Defending Bonds - Posted by J. Clifton

Real Estate Investing Real Estate Law
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Posted by John Behle on December 08, 1998 at 21:04:22:

I run into problems here at times when I am in a little bit of a cynical or negative mood. I get that way around some of the promoters and scams out there. I hate to see investors, home sellers or others burned or mislead.

Some scams and harmful seminar promotions have had to do with bonds, so instead of saying “WOW, YES, BONDS CAN BE A GREAT TOOL IN THE RIGHT SITUATIONS AND HERE’S HOW AND WHEN TO USE THEM” - I end up trying to warn off the newbies from some of the mis-information or potentially dangerous techniques out there.

Sorry about that. I just have a real thing for some of the promoters and scams out there. They annoy me grate against the educator in me. The “circus circut” with the evangelists running down the isles making false promises for money gets under my skin.

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Defending Bonds - Posted by J. Clifton

Posted by J. Clifton on December 08, 1998 at 24:06:18:

I was surprised to see John Behle’s critical view of bonds a few days ago, and would like to say a quick word for their use in real estate. John basically stated trading bonds are too hard to negotiate or justify ethically, are more limited in thier value and use, and that the technique is passe. Having worked both note and bond deals, in my experience I have found them about equally difficult to negotiate, past and present. Ultimately, it comes back to the level of motivation in the seller—i.e., if they really don’t want the investor to make a profit, they won’t agree to either mechanism. And ethically, what’s the difference between a seller objecting to finding out about a 30% discount you got from a note, as opposed to a discounted bond, once the knowing agent or attorney explains it to him? Notes can be arcane, but they are not that arcane.

In some cases, when explaining substitution of collateral, sellers found the bonds more acceptable (whereas manipulating notes was considered the fishy option). One strong advantage of using bonds over notes as collateral is that some sellers don’t want to have to take the property back, if the paper they carried back defaults. Although you can construct note deals that do the same thing, the “known commodity” aura bonds give off is more comforting to certain people. To get around the negotiation and ethics issues, I have only offered bonds to sophisticated sellers (owner-brokers, REO reps, business owners, professionals), and offered to create notes only against the actual, not face value of the bond. If one uses the higher face value interest (of an interest bearing bond) to pay off the amortized interest of smaller notes created against it, instead of zeros or zeroes only, the deals do work and can be negotiated.

Finally, bonds do have a range of value similar to notes—it’s just that there is an extremely efficient and highly visible market for bonds where the investor’s value is well-known, whereas with notes the investor value is more obscure (for now). While notes are clearly more flexible as regards yield, bonds are a viable alternative due to their solidity as collateral. It is thus surprising to see Mr. Behle be infinitely flexible when it comes to notes, but not be able to think as creatively about the latter.

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Re: Defending Bonds - Posted by John Behle

Posted by John Behle on December 08, 1998 at 15:27:14:

This isn’t a matter of flexibility or creativity, just practicality.

I have negotiated millions in “paper trade” deals. With some expertise, negotiation skills, backup information and the right seller, they can be quite easy to do.

The problem I have with bonds is as I stated. A bond does not have at a given moment a true value that reflects in the face value. Especially with zero coupon bonds - which also carry a potential tax problem of imputed interest.

Most of the sellers I have dealt with in “paper trade” type transactions would prefer cash, but just can’t get it in a given market. Few people know that bonds do not sell at face value. It takes one simple phone call and they know what potential discount they would have to take. They then view that as taking an extreme discount in the property and it doesn’t work in the negotiations.

With notes, they see something very similar to what they would take - just with different collateral. It makes the negotiations far simpler. It isn’t that often that the subject of selling the note for cash comes up and they then don’t jump to the “I’m taking an extreme discount for my property” type of thinking.

With notes, the value is relative. A note for $50,000 at 10% interest is worth that in trade to most potential sellers. To me it may be worth as little as $30,000.

Which brings up one of the bigger challenges with bonds - the margins. I can’t get any where near the type of discount on bonds that I can on paper - If you compare apples to apples.

I can get decent discounts on near worthless zero coupon junk bonds. That can lead to the margins to make the deal work financially, but I will not give them to a seller. Neither will I stay in the middle and in any way guarantee them.

I will never ask a seller to do something that I would not ethically suggest as an agent or consultant. I won’t ask them to do something that I would not do myself in the way of risks, etc.

I guess that loses me a few deals.

So, good bonds don’t discount enough to make the deal fly and I will not stick a seller with bad or risky bonds. EXPECIALLY when I can get great margins in good safe paper that I am willing to guarantee.

The guarantee portion is important, because they almost always ask for it and tax wise, it is usually the only way to make the deal fly. If I were to buy the notes (or bonds) at a discount and trade them at face for the property, I have a short term capital gain. I can work around that. The problem is with the seller. If they accept notes or bonds for their equity, they are taxable as if they received cash. The fact that most of them don’t know that isn’t acceptable to me - I will not stick them with a tax bomb that explodes later. Many of the sellers I work with accept paper or are persuaded to do so because they can keep an installment sale treatment if it is done properly - which means me staying in the middle.

If I stay in the middle with paper, I can continue to profit on the notes constantly. I still have an active portfolio that I can make a great deal of money on. I am thrilled to be in the middle for the profit advantage alone.

With bonds, again, if they are good bonds there isn’t enough discount. If they are weak enough that I can get the margins, then I (and most sellers) won’t do the deal. There is also NO upside profit. This is an extreme amount of money. At some point, maybe I’ll show why, but it is way to deep to go into here.

I can see that the way you are using bonds works. No question there are situations where bonds are applicable - I know that fully well. It’s just that that isn’t the application that most people are “Sold” on.

I made the comments previously because the ways that beginning and naive investors are told to use bonds are both impractical and in my opinion unethical (depending how they do it). Obviously these are not the ways you are using them. I have no problem with a banker accepting bonds for the REO property. They don’t have the tax and risk problems. A little old couple selling their home or rental does. The average “newbie” investor either doesn’t know the risks and problems or doesn’t care - Both of which are not anything I will encourage. Few investors would have the negotiation skills to pull off a deal on these transactions.

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Re: Defending Bonds - Posted by J. Clifton

Posted by J. Clifton on December 08, 1998 at 19:38:27:

Thanks for your response. Your observations are quite sound about the pitfalls of bonds—and I certainly don’t won’t to further pick an argument with the King of Notes. I was just taken aback by the lack of follow-up inventiveness in this area implied by your criticisms, which stuck me as odd coming from one of the most creative pros around. Creative people can both identify the problems, and also find possible solutions—be it with notes, bonds, or other investment issues. Please take my comments in that light. All the best!