It’s plastered on billboards, bus stops, and cars: “Stop foreclosure! Avoid bankruptcy!” Behind every call to action is an investor with an eye on today’s booming pre-foreclosure market.  His acquisition strategy of choice: the short sale.

With a short sale, you purchase the property directly from the distressed homeowner subject to the lender accepting less than what is owed on the mortgage.  Without a doubt, this is a marvelous tool for buying properties at fire sale prices.  How does 40 to 80 cents on the dollar sound?

Here’s how it usually works:  The homeowner has missed payments and is in default.  He owes, say, $115,000 on a property worth $100,000.  You step in and negotiate the payoff down to $70,000.  You buy the property for the negotiated payoff amount—and end up with $30,000 in instant equity.

You may be wondering: Why wouldn’t the lender just foreclose on the property? Remember that banks are in the business of lending money, not accumulating properties. The foreclosure process itself can be lengthy and expensive. And there’s no guarantee that the property will sell at auction anywhere near fair market value, if at all.  Considering the cost of foreclosure, the holding costs, and the resale costs if the bank winds up with the property, taking the discount early on is often the smartest route.

Investors who have mastered short sales have a clear advantage in today’s marketplace.  Lenders are flooded with delinquencies and are willing to take deep discounts to expunge bad paper from their books. Perhaps most rewarding, short sales and note purchases provide a fresh start to strapped homeowners who would otherwise slide into full-blown foreclosure or bankruptcy.  In this day and age when so many investors are just out to steal folks’ houses from them, short sales and note purchases offer a true win-win-win outcome:  the homeowner gets out from under the foreclosure without filing bankruptcy; the bank saves a tremendous amount of time and money on the foreclosure and possible marketing of the home; and the investor acquires the property at a very handsome discount.

Note Buying vs. Short Sales

No form of real estate investing is without challenges, even the beloved short sale. Any number of obstacles can complicate or even kill your deals.  But there is a way around the pitfalls of the pre-foreclosure market: buy the defaulted note from the bank.  Quite simply, when you buy note, you become the bank, which means you make all the rules.

The numbers generally work out the same. As in the previous example, you would purchase the note for $70,000.  At that point, the lender is out of the picture and you are in control.  There are two principal exit strategies in note purchases:  the homeowner executes a Deed in Lieu of Foreclosure and you take possession—or you restructure the note and the homeowner retains the property and makes payments to you.  Note that 99% of the time you would want the homeowner to vacate the house. After all, if he can’t make payments to the bank, why would he suddenly be able to make them to you? You would want to restructure the note only if the homeowner is solidly back on track financially, which is rare.

Eliminating threats

Since you are now the bank, you make all the key decisions about issues that could potentially kill a short sale:

• You decide whether to pursue a deficiency judgment against the homeowner.
  

• You decide whether to allow an assignment of contract.
  

• You decide how much cash the homeowner can get back. 
  

• You decide how much cash junior lien holders get at closing.
  

• You decide whether the homeowner can stay in the property.
  

The last point is crucial.  Many short sale advocates claim that you can keep the homeowner in the property on a lease option or land contract.  Don’t do it!  This tactic is often used by unscrupulous investors to steal the homeowner’s equity.  As a result, more and more states are enacting laws against these “sale/leaseback” schemes.  In other states, courts have declared that sale/leasebacks are loans in disguise.  Unless you have a license to lend money, you would have a serious problem.  To compound matters, if your deal is deemed to be a loan, your profit may be construed as usurious.  The only legal way to let the homeowner stay in the property is to buy the note and restructure it.  

Simplified deals

With a note purchase, you are buying an asset from the bank, not doing a workout between the bank and the homeowner. Your submission package is considerably lighter—no pay stubs, bank statements, tax returns, or hardship letters from the homeowner. You simply need to know the bank’s bottom line and deliver the cash. The closing boils down to two primary documents: the Assignment of Mortgage executed by the bank and the Deed in Lieu of Foreclosure executed by the homeowner if you are taking possession of the property.

