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Kevin Interviewed On Think Realty Radio with Abhi Golhar
My guest is Kevin Shortle with iNote Success. We’re talking about how to generate passive income through note investing. It’s a topic that I love talking about and it’s a topic that not a lot of investors know about. If you have questions, get in touch. Go to ThinkRealtyRadio.com. On the right side, you’ll see a little form that says, Ask Your Question. Go ahead and fill it out and we’ll send you a message back and then potentially answer your question right here on the show. Kevin, welcome to the show. Tell us a little bit about who you are, what you do at iNote Success.
Thanks by the way for having me on again. It’s my second time being on. I appreciate that. I enjoy it. Even from the last time we talked, the industry is changing, real estate and real estate notes. I always look at real estate notes as part of real estate. I know a lot of investors don’t do that. You’re totally right, a lot of people don’t know about notes. It has historically been looked at as a niche part of the industry, and it’s not. Anytime you borrowed money to buy real estate, whether it’s a private loan, seller finance loan or bank loan, it doesn’t matter. You’ve been in the note business, but we teach people how to be on the receiving end rather than the paying end. As the industry goes through cycles and I’ve been around in the note business for a long time. I’m writing my second book and my first book came out in 1999 on notes. I’ve seen many different cycles go through this. I’ve been active both on the note side and the real estate side for quite some time. The background is that I’ve played through the market as things cycle through. I’m excited about 2019 because I think what’s going to be the best for all real estate investors is to combine the best of real estate techniques with the best of note techniques. You’ve come into it fully armed when you do that and you’ll see a lot more opportunity.
I wonder why a lot of investors pass over notes as an investment strategy. It’s a unique one. It’s great for those that understand the game. It’s powerful. No headaches of tenants and property managers and all that stuff. Even though I choose to take on those headaches, I love the rental property, but I also love notes. Why is that not something that’s discussed more in the mainstream?
It’s always been a niche. Getting back in the late ‘90s, the note business was all about either you created your own notes through seller financing the property or you contacted people who had already done that and you look to buy their notes. What happened when we had the big real estate market crash in 2008, when all that started, there became a lot of massive amount of nonperforming loans that had to go through the market and were purchased out by the big hedge funds so it created this massive amounts of inventory. The attraction was there. I believe and I teach this throughout the United States, it has become more mainstream. It has become more accepted by investors because you’re right, there’s real estate and then there’s this note thing. It’s the whole finance side of the business.
Whether you’re a hard money lender, what are you doing? You’re creating paper. If you’re buying a home and selling it on terms, you’re creating paper. There’s also paper out there, both banks originated and non-bank originated that is available for purchase. I am attracted to it because I do think it brings along a lot of aspects that people would like if they took the time to understand it a little bit more and recognize it as a huge industry. You’re right, rental property it’s nothing wrong. For a rental property manager, it’s a great wealth creator and you’ll never hear myself or anybody on my team that I noticed say things bad about that. What’s wrong with some diversification in there? Owning some notes where you get that passive monthly cashflow without that. That comes back to my whole concept in 2019 and moving forward. It’s combining the best worlds here, but I do think you have to diversify even with that category of real estate.Using lease options is a very good, powerful real estate technique. Click To Tweet
You said the keyword diversify. I love hearing that word, diversify, especially if it’s within an industry and within an asset class. You have to pay attention to. Just because you’re buying single-family rentals doesn’t mean that you can’t also buy duplexes and triplexes. You’re joint venturing with flip operators where you by fix and flip and sell to the retail market single-family homes, it doesn’t mean that you also can’t buy notes. At the end of the day, cashflow is king and that’s all that matters. I almost think that cashflow is king and queen. That’s the way that I think about it. Let’s get down to the basics here, Kevin. What is a note?
A note is a promissory note if you break it down to simplicity. If you write a check to somebody, you’re writing a note. If I wrote you a check and you accepted that check and you went to the bank, it could become a nonperforming note. It could be insufficient funds. That’s a short-term promissory note. The longer-term promissory notes are in the form of mortgages. I wrote a blog and it relates to both what we were talking about. I see more people who are used to investing in stocks start to get into the note business. It’s something I’ve been pushing because a lot of times, people are like, “I do stocks and bonds and mutual funds,” and that’s it.
