Posted by Brent_IL on August 14, 2003 at 09:25:14:
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Using partials to combat unrealistic prices - Posted by Brent_IL
Posted by Brent_IL on August 13, 2003 at 10:57:09:
In another post, I said that we could use the purchase of partials to reduce acquisition costs. I got two emails asking for clarification. This is a cut-and-past affair, and I didn’t recheck the numbers so take it for what it costs you. I believe the figures are accurate.
The concept of buying a future balloon payment or a series of payments that is fewer than the remaining scheduled payments, i.e., a partial, to lower the acquisition costs of your real estate purchases are worth reviewing further. It?s similar to using junior mortgages, but partials are more efficient and effective. They are also better received by the note-sellers.
This is not a comprehensive how-to on buying partials. There are details of security and pay-off scheduling that has to be addressed. Your amortization schedule for early pay-offs is not the same as that of the payee?s loan. Partials are an excellent investment, but they are a wasting asset, and need to be managed. Right now we are interested in learning how to use partials as a buying tool.
The ability of modern electronic calculators to quickly determine the present and future values of an irregular stream of income or payments has opened the floodgates to creative real estate solutions that are limited only by your inability to conceive of them.
As a precaution, several times a day I must remind myself that most of the people that I talk to about real estate do not understand the industry?s jargon or nomenclature that I assume are transparently obvious. It?s the same with any specialized field. Most sellers do not use financial calculators. Most of the ones that do cannot find the yield of an irregular cash flow. Even the folks who use Microsoft Excel© daily will have comprehension problems because they will understand the definitions of present value or future value, but have not fully internalized the financial implications of the time-value-of-money in people?s lives.
When we talk to property sellers, it?s effective to refer to lump sums and also for us to determine their rate of return and then give that figure to them.
If a real estate seller wants details, but isn?t actually technically oriented, often the simplest explanation is, ?I dunno, I followed the guidelines of the people who pay cash for income streams and studied the calculator?s instruction manual to learn what buttons to push to get a correct answer. I must be doing it right because the note buyers have never complained.? Then, as a distraction, I often comment that when I was an undergraduate there were no financial calculators, and adding machines had to be plugged into an AC outlet. Electronic display machines that could add, subtract, multiply, and divide and had one or two storage memories were the size of Selectric typewriters and cost $2,500. The math discussion ends and we move on.
Let?s look closer at partials as collateral.
When we buy a partial of a note that we have just created, we buy the first part of the payments. When buying notes from others, we usually require that the notes be seasoned to establish a pattern of timely made payments. When we buy these notes, or buy a balloon payment, we are buying into the middle of the income stream. We can also buy the ?back-half,? or the last part of a series of scheduled payments. High discount rates make the back half of long-term notes worth very little. The seller takes a big hit.
Additionally, we can arrange to buy a percentage of the payments that?s less than 100% of the payment stream, e.g., 50% of the monthly payment for 60 months.
By using partials, we can increase the yield of our cash investment, keep the collateralization properties of the portion of the note?s value that we purchase high, and still have a sufficient residual value to impress our sellers.
The collateral that secures a purchase money mortgage note or note secured with a trust deed is the subject property. A trust deed is different than a deed of trust that transfers title, or real property ownership. The trust deed is a security agreement that describes the securing property and gives the note holder the legal right to take over ownership of that property if one fails to make the scheduled note payments or other commitments as agreed upon.
When you buy a partial, the security for the income stream that you’re buying is not the real estate. The partial note-seller?s ownership of the full note and its security agreement are pledged as security for the payments being made. They are guaranteeing the note payee?s timely payments. If the payee stops making the payments, they can foreclose on him, but they still have to make the periodic payments to us. If they don?t pay us, they have defaulted on their agreement with us and the trustee will give us ownership of the collateralized note. Then we foreclose on the defaulting homeowner to recoup our money. The affect is to lower the LTV ratio of our cash payment to the property that collateralizes the partial-seller?s note and, indirectly, our purchase of the partial.
