Re: what about defaults? - Posted by John Behle
Posted by John Behle on March 04, 2008 at 05:34:34:
There are basically a few approaches to handling defaults when you are using investor financing.
Option One. Your own funds. Many times an investor wants the monthly cash flow or needs it to pay their own bills. Some investors may not have much flexibility. So, if you are dealing with that kind of investor, you will need a reserve of 3-6 months of more of payments to the investor. One approach to this is to hold back funds right when you buy the note. So, you would take a smaller commission when you buy the note and hold some capital in reserve.
Option Two. Your credit. If you have unused credit where you could easily borrow the needed funds, then you can look to that source as your ability to satisfy the investor. Either of these two approaches are not the best bet for a beginning investor without a lot of cash. You donâ??t want to be financially stressed because you are not being paid.
Option Three. A more flexible investor. If you donâ??t have the funds or credit to satisfy your investor in the case of default, then you need a different type of investor. You need an investor that can forgo the monthly cash flow in case of default. Maybe they donâ??t need the cash flow or they have their own reserves or credit to draw from. As long as you are crystal clear and the investor knows what they are getting into, this can work out ok. When I first began, that was the type of investor I needed until I was able to guarantee the notes and cash flow myself.
Option Four. A second investor. If you investor that is funding the note is one that needs the monthly payment and cash flow, then you can work out the potential default problem by having a second investor that is your default investor. That could be an investor that wants a higher yield and has some liquid funds or credit for these type of situation. When I began, I had a couple of these type of investors and investors that would loan against or joint venture on notes that looked like they could end up being bad notes. One for example was an airline pilot and real estate investor that would be thrilled to get the property in case of default.
Those are some options, but I recommend strongly that you do have your bases covered somehow in case of default. That is one reason why it can help to broker the first few notes. Then you can find the type of investor that you do a little bit more of a joint venture with. One of my first investors was one where I would sell them the notes but would keep an option to buy them back. That came about because I had taught them a little too much about notes while cultivating them as an investor. They knew the greater profits that were available, but were not in a position to find the notes or deal with them in the way of improving them. I had the option to buy the notes at a little profit to them and an agreement to split the profits with them if and when I was able to improve the yields, encourage an early payoff, etc.
Then, when you are more seasoned, you can lower your cost of capital by dealing with investors that just want a simple, risk free, cash flow. When you are set up with reserves and know the ins and outs of collections, dealing with defaults, etc. then you move on to that type of investor.
There is a lot to learn and some experience necessary before risking your capital or that of an investor in purchasing a note. The first rule is to NEVER sell a note to an unsophisticated private party. Broker the first few to well established and professional note buyers. Only when you feel totally confident would you invest your own funds in a note. And never borrow funds from an investor to buy a note that you wouldnâ??t buy with your own cash. I view funds borrowed from an investor as something that is to be even MORE safe and secure than with my own funds.
When I say that I sold notes to a few investors, it was only because a couple of them were more sophisticated or knew more about paper than the average investor. I would be very cautious about advising someone to do the same. Avoid it if possible. Even if the investor is more sophisticated or thinks they are, when the chips hit the fan - they will blame you. If they are handling the collections for example and do a lousy job, they may cause a problem and be mad at you for the problem they created.
Example. One investor that was more experienced wanted to own the notes rather than just lending me the money. They were too lax in collections on a couple but one became a problem. The payor ended up being a true pathological liar. They fell behind. I instructed the investor what to do and they got them out of the property quickly without even needing to go through foreclosure. Given the circumstances I advised them NOT to sell the property back to the same people. They did anyway. The second they got back into the property they pulled a bankruptcy. That was a pain in the neck and the investor acted like it was my fault. They ended up making some great profits on the property in the long run, but I donâ??t recall them thanking me for the excess profits.
If someone were looking to broker notes and chose to broker them to private investors, I would advise them to sell life insurance or something else instead. Selling to private investors is risky and can be deadly. The profits in brokering the notes would not be worth the risk. Whereas the profits in brokering to a professional note buyer can be substantial and done safely.
But, borrowing from private investors when you really know what you are doing can be a great way to go and can be done safely. At the same time, using banks and other financial institutions can be a much better way to go when you learn to cultivate those relationships.