Brokers at the Crossroad: The Return of the Private Investor

by John W. Moren

The seller-financed mortgage industry (a.k.a. the cash flow business) is again at a crossroad.

Twenty years ago the business was a cottage industry dominated by broker-investors with real estate backgrounds working from home offices. John Behle (jbehle@papergame.com) taught how to run a profitable mortgage business using private investor money. A few years later, as some people were unknowingly violating securities and lending laws, Bill Mencarow offered classes on how to avoid that and still use private investors. Brokers frequently “stayed in the deal” by either investing some of their own money or by taking their profit in the form of ever-compounding payment streams.

Money was tight in those days–there was not much of it available for investment and what money there was commanded rates in the upper teens and higher. Markets that are taken for granted today didn’t exist then. For example, it was virtually impossible to sell a note on a commercial building.

The First Significant Industry Crossroad

As rates eased and the money supply grew, long-time investor Michael Morrongiello (707-939-9450, MikeM@sunvestinc.com) warned me that the industry would not look the same in 5 years. He was right, and private investors faced their first significant industry crossroad.

Insurance companies and investment houses took an interest–so to speak–in seller financing. Broker business proliferated due to the quick money and ease of passing a deal to large investment companies such as Metropolitan Mortgage and The Associates. Investors had a harder time securing quality deals because they were competing with brokers anxious to pay today’s bills by selling tomorrow’s payments.

Successful industries always undergo a period of consolidation. Just as McDonalds consolidated the hamburger business and Blockbuster consolidated the video tape industry, investment companies are consolidating our industry. The largest corporate investors are beginning to advertise directly to the public, which puts companies such as Metropolitan Mortgage in a competitive position with the same brokers who had been channeling them profitable notes for the last ten years.

The Second Significant Crossroad

Note brokers are now at another crossroad. Their growing numbers increase competition with each other for the fixed number of deals. Further, they may be at the mercy of corporate buyers advertising in the brokers’ back yard. As this trend continues, watch for the extinction of the independent broker. The entrepreneur who will succeed during the next 15 years will be the one who can find and fund his or her own deals.

Investors have a fixed floor under their income level and are immune to corporate politics, restructuring, and downsizing. The balance of this article will list many points devoted to fine-tuning your investor skills. Those of you who are strictly brokers should find a few tips for easing yourself into the investor role, balancing out the risk in your business plan, and successfully negotiating the next crossroad for your business.

– Hypothecate, don’t sell. When you sell a note, you finance your business at the investor’s yield. That’s great if you’re a high risk internet startup, but too high if the security is a quality first mortgage. You face an immediate tax consequence when you sell a note and you give away the windfall when the note pays off early.

– Cut it thin, you never win. When investing with other people’s money and your name is on the documents, we’ve estimated that it takes 2 yield points to stay profitable. If you need a financial calculator to analyze your spread, it’s too thin. Hypothecate profitably.

– Disclosing everything to an investor is common sense: Be sure to have them disclose to you. You don’t want to take a widow’s $10,000 only to find out it was her last $10,000. You do want to pledge second mortgages to investors who have held seconds before. Our investors include CPAs and attorneys we met in mortgage seminars who were privy to the same knowledge we have. It would be hard for them to claim we took advantage.

– Borrow long and lend short. The banks tried this the other way around some years ago and we all paid for it. Controlling a portfolio of 10-year mortgages with an adjustable rate line of credit is risky. Add a short term call provision and it’s suicide. Rates are at historic lows–watch the fallout when they creep up a point or two. Have your money come back to you faster than you pay it out (time value of money) and you can always pay your debt off early if rates move against you. Low rates, and especially flat rate environments, are very forgiving. Protect yourself against rising rates and short term calls.

– Restructure for profit. Large investment corporations buy a note and immediately go to work on the payor. They encourage an early pay out to reap a higher yield. Offer to halve the interest rate of the note if the payor will double the payment. Try it out on a financial calculator and see if it doesn’t raise the investor’s yield by 4% or more. That’s just one trick–there are many others.

– No paperwork, no money. The days of handshake deals ended 15 years ago.

– Compare the quality of the debt you give to the quality of the debt you receive. When you sign a line of credit, you are guaranteeing the payment and you know you will make the payment. This is high quality debt. Use that money to buy a note with similar or better quality so you can be sure the cash flow is there to make your payment. Check with Peter Fortunato (727-397-1906) for more details (Ask Peter about his next seminar, and go! — Editor)

– Disdain partnerships. Partnerships fail due to the perceived inequity of what each partner brings to the table. Set up your deals so that each party is independent. If investors insist on buying in on your deal, give them the paperwork, assign them the entire note, let them do the servicing, and be done with it. – The best predictor of foreclosure is a small down payment. So says the FHA and isn’t that ironic? Our late friend, Earl Woodell, told us that every note he bought behind a $1000 down payment eventually defaulted.

– Find additional profit centers in your existing deals. It takes about $10 per note per month to make a profit as a loan servicing company. If you service payments your own contacts receive, however, you can be profitable in the $2-$7 range by keeping your name in front of them. We recommend you do not service the same notes you sell to your investors to avoid potential securities issues. The servicer keeps all insufficient funds (NSF) and late fees. Structure the servicing so that incoming payments are due, for instance, on the 1st and investor payments are due out on the 15th. Get some float, make sure the receivable check clears, and try to get outgoing payments bunched up so they are due on just one day each month.

