SHERMAN ARNOWITZ INTERVIEW – Paying Cents on the Dollar to Invest in Distressed Second Mortgages

Welcome to the Next Level Income show, where it's our goal to help you take your income, your investments and your life to the next level. I'm Chris Larsen.

And I'm Caleb Welborn.

You can get our book Next level income@nextlevelincome.com today on the show, we have Sherman Arnowitz, president of Keyhole Financial Services. Sherman buys, sells and services distressed second mortgages. Since 2001, Keyhole Financial has continually outperformed the S&P 500 as an investment. And Sherman has created and managed funds with thousands of distressed second mortgage notes. In 2013, Sherman and his team created Keyhole Academy, which is when you and I linked up. Sherman. It's an online educational program designed to educate students interested in learning how to invest in the distressed second mortgage market. Sherman's also written a book, and Keyhole Academy offers their students private joint venture mentoring. And before the end of the show, we'll tell you how you can learn about Sherman's upcoming events here. Sherman, welcome to the show.

Thank you so much, guys, for having me. It's a real treat.

Yeah, absolutely. Sherman, you and I had the pleasure of meeting down here in Asheville, North Carolina, because your sister was working at a local private school.

That's correct, yeah.

So I think we originally linked up when I was working with one of your partners, Fuquan, in an investment fund that I was with on him.

It's a very small universe and I really enjoyed meeting you and I enjoyed seeing Asheville. It's one of those things that when my sister Debbie moved down to Asheville, no one in our family ever heard of Asheville. And then before you knew it, I was reading newspaper articles. I was away in Europe and I was at a wine tasting tour in Portugal, and, hey, where are you from? And the person said, oh, I'm from Asheville, North Carolina. And so it's just kind of weird how the universe brings people together, especially you and I, Chris.

No, it really is. And I'd like, you know, I'd like you to share for our audience a little bit more about how you got here in the note world. I actually, John Richards is with noteworthy was who I first learned about notes with. And this was back in when I was doing my MBA. This is about 20 years ago when I was looking at different investments in the real estate world. But, Sherman, would you please share how you ended up being a specialist in the world of notes and distressed notes and ultimately investing?

Sure, I'd love to. Again, it's incredible how the universe works. And I'll try to make it as short as possible. When I graduated college, my college roommate and best friend asked to borrow $5,000 for a real estate deal. He told me, I'm going to get it back to you within 30 days. And I lent them the $5,000. And 30, 60, 90, 120 a year went by and I didn't get my money back. And we lost touch. And sadly, we lost a friendship. Fast forward 15 years and I get a certified check in the mail for $5,000 with Scott's phone number on it. And so I call Scott up in California, and of course, the first thing I say is, where's my interest? So after talking and getting information, what have you been doing? What have you been doing? Scott visited me in New York and he told me how he stumbled upon this business. And the business was these banks, particularly second mortgage banks. People banks that are offering second mortgages, they try, in certain instances where the borrowers have not been making payments, they try phone calls, letters, phone calls, letters. And nothing happens with the borrowers. And so these banks wanted to get rid of these mortgages. And my college roommate friend Scott stumbled upon this, and at the time, it was GMAC, which was Ditech. And he literally was getting a tape of between 200 and 500 mortgage notes a month that he would have to analyze. And. And at the time, he was paying anywhere between 20 and 30 cents on the dollar for these mortgages. These were second mortgages. And so once he acquired those mortgages, he would then, because he paid such a great discount on these mortgages, he would make the phone calls to the borrowers and say, hey, I just bought your mortgage note from Ditech. You owe me $40,000. He didn't tell the borrower that he paid $5,000 for that $40,000 note. And because he paid such a great discount, he would be able to work out deals that the banks would never be able to work out with these notes. And before you know it, back then, and we're going back probably 20, 25 years, there was tons of equity in the property. So all you really had to do was make a phone call to the borrower and kind of sometimes have to mention the F word, as in foreclosure. And before you knew it, he was getting checks. And so as the universe brought Scott and I together, he said, look, why don't we do this together? I'll start teaching you. I'll handle the West Coast. As he was living in California, you could handle loans on the east coast showed me the ropes. And this is some 25 years ago. @ that time, there were probably only a small handful, maybe five investors that were doing this. It was the greatest secret ever. And so actually, when he said, hey, let's do this together. I'll show you the ropes. Why don't you invest $100,000? And I invested my $100,000. And of course, I was skeptical based on previous experience with Scott, but I invested that $100,000, and within a year, less than a year, I doubled my money, and within three years, I tripled my money. And so, as the universe brought us together, it was a great opportunity for me. And at some point, Scott had said, look, I've showed you the ropes. Now you got to do it by yourself. And at that point, I had to make a decision. Did I want to start continuing investing in these kinds of notes just by myself, knowing that I had a limited amount of money to invest? Or here's an opportunity, maybe I can make it bigger and I can turn it into a business by going to friends, family, business associates, and create funds and have these people invest in the funds, and then I would manage the funds. So that's basically how I got started in the business. And since then, we've created probably about 20 funds over the years. A fund could be anywhere from 20 loans up to about 400 loans. The fund itself usually lasts between five and seven years. We manage the funds, we take a certain percentage for managing the funds until everyone gets their money back. And then once everyone gets their money back, that percentage increases the date over all the funds that we've invested, our average net return of investment falls between 20 and 30% on an annual basis. So we're very happy.

