Originally Published by The Paper Source Journal, July 2018
By Sándor Lau
Investing in residential or commercial junior real estate notes can give tremendous advantages to investors willing to understand them and put in the effort and patience to collect on them. Some of those advantages include:
Discount: Loans usually sell for a discount from the full unpaid principal balance. Junior loans usually sell at an even greater discount. Defaulted junior loans sell at some of the greatest discounts.
Diversification: Larger discounts and smaller loan amounts than first mortgages mean that the price per loan for seconds is typically lower than for firsts. Lower prices allow investors to diversify their portfolios across more assets in more markets, putting more eggs in different baskets.
Appreciation: My dream residential loan is a $50,000 second mortgage on a $500,000 home in an urban or suburban area of a nonjudicial foreclosure state where the borrowers are paying the first mortgage. Assuming uniform appreciation of 5%, that $500,000 house goes up $25,000 a year while a $50,000 home goes up only $2,500 a year.
Principal Paydown: Borrowers paying their first mortgage every month are reducing the principal balance of their loan, increasing the equity securing the second loan. The longer they pay, the more the loan amortizes down and more of their monthly payment goes toward principal.
Property Preservation: Whether or not borrowers are paying their first mortgage, as long as there is a servicer managing the first loan, that servicer is making sure taxes, liens and insurance are being paid. The bank is not going to let their $500,000 collateral get foreclosed on for a $2,000 HOA lien.
Borrower Motivation: Borrowers who are paying their first mortgage are also very likely to have a job or income stream. They pay the first mortgage because they enjoy living there (or collecting rent from their tenants). Their payment history as revealed by their credit report is the quickest way to see their level of motivation. If they have income and like living there, they are likely to be more motivated to want to pay their second mortgage.
I began note investing in the residential second mortgage space, but market prices for second loans, even defaulted ones, are now often higher than I’m comfortable paying. No one wins arguing with reality. You can try to change others, but it’s much easier to change yourself.
Looking for an additional investing niche, I have started investing in commercial second mortgages which afford investors most of the same advantages as residential loans, and a few more.
Commercial Mortgage Advantages
No FDCPA: The Fair Debt Collection Practices Act (FDCPA) governs collection of consumer debt and places severe restrictions and penalties on collectors who break it. I’m not a lawyer, accountant, or pro wrestler. If you want advice in any of those areas, please seek it from a qualified professional, but here’s what the NOLO Legal Encyclopedia says: “The FDCPA only applies to consumer debts incurred for personal or household expenses. It does not apply to corporate or other business debts.”
High-Value Properties: Commercial properties are often more valuable than average homes. If a $5,000,000 apartment complex, medical building, office, shopping center, self-storage facility or mobile home park appreciates 5%, it goes up $50,000.
Income-Generating Properties: Most homeowners only consider one option for generating revenue to pay their obligations — employment. Many homeowners are also perfectly capable of increasing their income by renting out rooms or space on Airbnb or driving for Uber or Lyft if they want to, but many prefer not to.
Investors who own commercial property are already entrepreneurial. That’s why they bought the property in the first place, and if they are motivated, they can probably find a way to increase income from the property.
Bigger Discounts: Very few investors will touch the most plain vanilla second mortgages — residential loans. Even fewer will consider commercial seconds. You may have heard of the law of supply and demand.
Shorter Terms: Lending money is inherently risky because the borrower gets what they want up front and all at once in exchange for a promise to consistently make their payment every month in the future. Every month is a new risk in that the borrower may break their promise. Whereas a typical home mortgage fully amortizes over 30 years, a typical commercial loan has a balloon in five or 10 years.
You can increase your returns by increasing the velocity of your money, buying at a discount and getting a full payoff in the shortest time possible. Most commercial loans also amortize on a shorter schedule, meaning the proportion of the first mortgage payment going to principal starts higher and increases faster than in most 30-year residential loans.
Rational Borrowers: Most people make the majority of their decisions based on their emotions rather than logic. And many homeowners decide whether to pay their debts based on whether it makes them feel good. Business owners are more likely to be more rational and acknowledge their responsibility to pay their debts.
Next month: The unique challenges of second loans on commercial property.
Sándor Lau is the founder of Noted Financial and has been investing in junior notes and speaking at the Paper Source Note Symposium since 2013. His Paper Source presentation videos and many others on how to live richly are all free at YouTube.com/Sándorlau. We would be happy to quote a price for your junior loans secured by residential or commercial real estate. firstname.lastname@example.org. NotedNoteBuyers.com.