Buying the note also makes it easier to sell the property to an end buyer at closing. Many title companies are shying away from simultaneous closings because they want to avoid getting involved in any illegal property flipping schemes. Since you are not flipping a property when you buy the note from the bank, most title company underwriters will allow you to do a simultaneous closing. Plus you only pay one set of transfer taxes, a delightful perk that can really pay off over time.

Furthermore, your end buyer can obtain financing regardless of his lender’s seasoning requirements.  Many lenders require the previous owner to be on title for at least 90 days, which can be a major obstacle to short sales. But if you opt to buy the note and you become the bank, you can now permit the homeowner to sell the property directly to the end buyer on a short sale, thereby eliminating the 90-day seasoning issue. As the bank, you make your money by receiving the payoff on a note that you purchased at a hefty discount.  

When the deal is done, most investors don’t want to broadcast their profit.  But that’s exactly what happens with a short sale. The sale prices are public record, freely available on the Internet and elsewhere.  Both the homeowner and the end buyer know exactly what you paid and what you pocketed.  Note purchases are not a matter of public record. Only the bank will know what you paid for the note and the bank could care less what you do with its castoff paper.

Many lenders are completely up to speed on selling their delinquent notes.  Others are still finding their legs. As foreclosures increase nationwide, more and more banks are recognizing that individual investors are prime outlets for bad paper. For now, the wise strategy is to go for the note purchase every time, and use the short sale as your fallback position.

The bottom line is that both short sales and note purchases serve the pre-foreclosure market well by providing a winning outcome for all parties.  Unfortunately, there are a number of obstacles that may sabotage your short sale deals.  To stay in the driver’s seat and eliminate these obstacles, simply buy the note instead. When you buy the note, you become the bank, which means you make all this rules.

Did you know that by creating a real estate note you may purchase some fantastic deals without using any of your own money? Writing notes is like creating money out of thin air. Governments do it all the time. If you look at a U.S. Dollar you will see that it is simply a note from Uncle Sam stating that he owes you one dollar.

Is creating these notes to use for money–legal?
A note is just an IOU, a promise to pay a specific amount of money. Anyone can write an IOU anytime for anything. But how does this knowledge translate into being able to purchase real estate?

How do you use a note to purchase real estate?
When someone is desperate to sell their home (a motivated seller) they will be willing to listen to just about any creative financing technique that will help them solve their problem. You may offer to pay-off their existing mortgage either by taking it subject to or getting your own first mortgage to cover that amount-then give them a note for the balance of the purchase.

Sounds good but how do you create a note?
The easiest way to create a note is by having your title company or real estate attorney do it for you (the title company is usually less expensive). You will only need to provide them with some basic information.

What information is needed in order to create a note?
The maker of the note? (The buyer-YOU)
The amount if any that is being paid as consideration or equity? (the cash being paid to the seller?)
The collateral to be pledged as security? (address and legal description of the property)
The amount of the note
The term (when the total payoff is due)
The percent of and type of interest (simple or compound)
The amount of each payment and when these payments are due (may be any amount)
If there is to be a balloon payment due at the end of the term

What assurance does the seller have that I will pay the note?
The seller should have two documents recorded (the title company will do this as part of the closing). A promissory note and a security instrument. The note is the written obligation to pay and the security instrument pledges the collateral. If you are making house payments, your mortgage or deed of trust is your security instrument and the promissory note is your obligation to make the payments.

Sometimes the owner financed note is what’s called a second or a “second mortgage”.

Another creative note technique is to create a note to finance a property. That note may be sold in advance and the proceeds paid to the property owner as the cash part of the transaction. I will elaborate on this technique in another article.

For additional support material about investing visit http://www.dennisjhenson.com. Also visit http://www.turbo-bidder.com for great real estate investor tools. Thank You, Dennis Henson