Sounds like it. Yeah. That's an incredible story. What does the risk profile look like on this? And how do you explain to people the benefits of investing in distressed debt and distressed assets and why they would want to do that?

The first thing, I kind of divide it up into two parts. The first thing is, are you an investor that just you want to be a passive investor and not do anything? Here's my money. Make me money. Or do you want to learn how to do it? Do you want to learn how to milk the cow? And so the first part of it, when I go to passive investors, the first thing I tell them is, hey, you could lose all your money. There's no guarantee whatsoever. The only thing that I could tell you is based on me doing this for X number of years, and it's coming up around 25 years. I show them my previous funds. It's an open book. I show them my accounting. I show them the software that we manage the funds in. It's an open book. And based on that information, I let them make a decision to say, based on what I've been doing with these funds, I've been generating between 20 and 30% net annualized return on investment. So, yeah, when I describe it to them, I say we're dealing with second mortgages. The downside is that these are behind first mortgages, so we are second in line. So if there's a foreclosure, and the worst thing that could happen, obviously, is a foreclosure. And if there is a foreclosure, the first mortgage is going to be taken care of first. And if there's any surplus funds, that's where we will come in, depending where we are in the economy. When I started out back in 2000, there was tons of equity. And so if and when there ever was a foreclosure, and I'm happy to say I've only had to foreclose on three properties, but if there was a foreclosure back then, there was so much equity that we would stand in line for that surplus. Well, after the bubble broke and we were facing reality, there wasn't equity. There's been one fund that we've been affected by the economy, and back in 2004 or 5, we purchased about 77 loans. And when we did, there was tons of equity, and that's how we bought the loan based on that equity. Well, if I bought a loan where they owed the first 100 and they owed the second 20, that's 120,000, and the house was worth 250,000 tons of equity. Well, the bubble broke and that same $120,000 had an equity of $90,000, the value of the house. So we were underwater. And so during that time period, there were a lot more foreclosures, and so no surplus. We lost. The upside is during that time, we were able to give back to our investors about 87% of their investment. So I kind of feel in the scheme of things, everybody was happy based on the situation. So going back to your question, if it's a passive investor, I want to let them know this is the worst thing that could happen. And has it happened? No. But I have to be forthright and honest based on that past performance. This is how we've been performing. When I go to a investor who wants to learn how to milk the Cow and do the investing and learn to invest in seconds like I do. It's important that I do ask them what's their risk tolerance, because somebody that doesn't have risk aversion, they might just be looking for performing second mortgages or re performing second mortgages versus non performing second mortgages. The upside of that is that pretty safe. If somebody has equity to cover both the first and second mortgage. If somebody's been paying their second mortgage for years, it's a pretty good risk. The downside of that is they're going to be paying a lot of money. Typically what happens is if I'm investing in first mortgages, I'm going to be paying anywhere from 50 cents to about 80, 85 cents on the dollar. If I'm going to be investing in a performing second mortgage, I'm going to be paying pretty much the same amount. And so you're still investing in a second mortgage. And you have to keep that in perspective because if something does happen, you're still second in line. But for the person that doesn't want that much risk, that's where I would point them to. As far as going after performing seconds or reperforming seconds, my world and where I've made money has been based on non performing. You got to crawl a little bit higher up in the tree. But risk reward, so far it's been worth it.