Here are two examples:
Three years ago, a property owner wanted to sell his $125,000 house to a buyer who could qualify for an eighty percent LTV loan, but only had enough money to pay a 10% down payment, plus closing costs. There were some direct adjustments to the selling price, so the final contract price was $122,259.79. The buyer put ten percent down and the seller took back a purchase money mortgage for the remaining 10%, or $12,225.98. The terms were a junior position note for $12,225.98, fully-amortized over 360 payments, charging 10% annually with a monthly payment of $107.29. The seller is making a loan at 90% LTV. Now, 36 months later, he is still just about at the same LTV.
He wants to sell the $12,000 balance of the note to us to get some quick cash, but he objects to the extreme discount that we demand. We offer to buy part of the payments by giving him $3,000 or 25% of the note balance for the next 81 payments, which is 25% of the remaining payments. That?s fair, isn?t it?
He agrees to the deal when we point out that he was scheduled to receive $34,762.52 over the next 324 months; that by accepting our offer he will still receive $29,071.89, and $3,000 of that is available right now. That?s only around 16% less than collected over the next 25 years, but the $3,000 is in his pocket immediately.
If the value of the house is unchanged, and considering the principle pay down on the first position loan, our loan is at 80% LTV because the seller has pledged the entire $12,000 balance of the note to collateralize his agreement with us. If inflationary appreciation or recent improvement has pushed the FMV higher, our LTV will be lower, and therefore better.
If we keep the partial after the deal is done, our position is an annualized return on our $3,000 of 39.88% for the 81-month term. That?s a nice return.
We can utilize the partial as security for our own purchase loans. The average property seller who will take back a 360/10% loan will allow us to plug the numbers into the calculator and use the 81 monthly payments of $107.29 to collateralize $6,301.25 without requiring us to get an appraisal. That?s 210% of what we paid for it. Two for one is nice return, too.
Note that the collateralization value of a note is subjective. It?s linked to the payments, but they are more of an influence than a fixed parameter. Someone, somewhere, might believe you if you said that the total payments (81 x $107.29) of $8,690.49 will collateralize that much property value. We wouldn?t accept that premise, but some do, and it only takes 10 seconds to ask.
If we were to purchase a portion of a PMM note, the remaining payments are sufficiently adequate so that the discount will be perceived by the seller to be irrelevant in the larger picture. That?s helpful in closing the deal.
In our second example, the seller was transferred on short notice and had to sell to the first buyer who walked in the door. He has a new $100,000 face amount, 8.00% APR 30-year note with a balloon due in ten years. He?s moved across country and wants cash, but he needs the monthly income to make the payments on his new home. Let?s say that our minimally acceptable long-term ROI is 24% (unlikely to be that low in real life), so we will offer to buy only the balloon payment that is due in 10 years of $87,724.70 for $41,429.12 if he pays for the appraisal and title insurance. Our offer is accepted because the seller is unaware of an alternative source of buyers. Few note buyers want to wait 10 years to get paid.
Even though we are not receiving payments, on our next offer to purchase a house we will ask the seller to take our $87,724.70 note, secured by a property different than his, as collateral for his purchase money mortgage. The majority of sellers that have some involvement after the close will accept. They are tired of their property, the grass is always greener, and the collateral for the note is of secondary concern. If they believed in their heart that we would fail to make the payments on their carry-back note, they would not have agreed to finance at all.
Our $87,724.70 note has secured $87,724.70 worth of the property to be acquired though all we paid was $41,429.12. The collateralization capacity of our cash has increased by 212% by using the partial purchase as an intermediate step. Taking this step frees up $46,295.58 more equity in the property that we are buying than we would have if we had taken our $41,429.12 and made a cash down payment.
Since our note to the property seller is secured by a different property than his, we have $87,724.70 worth of equity in the subject property that we can pledge as security for our purchase note on yet another property. Twenty-five years ago, Robert G. Allen referred to this kind of alternative collateralization as using property A to get property B; B to get C; C to get D; and so on.
The only thing that we do differently than he suggested when we use notes as collateral is to use partials wherever and whenever we can. We get a bigger bang for the buck. Partials are indeed potent.
In this example, what if we didn?t have the $41,429.12 to start out with? What if we start out with zero dollars? In past posts, I?ve beaten to death the concept of using a SOC and subsequent sale of the subject property as a source of funds. I would explore that approach before searching for Hard Money lenders or private investors. It?s much easier.
