by Sandor Lau
Imagine an investment in a single-family home where you put down only a fraction of the property’s value. The home has been occupied without vacancy for the last 10 years. The occupants are internally motivated to mow the lawn, fix the roof, and unclog the sink on their own dime.
You can profit from this investment through value appreciation and principal paydown, like any other piece of real estate. This way, you can do so without ever dealing with tenants, toilets, or termites. Because you’re not the landlord, you’re the loanlord. You’re the bank. And they’re not tenants, they’re homeowners.
Real Estate without Tenants
You can stop imagining now because it’s real. Here’s my business plan in one sentence: Buy nonperforming second loans on residential properties where the borrowers are current on their first mortgages.
You are dealing with borrowers who have been investing emotional equity in their homes for a decade or more. They have a lot to gain by cooperating with you, and a lot to lose if they won’t. You have only a little to lose, and an incredible amount to gain.
Every day the borrowers are taking care of the property and paying the first mortgage, you win. The property is overwhelmingly likely to go up in value, and the homeowners are paying down the balance of the first mortgage, increasing your equity position. They are also overwhelmingly likely to be paying the taxes and insurance.
Our culture teaches us that what is common and average is good and right. What is unusual or extraordinary is bad and wrong. Just ask a guy with a weird name. One of the worst myths perpetuated by the mediocracy is that risk equals reward. In the stock market, for you to win, someone else has to lose. There is better way.
I believe in abundance. I don’t want to enlarge my slice of a finite pie by taking parts of other people’s slices. Besides, I don’t even like pie much. I like dark chocolate. With sea salt and almonds. I want to make a bigger square of the chocolate bar for myself by making a bigger chocolate bar for everyone.
The average American watches four hours of television a day, has $15,000 in credit card debt without a plan to pay it back, and reads at an eighth-grade level. Do you want to be average?
In the second notes investing world, reward outstrips risk many times over. As my mentor Gordon puts it, investing in junior liens is the real estate equivalent of stock options.
Case Study: Joe and Jane
For round numbers, imagine a home worth $100,000 in the Atlanta suburbs. Joe and Jane American homeowner bought the house for that amount in 2005. They put no money down and got an 80/20 piggyback loan with a first mortgage of $80,000 and a second mortgage of $20,000. The market crashed. Joe lost his job.
Jane kept her job and they were able to keep current on the first mortgage or get a modification they could afford. The bank who owned the second loan sent them a letter when they stopped paying, “Dear Joe and Jane, we would really prefer you to pay your second loan. Pretty please.” Joe and Jane had bigger problems to worry about.
Now, real estate has recovered, or is at least recovering. Joe is working again. The house is once again worth what they paid for it and is going up. Let’s say they have paid down the first mortgage to $75,000.
The bank wrote off the second loan, and sold it to you for $3,500. Now you have the right to collect the full $20,000 they owe, and back interest and fees of another $5,000, or $25,000 total.
The house is worth $100,000, and you could foreclose, and pay off the $75,000 first and keep the rest for yourself. But foreclosure is expensive, and you’d have to pay a realtor to sell it. What I like to do is talk with the borrower and find an affordable way for them to keep their home.
Maybe they can pay $2,000 down and $250 a month, then refinance, pay it off, or sell the house when the note comes to maturity in three years. Now I’ve got a valuable asset, a $20,000 performing note. I can borrow against that note and pay 9% interest to people who want to invest passively and don’t want the risk and fluctuations of the stock market.
Maybe Bank of Mom and Dad can help Joe and Jane out or maybe they have money in a retirement account. If they owed you a total of $30,000, but could pay you $20,000 today, would you take it? I would. Happy birthday Joe and Jane, you just won $10,000 free! Enjoy a little bigger slice of pie.
If the borrowers won’t communicate or can’t or won’t pay, you absolutely have the right to foreclose. In Georgia, you could foreclose with around $2,000 in a few months.
You can also just sit and wait while the property appreciates and the homeowners pay down the first mortgage. Want more equity? Patience, Grasshopper. If the Atlanta metro area is going up 5% annually, your $100,000 house should be worth $105,000 next year whether you have invested $3,500 or $100,000. Leverage cuts both ways, but in this business, it cuts only a little way down, but way, way up.
If you were totally wrong and this note is a complete write off, you only lost $3,500, a little more than you would pay for a 2001 Geo Metro. If you are right you’re probably earning over 100% return. Do you see why my heart is on fire for this business?
Sandor Lau is the author of Intoxicating Assets: How to Be the Bank, Invest in Real Estate without Tenants, and Why Seconds Come First, due for publication later this year (2016). He is the co-founder and Chief Inspiration Officer of Stewardship Capital which specializes in rehabbing defaulted second mortgages.