Terrific. Yeah. Sherman. So personally I've invested in first, I've invested in seconds performing non performing. For our audience that may not be as familiar with the terminology, would you go through what a first mortgage is, what a second mortgage is? Performing reperforming and non performing real quick?

Sure, no problem. So everyone knows if you're going to buy a house, you have to take out a first mortgage. You're going to put a certain percentage of money down as a down payment deposit, and then the balance of that note is going to be taken care of by the First Bank. So if I want to buy a $500,000 house and I have to put 20% down, that's $100,000 that I put down. I have to take a mortgage out on $400,000 and the mortgage is collateralized by my actual property. And so I'm going to be making payments depending on the interest and how long I've been taking this out, 15, 20, 30 years, I'm going to be paying a monthly mortgage on that. That's a first mortgage. Sometimes if the borrower is defaulting, the bank's going to try their own set of Procedures, processes to make phone calls, send out letters to try to get that borrower to start making payments. In certain instances, they go only so far and then they want to write it off and they want to sell the note to investors, private investors like yourself, Chris, as I mentioned before, they're going to sell that mortgage, that first mortgage note, anywhere from, depending on the condition of the note and what kind of equity and what the house looks like, anywhere from 50 to 60 cents up to 80, 85 cents. The advantage of investing in the first mortgage is that you're in the first position. The disadvantage is that you're going to be paying more money for that investment and so a lot of your money is going to be held up in that mortgage. The other downside that I see is that it's very limiting as to what strategies you can do when you buy a first mortgage. Really the strategy is because you've paid so much for that is, hey, borrower, are you going to pay me or am I going to foreclose on you? Because you've paid so much, you don't have the luxury or flexibility to say, oh, borrower, tell you what, you're paying $2,000 a month, why don't you just pay me $1,000 a month? You can't afford to do it. So it's a very succinct strategy that you're dealing with those kinds of borrowers with first mortgages. The first mortgage you're either performing or you're non performing. When we move into second mortgages, it's a different world. As much as there are certain similarities between the two, it's almost like speaking Italian versus speaking French. There are certain similarities, but the truth is that when we deal with second mortgages, it's a whole different world. Because we are paying so little on the dollar, we're able to be a lot more flexible and a lot more credit creative with how we're handling borrower. When we deal with first mortgage, all we're dealing with and we're looking at is just the property. You don't really care about the homeowner. And I mean to say he doesn't come in, they don't come in to play with strategies. When we're dealing with second mortgages, we're dealing with both and we look at both the house and the homeowner. And so by this, I mean, if we're able to buy a $40,000 second mortgage and we buy that for $5,000, I now have the flexibility because I've only paid $5,000 for it. Hey borrower, you owe me $40,000. Your monthly mortgage is $500. Oh, you can't afford to pay $500. Okay, what could you afford to pay? Oh, I can only afford to pay $300. Tell you what, for the next six months we're going to try it out. You pay me $300 instead of the $500. Again, they don't know that I paid $4,000. The name of the game for me is to get my initial capital that I laid out back as quickly as possible. And so at $300 a month for the next six months, keep in mind these people, these borrowers haven't been paying their second mortgage sometimes 1, 2, 3, 5, 8 years. And so their mindset psychologically when we speak to them a lot of times is I don't owe you any money. What are you talking about? Well, you do. Here's a copy of the agreement, here's a copy of the deed of trust. And so psychologically there's a barrier that we have to cross with them. That's when I teach my students, there's many hats that we wear. And one of them is psychologists because we have to deal with these borrowers who are of a mindset that they don't owe the money. So if I can get somebody, a borrower who hasn't paid in five years to pay me $100 a month for six months to try it out, I'm going to do that. After that six months, we reevaluate. And in a lot of cases, we turn that temporary payment agreement into a loan modification. And doing the loan modification, we're able to bring them current. We take their past due balance, we might forgive a little bit of the past due balance. We take their mortgage interest and we lower it down. We extend out the maturity date another 20 years. And we're doing this all so that the net result is that the monthly mortgage that we come up with is something that the borrower can live with. So once we do that, after that six month trial period, do the loan modification, we now have a brand new shiny loan where the homeowner is performing. So back to your question, Chris. When I buy non performing loans, these are loans, second mortgages, where the homeowners haven't been paying anywhere. On average, I'd say probably three to eight years. If I can get somebody paying a monthly mortgage for six months straight. In my world, technically that's a reperforming note. If I bought that note for $4,000 after six months of paying. Maybe they're going to pay the entire $500 a month. We have a lot of borrowers that hey, they were with Chase bank with their second mortgage. They haven't heard from Chase Bank. All of a sudden we're rattling and hey, good morning, here I am, you owe me $40,000. Oh, okay. Chase bank kind of gave up. Okay, I can start paying you the 500 in some instances, not only are they able to pay me the 500, but I'll bring up the past due balance. How are we going to take care of this past due balance of $8,000? Because you haven't paid in four years. I tell you what, some of them say instead of $500, we'll suggest them paying $700, 500 to the mortgage, 200 to the past due balance. Some of them will say to them, hey, you owe me $8,000 past your balance. Tell you what we'll do, we'll do a one to one match. For every thousand dollars that you give me towards paying off your past due balance, I'll match you $1,000. So here's an opportunity that we're giving them a break for me because I can only do this because we've paid at such a low rate. So now we have somebody that's paying us for six months maybe, then we do a loan modification and now we get them paying for another six months. Now I have pay history and so I can go out and I can market that to my investors to say, hey, this was a non performing. We've gotten 12 months pay history. I consider that a performing. So that $4,000 that I've been paying, I'm probably after 12 months going to be able to get seven to $9,000 from that mortgage because I've turned it into a reperformer performer. The only difference between a reperforming second mortgage and a performing second mortgage is, is the amount of time that they've been paying. So usually it's within a year to maybe a year and a half, maybe two years. I would probably still call that a re performer, but anything over a year and a half to two years, I would call that a performer performing.

