The beauty of the note business and the challenge of the note business at the same time is the infamous question of “what is your yield?” Or “what kind of return are you looking for?” We get that question on a regular basis from sellers and we also get that question on a regular basis from investors. How can I make 10% or 12% from the buyer’s side and from the seller’s side, what kind of yield are you buying at?
My answer to that question is very broad based on my time in the business. It goes like this: we have bought deals at 7% yields, and we have bought deals at 16% yields. I know that’s a big, big swing in yield calculations. But here’s the reason why. The number one thing that you have to keep in mind when you are buying private notes is that this person or property is not an institutional quality product, which doesn’t make it a bad product. It just makes it a higher risk product. Now, higher risk is relative to the overall quality of the deal. What does that mean? Number one, you have to look at it from the banking industry side, which gets their cost capital, which is literally zero. So, if they are lending me money to buy a house and they are lending it to me at three and a half percent, then they are making a three and a half percent spread on that money. But their number one goal, their exit strategy and we’ve all experienced it, is to loan the money out, create the loan, bundle that loan with a large package of loans, typically ten billion or more, and sell off that entire package in a mortgage backed security marketplace, where they’ll get 103 to 108 even as high as 121% of the loan amount.
So, if they lend out $100,000 on a mortgage, they’ll bundle that with a portfolio of mortgages somewhere between five to ten billion dollars’ worth of product, which ultimately will increase the value to 103% to 108%. Like I said, back in the premium days, it went as high as 121%. Why do they do that? The masses of product create higher quality bundles which spreads out the risk, which increases the returns on a large-scale loan. That’s the institutional mortgage industry. That’s the Wall Street mortgage industry. That’s the mortgage backed security industry worldwide. That’s a model that I can’t compete with and I don’t know anybody who can.
The reason I share that with you is because people will sell their property to somebody who is not qualified to get a loan from a bank. And yet, that person wants to buy their house and they have decent credit, they have a decent down payment, they have a job, all of those checks are marked but they want a 3% or a 4% interest rate on a 30-year mortgage. And property owners agree to those things. Note holders agree to those types of terms. And they typically agree to them because they’re trying to compete with the banks. Well the truth is that they don’t have the same structure as an institutional bank.
Why would I tell you that story?
The reason I tell you that story is… don’t do that. Do not do those kinds of things if you’re creating seller financing. Don’t try and compete with a bank that gets their money at zero cost of capital and they lend it out in the multi billions of dollars per week.
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