Re: Using partials to combat unrealistic prices - Posted by Ken (in Iowa)
Posted by Ken (in Iowa) on August 15, 2003 at 13:11:26:
Brent,
First off, thanks for a great post. Since I found this site a little over two months ago, I’ve appreciated your comments whenever I see them.
I know you cautioned at the beginning of the post that you didn’t recheck the numbers, etc., but I want to make sure that I understand things correctly so I’m going to question you on one of the examples. I followed all of the numbers in the first example on my HP12C and understood everything clearly. In the second example, you mentioned buying the $87,724.70 balloon payment in ten years for $41,429.12, which was supposed to be a 24% ROI. When I plug “10” into “n,” “$41,429.12” into “PV,” and “$87,724.70” into “FV,” I get an annual ROI of 7.79%. If I wanted a 24% ROI, I could only pay $10,207.16 for the balloon payment. Is this correct, or am I missing something?
By the way, this doesn’t change anything concerning the viability or usefulness of the strategy.
Thanks again for all of your valuable posts.
Ken (in Iowa)
SOC = ? - Posted by firefox
Posted by firefox on August 14, 2003 at 17:51:18:
What does that acronym mean? Great post btw.
Where’d you learn to talk like that, boy? - Posted by rm
Posted by rm on August 13, 2003 at 17:36:24:
On a serious note, I realize that fully understanding this would boost my profitability.
What courses did you study to learn about paper?
Thanks.
Re: Using partials to combat unrealistic prices - Posted by Brent_IL
Posted by Brent_IL on August 15, 2003 at 20:30:10:
Ken,
It’s good to see you posting. I tried to reconstruct possible calculations to see how I came up with the $41,429.12 figure, and I haven’t a clue. Sometimes there will be fractional differences because I automatically use monthly payments, or I’ll use the HP BA-II. This time around I don’t know what I was looking at
But you?re right; the correct number makes the example stronger.
Thank you for correcting me within the thread. Many times when I mess up, I’ll get private emails telling me to be less stupid next time. The senders are considerate and think I may be embarrassed by a public correction. This is thoughtful, but it doesn’t help someone who pulls a post out of the archives two years from now.
Stick around. The collective expertise of the CREonline.com posters is incredible.
SOC = substitution-of-collateral - Posted by Brent_IL
Posted by Brent_IL on August 14, 2003 at 18:02:22:
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Re: Where’d you learn to talk like that, boy? - Posted by Brent_IL
Posted by Brent_IL on August 13, 2003 at 20:54:53:
I prefer books to courses because the forms provided in good courses have to be re-worked anyway. $5,000 spent for a three-day boot camp would pay for a goodly amount of one-on-one legal advice and a fast start on customizing docs. I’ve read two books on seconds in my life. Both were 25 years ago. Jimmy Napier’s was the first. Right now, I can’t recall the second. Dave flashed through my mind and I kind of remember that is was written by the guy from Professional Publishing.
The only thing that I do is to think of parallel applications. No rocket science. As Ron said, it’s old school. Bob Allen explained the use of seconds to buy property in his first “No Money Down” book. That was around the late 1970?s. What are the most efficient junior mortgages? Partials. What are the easiest to buy because they are the most palatable to the seller? Partials. So what kind of substituted collateral should be used when using mortgage notes?
The cash-flow forum has a ton of info on discounted seconds. Good, attorney-prepared docs pre-empt some trouble spots down the line.
I?m still reserving revelation of the absolute best candidate for SOC until after I?ve retired from CREI.
Dave Glubetisch - Posted by Ronald * Starr(in No CA)
Posted by Ronald * Starr(in No CA) on August 14, 2003 at 06:42:35:
Brent–(CA)------------------
I think your memory is serving you correctly. Dave Glubetisch was the publisher of real estate investing books at Impact. He wrote some of the material–or at least put his name on some of it. Impact went bankrupt when the real estate investing education market slowed down in the late 1980s do to real estate values going down. He was not a very good businessperson. He had a great concept and poor execution. Dave had too many people not working for him, even though they were on the payroll. The “build a big empire” syndrome that felled Tony Hoffman, Robert Allen, and others.
Good InvestingRon Starr