No. Thanks for, thanks for going through that because it is, it is a little confusing when you first hear about it. You know, I've gotten used to the lingo but one of the things I do like about what you do, Sherman, and what, you know, the group I invested with is to me, the goal of the first is a lot of times to take the house back, you know, if they don't pay, go foreclose on the house.

Right.

This side of the business is, hey, let's see if we can help the borrower, you know, work this out in a way that works for their current situation because they do owe the money. It's a loan, it's a lien on their home. And it's not just going away into the ether, so to speak, unless, like you said, they go through bankruptcy or foreclosure, that sort of thing.

And that's there. And that's an interesting point on twofold. The first is when we buy second mortgages to clarify for your investors, they're secured debt, just like the first one we buy. These are secured debt. We have the right to foreclose, just like the foreclosure first has the right. And a lot of investors, but also a lot of borrowers don't understand that when we, when we decided to get into business, part of the process was, what kind of business do we want to be? And by that I mean there are some investors that will buy seconds, and as soon as they buy the second, they start the foreclosure process. It's a strategy. I'm not saying it's right or it's wrong. It's just their strategy. They believe that these borrowers have been sitting long enough doing nothing, and so their strategy is, let's get them a bomb going off, and so they start the foreclosure process. Again, I'm not for or against. It's a different kind of strategy. Our strategy at Keyhole Financial is different. We have plenty of time to get to that point. I much rather deal with these borrowers sending out a letter, trying to make contact, hey, we're on your side. We know that you've gotten the raw end of the deal. You're in a bad position. How can we help? As a matter of fact, when we first started out, a lot of my friends and other business associates would say, how could you do what you're doing? You're kicking people out of their houses. And I said, no, it's 100% the opposite. We're keeping people in their houses because we have that flexibility. We want to utilize and turn that flexibility into an opportunity that we can help the homeowners. And not to sound like Saint Sherman or anything, but my belief is borrower, if you're going to help me and work with me, then I'm going to work with you. We've had instances where borrowers have called us up around the holidays and have said, hey, would you mind if I skipped November or skip December? Of course, you know, no problem. We look at it as an opportunity again. So that's kind of the way that we wanted to design the business. And quite frankly, when it gets to a point where we're caught between a rock and a hard place and we have to decide whether we want to foreclose on this, most of the time we would rather sell the loan than go through the foreclosure process. And that's just how our philosophy is. Other investors do it differently, but that's our philosophy.

