Selling notes

Here’s an angle on real estate that some lenders pursue: Selling notes.

I was trying to explain this business to Lucy two nights ago as we were lying in bed. Needless to say, it put her to sleep. So please stop reading if you have anything important to do this morning.

Anyway, here’s how the business works: Say a hard-money lender loans a borrower $300k as a first trust deed against a $600k apartment building. The interest rate is 10% / year, interest only. The term is two years. At the end of the two years, the borrower has to pay back the principal ($300k). And let’s say the borrower also pays the lender a 4% fee ($12,000) to close the deal.

During the course of the  two year loan, the borrower is going to pay the lender:

  • $12,000 as a fee
  • $60,000 in interest
  • $300,000 in principal

That’s $72,000 on $300,000 invested for two years, or 12% / year. So far so good.

But the lender has a problem: He needs to wait for two years before he can make another loan. What if, instead, he immediately finds someone to buy the note from him? For example, say he sells the note for $315k to a rich old guy just looking for an easy yield.

The lender immediately gets back his $300k principal. He keeps the $12k fee, plus he gets $15k as a profit. He can turn around and do the same deal again and again, earning fees and profit all along.

Meanwhile, what about the rich old guy? Didn’t he get screwed? Not really: He did not work and is going to collect $60k in interest over two years. So he gets $60k on $315k invested over two years, or 9.5% / year. Not bad, right?

P.S. There are actually brokers out there who do the above without any money of their own at risk at all. They just connect borrowers and lenders and take fees and profit on each deal. It’s a pretty sweet position to be in, but you need to have connections with a bunch of rich people (on one side) and a bunch of hungry borrowers (on the other).