If they think in terms of real estate, it becomes a rental property again. Think of this. If you buy a bond, anybody can go and buy a treasury bond. If you buy a treasury bond, what are you doing? What you’re doing is you’re lending the federal government money. If you buy a $10,000 bond, you’re giving them $10,000 in exchange. You get what? You got a piece of paper. They don’t even use paper anymore. You essentially have a document, but it used to be a physical document and those documents actually had tear-off coupons that you could cash in. You might be able to cash the first one in five years and then another five years. What you’re doing is trading cash now, lump sum and it’s a debt instrument that you buy.
What is it backed by? When you buy treasury bonds, you do have security, you do have collateral, but here’s your collateral. It says on all these bonds that this bond is backed by the full faith and credit of the US government. You’re betting that the government’s not going to default. In the United States, that hasn’t happened. Hopefully, it never will. In other countries it absolutely has. I won’t go down that path, but it’s the same thing when buying a note. When you buy the note, you’re not buying that IOU. You’re buying a secured note. The security is the collateral. It’s the piece of property. When you buy a note, you’re buying two documents. You buy the note and the security agreement.
The security agreement says if you don’t live up to your promises on the note, then we get to go after the collateral. The collateral in the case of a mortgage note is not the full faith and credit of the United States, it’s that piece of real estate. That’s what you’re buying here. We don’t buy notes. We shorten that in the industry and everyone talks about notes, but you are not a note buyer. You’re a secured note buyer, which is secured by the property. A lot of real estate investors, they have transferrable skills. They know how to value real estate. They know how the markets work. Here, you’re buying what backs that up.
You can learn more about Kevin Shortle at KevinShortle.com. You can also visit iNoteSuccess.com. He will be live in the Think Realty events across the country. We have Irvine in July and Atlanta in September. Go to ThinkRealty.com and register for the event with the promo code iNote and you’ll get 20% off. Kevin, let’s keep talking about notes. What’s the easiest way for passive investors to get started in notes?
Being in the industry as long as I have and being in the trading part of business as long as I’ve had, I still do run into people and it makes total sense. They’re so busy and they’re professionals, they’re doctors, attorneys and they’re successful entrepreneurs. They love to get into the note business, but they look at it and go, “It’s so new to me. I know I have to go to training. I know I have to do this. I want to get started in this. What’s the quickest way for me to do that?” I also have people who go, “I’d like to buy notes but just the thought of investing in something and I get that I’m collecting payments for 30 years or 20 years or whatever it is.” They feel like, “Am I going to be locked in there?”
The solution is very simple. It’s one of the concepts that I don’t know why, but it hasn’t been taught. That is buying short-term income streams. A short-term income stream is part of a long income stream somebody owned. Let’s say I own a twenty-year note and I’m collecting payments on that. I might someday want to sell a portion of those payments for a lump sum. I might want to take that money and buy another note. I might have another business venture. It’s not where I’m locked in for that twenty-years. I can sell you the five years of payments. We would come up with a price and yield and return, but that’s the easiest way to get in.
Let me give you an example. Let’s say that I own a performing note. The property is worth $130,000 and I’ve already collected two years of payments. I’ve been happy with that, but I see an opportunity. I want to jump on something else. I can market the remaining payments. I’ll have 28 years left of payment to another investor. Maybe I’ve met you at Think Realty event and I say, “I’ve got this note.” What’s popular are people buying five-years. For some reason, people are comfortable with a five-year investment because their money’s been sitting five-years in a CD making that whopping 1%. I could sell you five-years’ worth of payments.
It’s good for me because I get a lump sum and I still own the backend of payment, but let’s take a look at it from your end. You’re coming in with only $42,000 for those payments on this note. The property’s worth $130,000. You’re in a senior lien position. If we look at the worst case scenario where something happens to the borrower, they default or they disappear. Let’s say we had to foreclose on this property. Guess who gets paid first? You do. The house is worth $130,000, you’re the first one to get paid. You’ve got a nice and secure investment there and you can buy short-term note like that in the market and still get 8%, 9%, 10% annualized returns on your money. You get paid every single month. I’m thinking of your payments would be about $880 a month, so you’re investing $42,000. You’re getting $880 a month. You run the numbers, that’s a 9% annualized return. It secured by something worth three times what you have in the deal. That’s a pretty tough concept to be. Would you agree?There are no guarantees. You have to do extra due diligence. Click To Tweet
I’m a huge fan of that. I totally agree. 1% a year actually sounds pretty terrible compared to 10%.
