THERE ARE FOUR ways to structure the form and paperwork related to partials. There are some distinct advantages and disadvantages to each format. Only the first form is commonly used and has the most disadvantages. It is the most common because some of the institutions use this format. The least common is the "compensating note" structure that I developed. It suits my needs the best, but would not work as easily with a multi-state institution.

1 - Contractual

This method of structuring a partial involves a form of joint ownership spelling out the interests of both parties. The note is assigned to the purchaser and then re-assigned to the original seller at the end of a certain term. The advantages are that it can be easier for an institution, but has potential risks "Industry White Paper on Partials" published by the National Mortgage Investors Institute).

One of the risks is that the note seller seldom understands their rights, liabilities and responsibilities and unhappy clients and their attorneys don't lead to a large referral business. You can and should cover your liabilities with some very explicit disclaimers signed by the seller of the note if you choose to use this method.

2 - Note splitting

Another technique is to actually split the note into two (or more) notes. The seller can take a subordinated interest. For example, you split a first trust deed into a first and a second. Squeeze the payments down into the first and have the second begin paying when the first is fully paid off. The problem (or challenge) here would be because the payor would need to be brought into the picture and possibly compensated or enticed in some manner. Still, this may be a much better option than the contractual agreement method. I would rather solicit the payor's cooperation now than try and deal with the potential problems of a failed "contractual" method.

3 - Compensating note

This involves buying the "Whole" note, not just a partial. The terms look the same and my yield is comparable or better. How this works is that I pay part cash and give the note seller a newly created note for the balance. It mirrors or reflects the portion of the note that I am not paying cash for. To buy a $10,000 10-year note, I pay $5,000 cash and give the seller a $5,000 note that begins payments in 5 years.

The note I buy is:

$10,000 at 10% payable $132.15 per month for 10 years (120 months)

I want to buy one-half of the note or 60 payments for $5,000. The last 60 payments will be reflected in a $5,000 note to the note seller. It is structured with no payments for 60 months and then will begin payments and totally amortize in months 61 through 120.

Where's the Security?

This note that I give the seller can be unsecured or secured by any agreeable collateral. I can use hard-to-finance real estate equities, land in Nevada, another note, my personal home, personal property or even the note I am buying.

I prefer to use collateral that is hard to finance. That way I am keeping the note free and clear and getting a loan that may be on much better terms than I would get at a bank.

An example is a $10,600 note in Idaho where the seller needed $4,000 cash real quick. I didn't want a note in Idaho at the time and we didn't have a branch office in that state yet, so I called two of my students from a recent seminar I had given. Both Rick and Tom said they were interested, but Tom moved quickest (You snooze - you loose, Rick).

The note was in Idaho Falls, Idaho. We structured a deal with the seller where she received $4,000 cash up front and a note for the balloon payment of the balance in 6 years secured by a condo Tom owned in Sun Valley. (Real estate exchangors might notice we just made the condo more salable at the same time.) The note that was purchased is free and clear of any financing or quasi-partnerships like we would have with the "contractual" method. The "compensating note" to the seller is secured by an entirely different asset - the Sun Valley condo.

4 - Top Secret!

How cruel. I'm supposed to tell you everything right? Sorry, but this one is not in place yet. It will be shortly and we will announce it to students. You'll love it. I can hardly sleep at night thinking about it. Besides, it would be way beyond the scope of this article and is not possible for a small company or individual to do without the outlay of tremendous financial resources.

In Summary

Consider the compensating note technique as an alternative to the contractual method. We haven't even discussed the issues of early payoff, restructuring notes, financing notes and trading notes for real estate. The profits available through using the compensating note far exceed the small hurdle of learning about the proper procedure on how to use it. In addition, once you fully understand this technique, it can be much easier to explain and negotiate than any of the other methods.

© 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.