REIA 108 Bob Fraser: Using mortgage notes to create consistent income

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Hello, enlightened investors. I am your host, Dr. Allen, and what a joy it is to be with you today. As we explore using mortgage notes to create consistent income. Bob Frazier is on a mission to help investors take advantage of one of the most effective and overlooked forms of real estate investing in the world, namely mortgage note investing. So, Bob, take us into the show today and share with us a memorable experience from your formative years that helped you to be who you are today? All right.

Well, it's a pleasure to be here with you. And I'll tell a little bit of my journey. I started out as a computer programmer. So I was a technical guy and started a business. We ended up raising $44 million in venture capital and it was in the dot-com era and it zoomed up and we ended up having some 300 employees. And I ended up winning the Ernst& Young Entrepreneur of the Year Award. I was literally gonna be the next Elon Musk or whatever. And then it all crashed. And with the dot-com crash, and I lost everything. And it was that that, one, made me realize that I wanted to get out of anything related to the public markets, the public stock market. I mean, you've been around as long as I have, and you probably remember too, the S&L crisis, the dot-com crisis, of course, the great financial crisis, the COVID crisis. It's like, and the public markets seem to exacerbate all of these emotions, right? And on the upside and on the downside, it's just, it's just like an emotional roller coaster and it's an investment roller coaster. And I realized that I just wanted to have something that I'm a little more control of. And so basically got into real estate related kind of investing at that, at that point, and especially debt investing, which is kind of one step safer than equity investing, right?

Well, I can totally relate to that. My problem, my problem with public markets is the lack of control that Any one individual has over them. And I just can't deal with it. I guess I'm just—

Exactly.

Just a control freak or something.

Exactly.

I don't know.

Exactly.

Well, anyway, so Bob, you have had a lot of experience in, as you call it, debt investing or note investing, as more people refer to it as. So take us into that. Tell us what that is, what it entails, and why are you doing that? Yeah.

Well, you know, real estate is of course a very good place to be and we, We like to focus on the debt space. And it turns out the debt is quite a bit safer and you can get fantastic yields with it if you do it in a certain way, like we do it. So in essence, we buy the mortgage. So, you know, most people have a mortgage on the home they own. They write a check every month to their bank, their mortgage servicer. And so we actually buy that note. So we, in essence, become the bank. So literally the borrower's get a statement saying, here's your new servicer, send it here, and they get a monthly statement and everything. And we buy these notes, we board them with licensed mortgage servicers, and we basically collect mailbox money. And so we become the bank, but we also have all that legalese that protects the same thing you signed when you signed that mortgage, right? The 28 pages of small print that protect the bank primarily, that's all ours. We inherit all those rights and all that All those things. At the same time, it's very advantageous because we don't inherit the toilets, the termites, the tenants. When's the last time you called your banker, your mortgage banker, when you needed a new roof or your toilet was stuck? And so it ends up being a far more passive way to invest. And most people don't think about it. They think about investing in the direct real estate. They don't think about investing in the real estate debt. So, so it's really far superior and in a lot of ways safer, and, and it can be very high yield in the way we do it.

Well, it sounds very attractive. And as you just explained it here, it sounds very simple, but there are complexities to that. So take us just through an example. How do you get a note? How do you get that note in your name? How do you start collecting on that note?

Yeah.

All right.