I like that. How did the financial crisis affect your business?

It has and it hasn't. You have to remember when we're buying notes, when I'm buying a note now, that note was originated back in 2000, 2003. And so that note, even though the crisis happened in 2008, that note has no effect on it because that happened back then. And so where we're going to get into trouble, I shouldn't say trouble, but where we're going to see changes is after the crisis, banks woke up and said, oh my God, we have to really get our shit together. And so I refinanced my house. And I have to tell you, it was such an unpleasant experience because they went back to my third grade teacher to try, you know, to understand, was he a good kid, should I lend him the money? I mean, they want anything and everything. And so they're really trying to, to cross the T's and dot the I's. And so if you look at it from this point forward, there probably will be less defaulted notes because of the different path that the banks have taken. But for the billions and billions of dollars that they wrote back in 2000, up until 2008, those loans are still out there, those loans are still defaulted. And so the crisis really has nothing to do with those notes. Where I see a change in the business is, number one, there's more investors who are getting into the business because it's no longer a really well kept secret. It's an excellent opportunity, whether you're a passive investor or whether you want to learn how to do it. And so it's still an excellent opportunity. What's happened is that because more investors have come in, the cost of the notes, supply and demand have gone up. So certainly notes that I'm looking at where I've put a bid, let's say, on 25 cents on the dollar for this note, based on my parameters, I'll hear back from the Seller saying, no, your 25 cent on the dollar offer didn't take. We had somebody for 55 cents on the dollar. Wow. So these are crazy. You know, these are investors that maybe don't know what they're doing. And so supply and demand, they just want the note. So that's kind of where we are now, but I think we're going to kind of see that shaken up. And there are more notes available for a certain period of time. The banks have been very cautious about releasing notes because of the potential danger if bank of America sells me notes and I take certain notes and I sell them to Chris, and then Chris sells certain notes and he sells them to John, and John picks up the phone and says something stupid to the borrower. And the borrower's uncle happens to be an attorney. The attorney is going to sue. John is going to sue, Chris is going to sue Sherman, he's going to sue bank of America. And so it's put. The popularity of this has put the banks in a precarious situation where they still have these billions of notes that they want to get rid of. They just have to come up with a way internally to protect themselves.

Sherman, thanks for walking us through that. The reason we had you on the show is because your company has Keyhole Academy as well as the investor side, so would you share? So if listeners are saying, hey, I'd like to learn more about how to do this myself, would you talk about your book Keyhole Academy, as well as the upcoming seminar you have next month?