– Nothing should come between you and your payor, least of all an investor. If you pledge your receivable notes instead of selling them note off, stay in the middle of the deal where you know exactly what is going on. Payments should come directly to you so you can track the payor’s history, then forward on the investor’s portion. Large principal payments and lengthy delinquencies are significant events of which you need to be aware. You only can be sure if all payments come through you first.

– Bunch up your note holdings geographically so you could give an attorney repeat business. You’ll get much better service if you ever need legal help. Trade out any note that is the only one you hold in that state unless you plan to increase your note portfolio there. At the same time, be sure to spread your risk by holding notes in multiple states.

– Check out your collateral after the closing. Few deals are closed without an appraisal, but be sure to do a quick follow-up every few years. Inspect the property if the payor files bankruptcy. You then can have your attorney petition the court for relief if you discover your collateral is being wasted. We had a payor go into bankruptcy although he never missed a payment–until he came out of it! When we took the property back, its only value was the land. Fortunately that was enough but we didn’t get the windfall we expected. A cheap, quick market analysis by a local Realtor would have clued us in much earlier.

– Make it easy for people to pay you. Payment coupons, deposit slips, credit card payments, automatic checkbook debits, and prewritten checks all can simplify your collections. Offer an interest rate discount to payors who agree to increase their monthly payment. Your yield, trust me, will increase dramatically. Have your attorney draft a note modification agreement to accomplish this and make sure there are no junior lien holders who would be adversely affected. We once left an account open at a bank for a year after we moved out of state. Two payors preferred making their mortgage payment ten days early every month–the day their Social Security check arrived–and they did not want to risk mailing their payment to us.

– Buy a note then buy the property. One of our best note purchases was in Summit County, CO. As you probably can guess, Summit County is not exactly in the middle of the suburbs. Corporate America would not go over 50% ITV at the time, so we overpaid the best offer and got a great yield based on a sizable discount. One day the payors called for a payoff. They sold the house with 35 acres, which had a commanding 360 degree view of white-capped mountains, and we recaptured all the discount in only a few years. A while later we drove by the area and it dawned on me that we could have bought the property at a huge cash savings by using their note to us to cover part of the purchase price. And we might have gotten them to finance the difference!

– Don’t spend what you earn, spend what your earnings earn. This is difficult to do when you first get started. Read “The Richest Man in Babylon” for guidance–George Clason says it so much better than I can.

– Don’t eat your seed corn. Of all the pearls Jimmy Napier has given to me, this is the most valuable. Stated another way, you can spend your $2000 paycheck on luscious groceries or you can eat cheap and invest $1000 of it toward your future. There is something warming about waking up in the morning and not worrying about where the money is coming from. Eating beans today sure beats eating pet food when your Social Security checks start coming in.

– Good paperwork doesn’t make a good deal, good people do. No matter how many clauses, how many contingencies, and what who says to whom, if the payor won’t pay, the payor won’t pay. We have systematically improved the quality of our portfolio over the years to the point where we have only IRA quality notes: good seasoning, low LTV, and above average credit. This maxim holds for your choice of investor, too.

– Don’t sue anyone for less than $10,000. The legal fees combined with the uncertainty of collecting your judgement makes anything less uneconomical. Unfortunately, the corollary is true as well. It’s not worth defending yourself for less than $10,000. A sad commentary on life and a sad commentary on the American legal system: You can be right or you can be happy.

– Maximum productivity is achieved at a point just behind the leading edge of technology and way ahead of the pack. The PC, PalmPilot, and Internet will put the pencil and paper crowd out of business. Use tools to reduce your grunt work and spend more time marketing for the next deal. Picture a Norman Rockwell bookeeper reconciling the checkbook with a visor and armbands hunched in front of a green banker’s lamp. Meanwhile, the techno-investor, whose Quicken books are continuously balanced, just closed another note.

– Exceptions will kill you. Regiment as much of your business as possible and you’ll get 80% of the work done in 20% of your time. Our portfolio contains only high quality notes–we give up a bit on yield but spend no time managing it. Hunt down Michael Gerber’s outstanding book “The E-Myth” for details. – Float like a butterfly, sting like a bee. Although Muhammed Ali was referring to boxing at the time, it’s applicable to any entrepreneur. Profitable opportunities come your way regularly and you need to jump on them. We moved to Colorado and discovered that rental houses would generate the same gross return that a mortgage would, so we moved some of our investments into real estate. This was just before the Californian invasion of Colorado and the 50% uptick in prices.

– The best investment of all may be to pay down your own debt. Debt that you pay is the highest quality debt you manage and often can carry some of the highest interest rates. Pay it off early. Think how reassuring your future will be when you are not continually borrowing against it to pay today’s bills.

– The more you hoard, the less you have. We really own nothing anyway, but are merely stewards of the property under our control.

John W. Moren has been a note and real estate investor for almost 20 years. He has taught classes for THE PAPER SOURCE, been a keynote speaker at many note industry conventions, and specializes in business applications and organization specific to this industry. He is perhaps best-known as the author of NoteSmith™, the premier servicing software for note investors, NoteWorks™, a complete electronic office for cash flow brokers, and RealtyWorks™, which includes contracts and forms. Visit www.NoteSmith.com for more information.