Well, typically these notes are sold by banks or hedge funds or something. And so they send out pools, we underwrite them, and we buy them. At that point, there's RESPA letters that goes out to the borrowers. You know, if you've ever got a letter in the mail saying, hey, send your check here now instead of here, you know, that's exactly what happens. You know, examples we buy— so obviously, if you're going to buy a mortgage yielding 3%, that's not very exciting, right? Who wants to get that? So we're looking for higher yields. And there's a couple of ways we get higher yields. Now we do buy, there's, of course, there's commercial debt, there's residential debt. We buy only residential debt. We buy only single-family homes. And these are also primary residences. So, that creates kind of this added stickiness. So, we underwrite this, but the way we get the high yields is we buy generally reperforming notes. So, these are notes that at one point the borrower had stopped paying. At one point. Things happen, right? You lose a job, you get divorced, you have a medical crisis. But generally, people get out of that. They get back on their feet and they want to keep their house. And so, they basically typically will modify the loan. Maybe they change their interest rate. Maybe they amortize some of the arrearages that were accumulated, put those into the principal balance, maybe various kinds of things, change the maturity dates or whatever. And then they start paying again. Well, once they do, that's called a reperforming note, or in bank terminology, it's a troubled debt restructure. Okay? And that's a very bad thing to a banker. Okay? A troubled debt restructure, even though these are fantastic notes. And once a troubled debt restructure, always a troubled debt restructure. So, these are never considered pristine paper anymore. And so, they sell at massive discounts. And so, we'll buy notes at discounts. We'll buy first mortgages sometimes with a 10% or 20% discount from what's owed. So let's say the borrower owes $100,000, we'll pay $80,000 for that note. Now, the borrower still owes us $100,000, so they don't know that we paid $80,000 for it, but we did only pay $80,000, but on their statement it says $100,000. And so if they ever sell or refinance that house, well, we don't get $80,000 back, we get $100,000 back. You follow me? When that note is paid off, The closing company calls, what's the balance of the loan? We say $100,000, they wire us $100,000. And so, we actually— so, we make the higher yields and we have a capital gain when that loan is paid off, right? Either through sale or refinance. So, second mortgages, which we like even better, and I appreciate most of your listeners, they're going to tune out right here, and that's perfectly fine with me. So, I love that everybody hates second mortgages. I just, I hope everybody keeps on hating second mortgages because they are the richest little thing ever. And so, we love second mortgages and you can buy second mortgages for a 50%, 60% discount sometimes. So, literally $100,000 notes, you're paying $60,000 for that. Why do I like second mortgages? Well, let's say you have a $300,000 house, $100,000 first with a, let's say, a 4% coupon rate on it and no discount. So, I could buy that, I get 4%, and I get no discount. Or I can buy— there's a $100,000 second mortgage, right? It's junior to the first mortgage, but there's still $100,000 in equity above me. You follow me? And that has a higher coupon. So, maybe that's a 7.5% interest rate. So, I'm earning 7.5% out of the gate, but add my 50% discount. So, I pay only $50,000 for that loan. He owes me $100,000, but I pay $50,000. So, now my yield is double my coupon. So, instead of earning 7.5%, I'm earning 15% yield. Okay? So I earn a 15% yield. Is it really less safe? I would argue not. And it's not much since the average home in the last great financial crisis crashed about 35%. What's the risk? It's not that great. So not only do I get a much higher yield, I also have a capital gain when that note exits. And so I basically earn 15% until I earn a double. You follow me? 100% cap gain. So what's not to love about these? And actually, we're mathematicians here. And if you look at the— we analyze, we underwrite notes very, very carefully, very mathematically. And if you actually look at the way we underwrite the notes, we look at the value of the note according to every possible outcome of this note. We model in a 30% chance of default, which we've never experienced. And the notes Notes in the open market are priced well below what I'll call intrinsic value, which is the actual mathematical value of this note according to math. The notes are heavily discounted more than the math would say. Then at 99 years and sort through COVID, and it's just a very, very, very good place to be and get great yields, get some capital gains. The other very interesting part of this. So, we run an investment fund. Obviously, you don't want to own one note. You want to own hopefully a handful. So, we have 1,200 notes or something in our income fund. And the other interesting thing, so these notes actually self-liquidate. So, let's say— so, one of the things that happens in this note fund is these notes self-liquidate periodically. So, a borrower sells the home or refinances, and we get our money back. So, we're seeing somewhere around 8% of our portfolio self-liquidate every year at a profit. So it generates this enormous internal cash flow, operational cash flow. So that allows us to offer a liquidity program. So basically, we allow investors, it's an open-ended fund, but we allow investors to get their money back on any quarterly basis. And we've never failed. There's no guarantee, of course. So redemptions or the— sorry, not the redemptions, the payoffs, the loan payoffs. So it's kind of a wonderful little niche that's very unique and very advantageous.

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We have a network of relationships. We have, you know, probably 100 sources from banks. We've bought from the FDIC before, as we've bought, you know, from private lenders. We bought self, you know, what you call it, self-originated or seller-financed paper. A lot of hedge funds that buy the non-performing notes. And then after they modify the loan with borrower, then they're done. They want to sell it at that point. So, that's typically our source. And there are some exchanges where you can buy this in onesies-twosies.

Is that right?

Yeah, there's a website called PaperStack that we use. We sell some of our notes there online. They're quite liquid. And you as an individual investor can buy them. You need to hire a licensed mortgage servicer to service that note for you. And you do need to pay, you know, consult an attorney for your state to make sure that there's any— no other licensing is required. In some states, you are required to have a mortgage lender license. So we do all that.

So is it better for a person wanting to get into this to go through a fund like you provide, or is it better to educate themselves and go out on their own? Which would you recommend?

There's a lot of homework to do. It's not— it does not really conducive to kind of a small operator. I mean, some people try to put these in their IRAs and that kind of thing. And you can do that, but you should probably know what you're doing. So I definitely would look at a fund. You really want to underwrite it properly, especially if it's a second. You really want to know how to get visibility on the first. You want to know everything about the state. You want to know everything about the real estate. You want to know everything about the debt. You want to know everything about the debt below you. And you can't underwrite without all of those. Precisely. So generally for most people, it just makes sense to just go with an operator that knows what they're doing.

Particularly if you're wanting to do this as a passive investment.

Yeah, for sure.

Yeah. There's just, you know, talking about first mortgages, second mortgages, as you say, most people, they hear the word second mortgage and that's the last thing they want to hear.

That's great.

Talk to us a little bit more about second mortgages. You think they're great. Well, One reason is, of course, because of the much higher yields in conjunction with that, but that must come with additional risk. And you talked a little bit about how you mitigate that risk, but tell us a little bit more about what you're doing there.

