Flow asset class for the finance oriented cash flow investor. Consider this asset class as a part of your diversified alternative asset portfolio.

I would to hear your thoughts and feedback on this asset class via the comments below.

Until next time, Happy Cash Flow Investing!

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