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Article by John D. Behle

The Ugly Duckling

The following is an excerpt from Mr. Behle's book "Creative Paper Formulas"

Ah, creative financing! Don't we just love it! It has been a fantastic way to buy and sell properties in the last few years and it has created some great opportunities.

Fantastic Opportunities

What are these opportunities? How much profit is there to be made? How hard is it? Does it take a lot of cash?

These opportunities revolve around what might be termed "TRASH PAPER". This consists of contracts, trust deed notes and mortgage notes that may appear at times to be no better than the paper they are printed on and sometimes seem to belong in the garbage can instead of the wall safe.

There are millions of dollars to be made in "fixing up" paper just as there has been millions made in fixing up properties. These problems in paper can seriously affect the value, yet they may be "FIXABLE" problems. Eliminating or reducing these problems can boost the value substantially. There is also another area of profitability of improving notes that do not have problems.

Correctable Clauses and Traveling Trust Deeds

One of the areas of "fixability" is with clauses and another is with the security. Let me share a couple examples.

Due on sale dilemma

A note holder called me one day with a Contract (Uniform Real Estate Contract). It had a 30 year amortization and a value of about $4500. The seller wanted $5500) but there was no way that anyone in town was going to offer her more than $4500.00 - including me. This note had an interesting twist to it since the contract contained a "due on sale" clause and was currently for sale. It had the distinct possibility of being paid off immediately for full face value. I wouldn't buy based on the "odds" that the contract would pay off early - I'm not a gambler.

My gypsy's crystal ball was in for repairs, so I couldn't tell the future either. I didn't buy the note and also didn't sleep as well as normal for the next six months. Something inside me seems to sense profitable opportunities. Sure enough, six months later I called and the note was still for sale.

A Fair Trade

My first idea was to delete the "due on sale" clause and insert a five year balloon payment. The note seller, property seller and the real estate agent were thrilled. The property had been listed for two years and had not sold because of the un-assumable loan. My rate of return would be even higher than I originally desired and the note seller would receive their price.

The second option was to raise the interest rate a little in exchange for the deletion of the clause. Either way, the value of the note would be increased at the closing. This gives me the ability to pay the seller's price and still get my yield.

A More Valuable Note

The note is more valuable in option 1 (due on sale clause deletion - balloon insertion) because the term of the note has been shortened. Here is the value of the original note and the restructured note at a 24% yield (the figures have been rounded a little to make the example more readable). The interest rates and yield rate are shown in the monthly form. (i.e. 10% divided by 12 = .83)

  PV %I PMT N FV

(CONTRACT) $55,000 .83 $499.79 300 mo. n/a
(FIRST LOAN) $45,000 .83 $408.92 300 mo. n/a

(EQUITY) $10,000 .83 $ 90.87 300 mo. n/a
(PRICE AT 24%) $ 4,531 2% $ 90.87 300 mo. n/a

AFTER INSERTION OF THE BALLOON PAYMENT

(60 PAYMENTS) $ 3,159 2% $ 90.87 60 mo. n/a
(5 YR. BALLOON) $ 3,212 24% n/a 5 yrs $9,416

(TOTAL) $ 6,371 (this is the value at 24%)

As you can see, there is a difference of almost $2,000 in the value of the note by improving it in this way. The seller could receive the $5,500 they were asking for and the yield for the purchaser is actually a little over 29%.

A Banker's Tactics

The second option was an excellent one also. The loan is currently un-assumable and stopping the sale of the property. A fair trade might also be eliminating the "due on sale" clause in exchange for an interest rate increase. If the rate were raised from 10% to 11%, it would make a large difference in the value of this note.

Being that the note is a "wrap", the increase in the rate charged will have more than a 1% effect. The note holder will pick up 11% interest on the $10,000 note equity along with 1% interest on the underlying first loan of $45,000. The value of the note at a 24% yield would be $6,370.73 instead of the original $4500. If the note is purchased for $5500 (the previously ridiculous price the seller of the note was asking for), then the yield is just under 28%.

Switchable Security / Traveling Trust Deeds

Other ways to fix up flawed notes are too numerous to mention or to give details on, but here are a few examples.

  1. INCREASE THE SECURITY - A note seller brought me a note once that had a 100% loan to value ratio and was signed by a corporation only (no individual recourse). I told him the two problems with the note, that I thought were incurable. A few hours later, I received a call from the payer of the note. He was willing to double the security (now a 50% loan to value ratio) and sign the note personally. All of a sudden an un-marketable, undesirable note has changed (ugly duckling to a swan).
  2. IMPROVE THE SECURITY - Move the note to more desirable security or even fix up the security that is presently there. How about using some money which would be paid for the note to improve the property? Subordination to a new small hard money loan to raise fix up capital?
  3. IMPROVE THE RATIOS - How about splitting a note with a bad loan to value ratio into two notes? Then instead of one large un-salable, undesirable note there are two notes - one that is salable.
  4. IMPROVE THE CASH FLOW - Could you work with the property owner on refinancing underlying loans to raise the cash flow on the wrap? There are dozens of ways to change the terms and cash flow on a note.
TAKE OFF THE BLINDERS

In buying notes, an investor tends to wade through a lot of "creative" notes. Some notes I've seen have the potential of only one buyer on the face of the earth - the person paying on it. Once my attitude changed and I took off the blinders, I could see possibilities and potential in the notes that no one would buy.

What a great way to edge out the competition. The technique dealing with the "due on sale" clause came about from a note that no one would buy - 6 months went by. The technique described just a moment ago as #4 came about with a note that was still for sale 2 years later. In fact, these types of situations tend to be some of the best profits that can be made on notes. LEARNING TO SEE THE POTENTIAL IN THE IMPROVEMENT OF NOTES CAN BE ONE OF THE MOST PROFITABLE THINGS YOU CAN DO

2000 Cashflow Specialists. All rights reserved.

John D. Behle, is one of the premier educators and practitioners in the field of "Real Estate Paper". John has an extensive background in consulting and coaching. In addition to the original "The Paper Game" book published in 1982, he is the author of 7 other books, several home study courses and over 200 nationally published magazine and newsletter articles on paper investment. You can visit him on the web at www.papergame.com.
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