Be the Bank With Your IRA to Invest in Notes

Guest post by Bob Malecki:

If you invest in real estate you know that “cash flow is king” — but at what cost? If you own rental property you know first-hand the challenges that reoccur such as repairs, vacancy, vandalism, insurance and many more details that erode your profit and time. If you have these in your IRA, then you have added costs for property management. Plus your IRA may need to use leverage to magnify your ROI.

So why not consider being the bank instead of the borrower?

By purchasing and holding a mortgage note on a property, you are receiving monthly payments like you would with a rental, but without the headaches associated with being the landlord and property owner. Also, as the lender you still have the underlying asset (the property) to secure your investment.

Why Invest in Notes?

A real estate investor has many asset classes available to generate cash flow including rentals, flips and paper (notes). These all have various advantages but owning notes or “the paper” provides one of the simplest risk models, since there are many fewer points of liability than owning the property.

When a note is performing and being repaid by the borrower, your IRA as the note holder receives payments every month, and even better, there is no ongoing work required to continue receiving those payments as there would be in a rental ownership. No employees, no contractors, no repairs, no tenants.

If the borrower defaults, your servicer will reach out to them to attempt a workout. If a workout is not successful then you direct a foreclosure attorney to foreclose and liquidate the property to regain your IRA’s investment. If your IRA purchased the note at a decent discount to the amount owed it will even make a nice profit.

Because the note investment space has so many third party vendors, it is very well suited for the self-directed IRA investor whose “hands on” capabilities are essentially restricted by IRS regulations. Managing a portfolio of notes is also much easier to scale than a portfolio of homes or apartment buildings. Your primary tools are a computer and your phone. No site visits, no permits, licenses or finding dependable contractors! Plus, notes are more liquid then property. It’s much easier to sell a note to another investor than liquidate a rental property or office building.

Discounted Notes

Distressed mortgage debt, a.k.a. non-performing notes can be purchased at deep discounts then restructured for borrowers to resume their mortgage payments. Because the acquisition cost – including fees and monthly servicing – is low, the ROI on the monthly income can be substantial.

Where do non-performing notes come from? If you read the book or saw the movie, The Big Short provides a good perspective on what occurred to create our housing bubble and subsequent collapse. Essentially, a small group of Wall street investors saw that the resetting of stated income loans from teaser to full rate will cause massive defaults and crash the housing market.

Needless to say, they were right.

A massive amount of sub-prime loans were originated which eventually displaced a lot of homeowners through foreclosure. These loans are the “toxic assets” that were originated as “stated income” or “sub-prime” loans during 2005 through 2008. The propagation of these loans led to the collapse of our housing market and has provided an unprecedented opportunity for those who understand how to acquire and reposition these assets for substantial returns.

Now the financial institutions have a portfolio of “seriously delinquent” loans – those over 90 days unpaid. Of the estimated $8 Trillion in total mortgage debt in the U.S., an estimated 3% are still seriously delinquent. That represents over $210 Billion in distressed mortgage loans.

New regulations such as the Dodd Frank act have provisions that place pressure on financial institutions to offload their distressed debt to the secondary market, typically by selling them to hedge funds. Since the loans are sold in pre-packaged pools, these hedge funds are forced to buy pools of mixed assets. Inevitably there are certain assets that do not meet their investment criteria and these are resold at a discount to small balance real estate investors − like us.

Risk Tolerance

Distressed mortgage notes are acquired in various stages of risk. There are performing notes, sub-performing notes and non-performing notes. A performing note that has 12 months or more payment seasoning is the lowest risk but usually will have a lower yield, probably around 8% to 12%. When you move down the performance spectrum the yield will increase. This is because the sub/non-performing assets can be purchased at a lower Investment To Value ratio and produce a much higher ROI when you get the note restructured and the borrower resumes performance.

We have been steadily buying non-performing, distressed mortgage debt in our self-directed Roth IRAs for the past 4 years at costs of less than 50% of the home’s as-is value. Of the loans we acquired last year, we have been able to work out a loan mod with the borrowers and now are seeing the annualized ROI from cash flow ranging from 19% upwards to 85%.

How do we do this? Well we buy these notes with specific underwriting criteria and we buy them at a substantial discount. This keeps our liability minimized and our investment-to-value ratios quite low, which provides us the flexibility to extend terms or lower the interest rates for borrowers, while still getting an aggressive ROI from their modified monthly loan payments. A rare win-win for all!

The Tax Implications

Now, because the income from note payments and the capital gain from liquidation has no tax offset from depreciation like rentals would, your IRA is an excellent tax-advantaged vehicle to own notes. Being a fairly seasoned landlord and flipper, I have to say that the process and upside for buying and re-positioning distressed mortgage notes far surpasses that from owning rentals and flipping homes, especially in my self directed IRA.

Being the bank allows for much lower liability and allows my IRA to obtain an asset for less than 50% of its current value. In addition, the management of the debt is much simpler, since I’m no longer dealing with tenants, contractors, real estate agents and competition from other investors. Now don’t get me wrong—our IRA still has rentals in our portfolio, it’s just that I’ve found that it is much more profitable and easier to manage to invest in notes.

Since 2006, Bob Malecki has been involved with the acquisition and management of distressed assets in his home state of Washington as well as other key markets in the U.S. He is the founder and Managing Director of Resolution Capital Management LLC, a private equity fund that provides investments in distressed residential mortgage debt. To learn more, you can reach Bob at 360-850-1252 ext.111 or via email to bob@rcm.company, and visit http://www.rcm.company/note-basics/.

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