In part 3 of our “Notes vs Alternative Investments” series we’re going up against the reality TV stars, pitting Non Performing Notes against Rehab Houses or Fix and Flips.
To make it as fair as possible we’re going to have a non performing note go head-to-head with a rehab property. A non performing note is very similar to a fix and flip because both of these assets are typically purchased at a significant discount.
First, the attraction to rehabs is usually the entry price. This is often the biggest factor in the rehab business because the investor needs to keep their cost as low as possible in order to maximize their return on capital. The acquisition price has the largest impact on the bottom-line profit at the completion of the deal.
So, let’s take a note that’s $50,000 and put it up against a $50,000 rehab to see how they fare.
Buying Non Performing Note Bargains
The first thing to consider is that both the note and the rehab will be purchased at a marginal discount. The rehab is cheaper than market value because its as-is condition is below the market standard and requires repairs or renovations to bring it up to saleable condition. The after-repair-value (ARV) of the house is expected to be higher than the purchase price.
You can also buy non performing notes at a discount because the borrower is not making their monthly payment and it will require effort to remedy the situation. Since the note is collateralized by the house, we can expect to pay around $0.30-$0.50 on the dollar when acquiring the note. That means we paid up to $50,000 for a non performing note balance of about $100,000.
Also, the collateral (the house) is usually going to be worth more than the note because it’s a tangible asset with its own market value and the homeowner probably has some equity. And since a homeowner lives in it, it’s usually going to be in better condition than a typical rehab.
In other words, the non performing note is purchased at a discount of up to 70% compared to the house value. This gives you a significant cushion in your investment-to-value (ITV) ratio. And typically, we don’t even need to do any major rehabs with it.
Fix and Flips Are More Expensive
As for the rehab: in normal markets you can obtain a rehab around $0.70-$0.90 on the dollar of repaired market value. So, at best, the rehab house bought for $50,000 in this example might have a market price of about $71,500 all fixed up.
Even bank-owned, or real estate owned (REO) properties are generally purchased at seventy cents on the dollar and then quickly resold with a 10-15% profit margin. A 15% profit would look like this:
Purchase Price: -$50,000
Rehab & Sales Costs: -$12,000
Sale Price: $71,500
A rehab will take on average around ninety days to have a contractor get the house up to local building codes. It could take even longer if you attempt to do it yourself and you’re new to the business. And these numbers are assuming there are no surprises with the rehab and the house sells in a reasonable time.
More Exit Options with Non Performing Notes
The non performing note has the advantages of a lower cost barrier and less capital risk because it has a higher discount rate.
Now at this point, we don’t actually own the house, we own the note. But owning the note gives you many more options in the financial space. Here are the three most common options:
- Modify the loan: Our servicer can try to negotiate new terms to have the borrower start paying again, giving us a passive monthly income. This is the simplest solution and happens more than you think. You can keep the income asset or sell part of it to refresh your capital.
- Offer cash for keys. If the borrower is unable or unwilling to pay, we can have them sign a deed in lieu of foreclosure. They give us the property back as consideration for the loan.
- Foreclosure: If the borrower won’t take the other two options, we can start the legal procedure of foreclosure. Depending on which state the property is in and the local market, we either get the property back or a rehab investor buys it from us at a foreclosure sale. If we get it back, we can do whatever we like with it, but that’s probably worth another article. If an investor buys it they’re going to pay what the borrower owed. That’s why it can be our financial best friend—remember, we bought the note at a discount!
Here’s a little insider knowledge: it normally doesn’t cost more than $3,000 to have a foreclosure done for you, and then you’re free to do what you want with the tangible asset.
These are the most common (but not the only) options for handling a non performing note.
On the other hand, the rehab business typically considers selling the house on the retail market as the only option. But before you can do anything with that asset, you need to bring it up to code. You’ll spend your resources in getting the asset to be presentable to the marketplace, all while hoping the house doesn’t need any major unforeseen repairs that will deplete the profits. You primary option to get a positive return on your time and effort is fixing up the house and selling it on the retail market, getting what the market will bear. Yes, you can turn it into a rental for long-term cash flow—but as explained in our notes vs rentals article, this wouldn’t be the best return for your investment and efforts.
For now, the only option you have is to sell the asset on the open market and hope the market will allow you to sell for top dollar.
Profitable Exits for Your REO Property
If you end up with the property behind a non performing note, you again have more options. You could:
- Repair & sell it at retail, like you would the fix and flip.
- Quick sell it at almost retail to a rehab investor or local landlord.
- Turn it into a long-term rental.
- Sell it to with a large down payment and owner financing to bring in monthly passive income.
- Sell with a large down payment and owner financing as a turn-key rental to a landlord.
Non Performing Notes in Your IRA
Another benefit to incorporating a non performing note strategy into your portfolio is that you can choose to do these in your IRA, either for lump sum sales, or for a truly passive monthly income once they resolve.
Compared to rehabs, you’re able to invest with a lower entry cost and then keep all the principal and interest payments every month.
To accelerate future wealth accumulation, you could sell a portion of the note once the note has seasoned a bit. This allows you to recoup your capital and still keep future payments for payoffs. Either way, you’re able to take advantage of the flexibility of notes and have multiple avenues that allow your money to grow with a substantial approach to wealth generation.
Non Performing Notes For the Win
So, there you have it. Once again, we think there’s a clear winner by investing with notes. We hope you like this educational series on notes versus alternative investments to help you see why notes are part of building true generational wealth.
Next time we’ll look at an even more active real estate strategy in “Notes versus Wholesales”.
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