I have a vested interest as well because I’m entitled to all the payments after you get paid. You bought the next five-years of payments from me, but I want to make sure things are going good. Of course, that note is already serviced and everything else. The reason this technique is going to be a good one coming up is if you remember that massive wave I was telling you about inventory. A lot of investors bought nonperforming notes. They’ve got them re-performing. They’d been seasoned for two, three, four-years. People bought re-performing and performing notes and it’s the perfect time where they start to think, “Maybe I should parcel out of the deal. Maybe I should sell some payments and invest in some new inventory.” They can take that money, invest to new inventory, but don’t forget they’re still going to get all the payments back on the backend. It’s a prime time for that. Nobody has identified that in the training market yet but it’s a great thing for investors.
We talked about combining two strategies. You have the best in the flipping world or the buy and hold world and then of course, the notes strategies. Why is that the future of investing? Is it because of the diversification or am I missing a link here?
Diversification is always a part of what investors should look at. The bigger picture, when you look at one of the market conditions, whether your notes are traditional real estate or anything else is the Millennial generation. They’re 80 plus million strong. The last study I read, about a third of those is living with mom and dad still. You’re looking at 25 million to 30 million and then who knows how many are renting? They want to enter the housing market. We can talk about student debt and all the reasons why they’re not able to move in. The salary’s not keeping up. It’s a real problem, a real issue for everybody. One of my favorite techniques is a lease-purchase note.
Everyone’s heard of lease-purchase, so people use lease options. That’s a very good, powerful real estate technique. There’s nothing new there that I’ve invented, but some of the byproducts of the lease-purchase where they’re obligated to buy it or a lease option where they have the right to buy it are that you typically have a much better tenant. They mentally feel that that property is theirs. They don’t own it. They are still and a tenant but mentally, that’s their thought process. There’s a tendency for them to keep it better. Some people include down payments in there. It’s a great technique to help this big generation, the Millennials that want to break into starter homes. There’s a huge market in starter homes versus high-end homes. Why don’t we structure a deal where we can lease with a purchase at the end of the twelve-month?
There’s a very specific reason for that thirteenth-month. That’s because of capital gains. Most real estate investors, especially when they’re new, most note investors are the same way. We don’t think of the taxes. They think of, “How much money am I making? How much can I buy?” You deal with taxes as it comes along. More seasoned real estate investors are sensitive to that. If you buy a property through whatever traditional real estate means where you buy nonperforming note in that property and you turn around and sell it like a flipper, you’re paying short-term capital gains. Short-term capital gains for most people are going to be whatever your regular income tax is, for most people, let’s say that’s 32%. That’s a pretty big chunk.
You were saying the number 36 and thirteen-months. Frame that up. I thought it was an awesome example. Start from the beginning and give us a little bit of background.
The technique I was talking about is a lease-purchase note. It could be a lease option note. You acquire with the real estate, whichever way you do. You want to market it then to somebody who wants to buy a property and you’re going to offer them a lease-purchase or a lease option. If you keep that property with that better tenant because they mentally think it’s their property. After the twelve-months, you’ve removed yourself from short-term capital gains which for most people is at 32%. It’s what your income tax bracket is. For most people doing that flipping business, it’s about 32%. After the twelve months, you go into long-term capital gains, which depends upon your income, but for most people, it would be 15%. Essentially you save over 15% on your money by doing it this way, which is like making more than 15% on your money. Tax-wise, that’s a great technique.
What they do is they can purchase it with seller financing. You can always give the option of them to get bank financing and you’d be cashed out. If you run the numbers and you now seller finance people, you took them from a lease-purchase, now it’s the person’s purchase obligation. Get them in that property and you seller finance it for them, now you’ve got a good note. They’ve already proven they could afford the payments for a year. They’ve taken care of the property and now you’re receiving that monthly passive cashflow again without being a landlord. It’s backed by a property you know very well and being paid by tenants that are now the owners that you know very well. From there, you can keep that note. Maybe I season it up for a little bit and sell a partial to another investor.
I never thought of a lease to purchase note before. I know what lease-purchase is. I’ve done a good number of lease-purchase transactions. I never thought of in my life creating a lease-purchase note.Everybody makes mistakes and hopefully, you will learn from them. Click To Tweet
When you look at the demographics, it makes sense because you’ve got these pent-up potential buyers that want to buy but they don’t know how. They understand renting, they understand leasing and you market lease option properties. You’ve done it before. You’re going to get more attraction on that. This is a perfect technique and you provide the financing and you built it all in. You’re taking them through thirteen-months, but technically, you don’t have to do that. Tax-wise, it makes sense. That’s what it meant by combining the best of real estate with real estate because it opens up all this new opportunity to provide something the market needs.