Sure, I'd be happy to. Probably about four years ago, I decided that I wanted to share my expertise and experience and put it in a way that I could offer this to other investors who do want to do it themselves. And so with the help of my team, it took us about two years to take this knowledge and put it in a way that we felt would be best suited to learn. We didn't want to do it necessarily all just with tapes or weekend seminars, etc. So we put it online and we put 27 chapters together online where we felt the best way is that the investor, the student can go at their own pace. Certain chapters they go through within 20 minutes, and certain chapters they might go through two days in order to really understand what's going on. And so we put the main course that we have, the Business of Investing in Distress seconds. As I said, It's 26 chapters. Go at your own pace. There's text, there's videos, there's quizzes, there's a final Exam. We want to make sure that when a student finishes that course that they truly understand the concepts of everything from A to Z when investing in seconds. And so it usually takes investors, students about average about three weeks to complete the course. Before I wrote the course, I put together a small book and, and I wanted to put together the book to kind of give people a thousand feet in the air perspective of what it's like to invest in distress second mortgages and what are the opportunities and what are the danger points and what you need to do. It's not for the faint of heart. And so that was the purpose of putting together the book. And after we put together the book, we then worked on the course and it's gone through evolutions of students after the course telling me, I like this, I love this, I didn't like this, why didn't you like this? They explain it and fine tune it. So I feel we're at a pretty good point now. But one of the things that popped up when students would take the course, I'd probably say 50% of the students that take my course course, after they take the course, they get an hour of me. Any questions that they have, I want to make sure again, these are my soldiers. So I want to make sure that these soldiers are prepared when they go out to battle, that they're truly prepared to go out to battle. And so 50% of them, after they would take the course, off they go and they start investing. I'd say the other 50% would come to me and say I'm a little bit nervous, I really don't, I need a little more handhold. And so we created this private mentorship. And the private mentorship gives the student the opportunity to either buy three mortgage notes or five mortgage notes. And when they buy the notes, they pay for the notes. But we're going to split the profits within 50, 50. But we're going to hold their hand every step of the the way. We're going to give them that much more confidence so that on a weekly basis discussing what's going on, we're assigning tasks that need to be done, we're answering questions, every letter that goes out, every phone call, every strategy, we're in this together and we're going back and forth as to what has to happen. And so we're giving them really that confidence so that at the end or whenever they want to start buying notes by themselves, they, that they have that confidence to start buying notes from us. So that's the private mentorship that we do. And I'd say about 50% do it. And the other thing I'd like to point out, it's not just about teaching. As I said, these are my soldiers. And what I have found is these students who go out and they go to seminars and networking groups. If I do right by them and they're speaking to other people, and those other people are saying, yeah, I'm looking for an investment opportunity. They're my best salesmen. They're saying, hey, I just took a course with Keyhole Academy and I really loved it, I Learned a lot, etc. The other upside is that it's not just about teaching the course. It's building relationships. So if I can build a relationship with my student. I just had a student last week who came back to me and said, hey, I was on a ski trip and I spoke to a guy who knows a guy who has about 200 notes for sale. And I can't afford, obviously all 200 notes, but I would like the opportunity to buy at least 10 notes. Would you be interested in looking at those 200 notes? And I looked at the 200 notes. I put a bid in on the. My. I took 100 notes down. She ended up taking 10 notes down, and I paid her commission on the hundred notes that I bought. And so it becomes opportunities. And we never want to discount those opportunities. In a lot of cases, it's the student becoming the teacher and looking at those opportunities. So just from a ski trip, this opportunity came into both of our labs. So that's another reason why it's important build those relationships.

Awesome. And your course coming up next month. How can.

This is the first time that I speak at a lot of seminars and networking groups and workshops around the country. This is the first time that I'm putting one on together. So it's kind of like having a party and you're sending out the invitations, and I'm so nervous. You know who's going to come? A fellow who I greatly respect, Fuquan Bilal, who's been in the business for many years. I approached him and said, look, we've been in the business together. Why don't we put together a weekend think tank? And it's not going to be about selling or anything like that. It's strictly going to be a think tank. And October 5th and October 6th at the Hyatt, the Hilton Hyatt in Newark, New Jersey, we're putting this on. It's limited. The capacity that we're going to stop at is 30 students. It's going to be a two day workshop. It's going to be an intense, whether you're beginner, intermediate, advanced, you're going to get something out of it. It's going to be an intense workshop. We want to make sure when people leave they're empowered with the, the knowledge that they can start going out and start buying and learning and networking, etc. So that's October 5th and 6th. Full days of learning about the stress, second mortgages, how to invest.

Sweet. So one question we always ask on the show is if you could go back in time and give your 25.

Year old self one piece of advice.

Out of everything you've learned, what would it be?

I would still lend the $5,000 to the college roommate because it's amazing what happened and how it all turned out. So I wouldn't change that. I personally would probably say I would take more risks and so I would take more risks in terms of investing more and what I do and the opportunities that I was a little gun shy about, I probably would have taken the chance and taken more risk to go for those opportunities.

Thank you for that, Sherman. So what's your, what's the best website to find out about all this? We're going to have this in the show. Notes and links to your book, your course as well as your upcoming seminar here.

Great. Keyholefinancial.com, k e y h o l e financial.com is one, keyholeacademy.com is one and then one for the think tank that's coming up is going to be and I'm pulling it up right now is notethinktank.com n o t e think tank.com and that will give you all the information about the upcoming seminar October 5th and 6th.

Awesome. We'll check that out from Sherman, check out his website, check out his book and his upcoming seminar and get your free book@nextlevelincome.com Sherman, thank you so much and thanks for listening today.

Thank you very much. Chris. Caleb, thank you so much. Thank you.

Absolutely.