And it's a sliding scale, right? As I say, there's really no such thing as a bad note. There's just a bad price. So if you have a $300,000 house and $100,000 first and $100,000 second, well, that second's pretty secure. But if you have a $300,000 house and a $1 first mortgage and a $100,000 second, is it any different than a first? Not really.

Yeah.

So, so, so there's a sliding scale, you see. And so that's what you really have to do is you have to do the math. And, and so we, you know, really what you need to look at is, is loan-to-value ratios. So we look at that, we look at what we call investment-to-value. It's Adding the senior balance, the balance on the senior mortgage, plus the cost of our second relative to the price of the home. That's investment to value. So, that's the thing we watch very, very carefully. You don't want to get it way out there. And if you do, you're getting a heavy, heavy discount. Okay? So, there's ways to mitigate that risk. The other main way we mitigate that risk is by buying only homes, home sweet home. These are literally owner Occupied residences. Okay? And so, there's a lot of investors, it's fairly common to get into what's called first trustees funds or hard money lender funds, right? And these are organizations that make loans, short-term loans to home flippers. Well, that's a very different thing. Even though the underlying asset is a single-family residence, perhaps, you're loaning to an investor. And that's extremely different than what we're doing, as it turns out. So, what happens if we do have the real estate values go down and you're an investor? Let's say you owe more to your lender, your hard money lender, than that property is worth. You know what you do as an investor? You're like, give the keys back. Here it is, it's all yours. And it may be a half-developed property. Oh my gosh, it's just a nightmare, right? It's got lumber and trash on it, who knows what. Okay, good luck. You basically, you know, those are very risky loans. What went— but with this home sweet home, so if you're home and your family and your kids are living there and you get it, you happen to check Zillow and notice that it's below, you're underwater on your loan, does that, does that mean, well, tell your wife we're leaving now, we're going to hand our keys back to the lender, tell the kids they're going to live out of the bus now? You don't do that. You don't do that. So, so these are extremely sticky. They're extremely sticky. And I can actually— we have data that shows that the default rates on primary residences is not related to the equity in the property. It's related to the job market, which makes sense. So people— it's just very sticky. As long as people can pay, they will pay.

They do pay.

So that's, that's one way we mitigate risk. And another way is we look at Price-to-rent ratios. So our PITI-to-rent ratios. So when we under— part of our underwriting, for instance, is we look at what is this homeowner paying in their mortgage, right? Principal, interest, taxes, and insurance, right? So if their PITI payment is $1,000 a month, but the rent is $1,500 equivalent rent on that property, are they going anywhere? They're fools to go anywhere. So that's literally one of the main underwriting metrics we use. we look at that and say, so yeah, they can stop paying, but they're actually going to lose big time if they do. They're going to not only lose the property and any equity that they have in that, they are going to lose cash flow significantly. So again, those are some of the underwriting metrics. And in fact, through COVID, we soared through COVID. We did not see any change in our portfolio. I mean, literally nothing because of that. And so, we just didn't see any issues. say, hey, that's— we're never going to see any issues. I've been around too long to say that. You know, I've been surprised plenty out there, right? How many of us have lost money somewhere in the markets that we thought would never happen? So I'm not going to say that, you know.

I—

but we designed it having gone through 3 crises. We designed it to be bulletproof as the best we knew how. And so far, it's, it's, it's showing us that it's, you know, weathering the storms that have come so far in the last few years, at least. So, so those are— that's some of the ways we mitigate the risk, you know, and we don't buy— we do buy seconds, but we typically buy deeply covered seconds.

Well, Bob, tell our viewers and listeners how they can get in touch with you to not only find out more about you, but to find out more about your fund.

Yeah, you can go to Aspen Funds, like Aspen, like the tree, funds.us. And we also have a podcast called thebillionairepodcast.com, and it's all about investing like, like a billionaire. Is, you know, the billion— you know, billionaires invest differently from even high net worth people. Most high net worth people are heavily in stocks and bonds. Billionaires are about 50% in alternative investments, so real estate, private equity, hedge funds. So it's— we're just educating people about, about all the benefits of alternative investments.

Well, Bob, one last question before we go here. Share with us one of your most difficult setbacks, and you've You've mentioned and alluded to those. Tell us about your most difficult setback. How did you come through that time and what did you learn from it?

Yeah, those are some of the toughest times, aren't they? And, and some of the most important. They shape us. Isn't it true that some of the worst times are, are some of the things that had the best outcomes for us, maybe personally or other things? You know, not always, but for me, that, that got me in a different track and I found my partner who is in real estate and he just brought so much to the table and, And we're having such a blast right now doing that. And you're doing it in this real estate away from this, the dynamics of the public markets, the craziness of the public markets in a field we love. And really it's, don't be depressed. Don't get up by your, you know, pick yourself up by your bootstraps and see the opportunities and don't let it get you down. Right. And that's really what I was able to do. I mean, it's been a year being depressed, you know, and ultimately we got to, Get back on the horse. And, you know, there's always another day.

Well, Bob, it has been a pleasure having you and very informative. Thanks for being with us today.

My pleasure. Great to be here with you.

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