Let’s talk about nonperforming notes, because you’ve got performing notes. That’s like the cherry on top of the cake, “I have a note, it’s performing and it’s great. I’m going to get paid every month. It’s amazing. The worst case scenario, I’ve got the security.” What about nonperforming notes? How do I move and groove with that? That requires more work, that requires more attention maybe. How much work is involved in that? Do I have to get into the nitty-gritty? Help coach me through that.
The nonperforming notes are delinquent notes. Somebody is in their home, they might still be living in the home or the home maybe vacant. You should know that before you buy the note. If you want the target nonperforming loans that are on vacant property, you’re making a pure real estate play. All you’re doing is acquiring that note and you’re going to pursue that property. As you know, there are two ways to do it. You could do with the voluntary way, which is they sign a deed in lieu of foreclosure. We always try to do that first. If you have to, you foreclose upon that property and you end up acquiring the property that way. The big difference is if you look at foreclosure sale numbers at courthouses, it’s a very tough market.
When you buy nonperforming notes at top markets, you’re paying more for those. I’ve heard people paying $0.80 to $0.85 on the dollar at a courthouse sales. I’m blown away, “How do you make money on that?” I guess they’re doing some very long-term strategy. With a nonperforming note, you still can get them for $0.50 on the dollar or less depending upon what price breaks you’re looking at. The other way is if it’s a vacant home or you can specifically target owner-occupied homes that are delinquent then you’re making a play to take that note from a broken note, fixing it up much the way you would fix up a rehab property. You’re paying for a broken note but you also understand what your expenses are in fixing that note like with fixing the property. You get it reperforming and you’ve increased the value as you would have if you did a rehab property. Rehabbing a note if you will is taking a nonperforming note, getting it reperforming, seasoning it and making it a performing note. The inventory is shifted on nonperforming notes and maybe you want to talk about that but I think that answered your first question.
What about those investors or potential real estate investors that will say, “Kevin, great. Notes, awesome, but I like actually buying property because I can depreciate it. I get the appreciation and all the other benefits.” What do you say to those people?
I totally understand that. There’s nothing wrong with it. There’s no way I can come back and challenge that because they’re right and continue to do that, but why not diversify and look at some other aspects? The people investing in real estate now I would think to know that property values can also go down. If you start talking about, “I get the depreciation on the write-offs and I’m getting equity in the property as it grows,” that’s if the property value goes up. There are a lot of investors, myself included in that group that was affected by that crash. We saw property values essentially drop in half. I don’t think there’s anything wrong with doing both. I don’t have a good come back, “Here’s why it’s much better.” I can tell you this, if you want to get away, which a lot of landlords end up doing, getting away from that management. I think what a lot of investors forget about is they look at the appreciation but start adding in all those costs every year to maintain the property and everything else in your numbers. With the notes, you don’t have that, so it’s a much more passive play in the market.
We’ve been talking about why real estate notes should be a pretty important part of your overall portfolio and investing strategy. If you’re new to the real estate game, check it out. We were talking about the nonperforming note inventory and how some of these are starting to come online and you have all these investors that pick these up and they’ve turned them around. Kevin, can you talk a little bit more about this nonperforming note inventory? Is there are a lot out there? Is it short in supply? What’s the deal?
The nonperforming inventory, I received vibes and I’ve received direct emails from people in the business going, “It’s drying out.” I do a lot of research, staying on top of the market, seeing what’s going on and what the trends are. I do this all the time. I put stuff on my blog Kevin Shortle website. We even talk about it in other places like my podcast. I went through and I said, “Here’s what’s going on with the nonperforming loan.” You can source inventory in other places. One of the great sources for tracking nonperforming loan inventory is Fannie Mae sales.
Hopefully, everybody in the audience understands what Fannie Mae is, The Federal National Mortgage Association. They buy bank-originated loans. When they do that, they’ve taken a lot of those loans. They bought them from the banks and a lot of them went into default. I went back on all of 2018 and ran all the numbers. How many notes were sold, what the unpaid balance was, who the buyers were and I created this spreadsheet. A couple of interesting things in the spreadsheet was this. The two biggest buyers of notes from Fannie Mae were Credit Suisse and Goldman Sachs. They were the two biggest buyers of notes. In fact, Credit Suisse was the biggest in 2018. They bought 51,324 nonperforming loans, over $11 billion worth. Goldman Sachs bought 28,333 for over $5 billion.
Why are we talking about that? They started buying those in August of 2018. Between those two entities. That’s 78,000 notes that they bought from August to December of 2018. Can you imagine how long it takes entities like that to go through every one of those loans and try to find out what the story is? Are they still in the house? Can we rehab the loan? Can we do a loan modification? Do we have to foreclose on this one? That’s a workload. What we see as a result of that is there is a recognized lack of inventory on the nonperforming side, but it is going to come back in a very big way for reasons I told you. You’ve got all these other companies going through this nonperforming loan inventory, deciding what they want to keep and what they want to sell. Deciding of the ones they keep if they have to foreclose or if they are going to remarket those as re-performing notes. 2019 is going to be a year of more reperforming notes, scratching debt notes a little bit. It’s a great market because you get better prices on those.Sometimes we need to take a risk to see the outcome. Click To Tweet
Where does one find nonperforming notes available for sale?
When it comes down to it, there are a couple of funnels if you will. The banks don’t keep them, so banks are turning around and selling those. They sell them in bulk. You can buy directly from banks, but it’s not as easy as one might think because if the bank is under investigation from FDIC and they’re looking at their portfolio and saying, “You’re over a 5% nonperforming notes,” it does trigger an immediate investigation at 7%. They want to get those notes off their books. If you buy one note from a bank like that, it doesn’t move their needle. If they’ve got a thousand nonperforming loans, you go, “I’ll buy that one for $25,000.” It doesn’t do anything to them.
They typically need to sell in bulk and that’s where these hedge funds come in. You can get online and look for an inventory that way and with some of these hedge funds and do your due diligence. Don’t blindly buy. There are also some trading platforms that are out there that you can buy those from. Understand the trading platforms. There are no guarantees. You have to do extra due diligence. You need to be trained well in nonperforming notes because you have to know who you’re buying from. You have to know the assets, you have to know the problems, if the problems are fixable, so you’re right in what you said where it does take more effort. It’s more of an active investment versus a passive investment we were talking about. I’ve been in this long enough and we’ve developed relationships and we have a platform, IntelliNotes that we offer inventory for sale through that for both performing and nonperforming notes as well.
What are some of the mistakes that you’ve made as an investor in notes that you can share with us that you feel would be a valuable learning experience for our audience? Was it buying it directly? How do you evaluate notes? Was it you didn’t evaluate something correctly? You thought UPB was something else?
Everybody makes mistakes and hopefully, you will learn from them. In fact, when I’m teaching this, I tell people, “In this industry, the first thing you think about is your risk.” Too many investors coming into the note business and probably the real estate as well looking at, “How much am I going to make? What’s my profit going to be?” In the note business, we call it to yield. People look at, “What’s my yield going to be on this note if I buy this?” I’m like, “Forget about your yield. Think about your risk first.” I take the approach of identifying the risks and then the yield will take care of itself by either passing on the deal or negotiating a better deal. The focus here on note whether it’s performing, re-performing or nonperforming is the due diligence. It’s the understanding of this.
This is where not all real estate skills are transferable. An example everybody can identify with. If you go to a real estate closing and you watch a real estate closing. It’s pretty amazing how the whole thing works. I know yourself or an audience has done this, but I’ve seen this with other people. They sit there and sign the document and pass it along and they don’t read anything. Everybody signs those documents. In the note business, that’s what we’re buying. You have to understand what’s in those documents.
The mortgage for example. What type of mortgages is it? Is it traditional mortgage or is it a deed of trust because that will affect how the foreclosure would play out, whether it’s judicial or non-judicial. What’s going to set your time and costs valuations there? Is it a hybrid type of document? A land contract and what does that mean? What do I own there? Do the numbers make sense? It starts with looking at your documentation and understanding what’s in there. What I did not say was every time you buy a note, you have to read every single word in these documents. No, you know the key things to look for. You jumped part to part.
Many notes, for example, can also be traded. They’re traded through launches or endorsements. They’re traded to assignments of mortgages. You’ve got to be able to track those things. The paper people and the real estate people, they have the real estate skills where you have to evaluate the property. Understand what the rehab might be. Everything that real estate investors do, but on the note side, you have to do the same thing with the paper and understand what’s in there because that’s what affects the entire deal. I think when you get a little too advanced or intermediate, you start to cut corners. I know I did this as a real estate investor. I bought a lot of rehabs.
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About Abhi Golhar
Abhi Golhar is a media host, educator, and sought-after speaker with a large national following and wealth of resources to share in the RE investment industry.
He has built and managed a sizeable, profitable investment portfolio across the Southeast US, with expertise in benchmark markets.