#236 Understanding The Benefits of Real Estate Note Investing

All right. Hey, everyone. Today we're talking to Tom Berry of ILS Capital. Just tell you about a little bit about his background on his bio. From humble beginnings in Appalachia, he rose from a career in sales to a remarkable journey in finance and real estate. He started this company called Investor Loan Source, which has closed over a billion dollars in loans today. He manages 118 million in investor capital. He's helped families achieve financial freedom while sharing his expertise in real estate all across the nation. Investor Loan Source has been a part course at PIMD. Many of you who were there at PIMDCON 2024, you got to meet him and found out a little bit more about who he is. But I thought I'd invite him on the show so that he could tell us a little bit more about his story, teach us in terms of educating us on the concept of notes. And I think it's something you'll find really interesting. Tom, how are you doing?

I'm doing fantastic. Thanks for having me on.

Yeah, I'm excited to talk to you about this because this is an area I think people have maybe heard about in terms of notes, but they may not know a lot about it. Is this something that you always wanted to go into? Were notes kind of always part of your path or how did you actually find your way into it?

You know, they weren't. Honestly, I found notes like a lot of people do by accident. I am a real estate investor at Hired. I've been doing real estate investments since 2004 and full time since 2007. And I love the physical purchasing of the property and owning of the property. But there came a time when, you know, we weren't able to get the deals that we were looking, looking for. So we started lending and, you know, creating these notes as they're called and that really. I didn't have a lot of experience in notes, so I partnered with a guy that had been doing node investing for 20 years. And so we started this little thing. We figured we'd do it for a couple of years and see what happened. And, well, lo and behold, 10 years from then, now it's taken on a life of its own. So I've grown to love it over the years.

That's cool. Let's. Let's talk about what notes are just. Again, we're using that word, we're using that term, but people may not have any idea what that is. So if someone were to come to you and say, teach me, like, I'm brand new to real estate, I don't know what it means by investing in notes. I know about investing in apartment buildings or something like that. Maybe owning your own properties. But what is it, what is, what does investing in notes really mean?

Yeah, so you're buying the debt on the property, you're lending on the property. It's a loan. In simple terms, it's a loan. Now the term note has many aspects. Aspects. Just like physical real estate has many aspects. So with physical real estate you could invest in a single family home or an apartment building or a retail center or, or whatever in notes. It's kind of the same. There are a lot of different aspects or facets to it that you could invest in. So it could be a performing note or a non performing note or a re performing note. And then again it could be a note on any of those asset classes that I just mentioned. It could be a note on a house or a note on apartment or so forth.

I'm wondering, you know, most people think of lending or they think of loans, they think of the bank owning the loans. How is this different from a bank owning a loan? And, and why would somebody actually lend with you?

Sure. So it's really no different at all than the bank owning the loan. You know, when I talk to my passive investors that invest in our note funds, I tell them it, you're, you're the bank, you're, you're being the bank when you invest in a, in a note or in a note fund like we manage. So it's really no different. Now the, the second half of your question was why would somebody borrow from us as opposed to going to the bank for the loan? And I can tell you there are three reasons. The first one is they are not bankable. Right. There are a lot of people in the real estate space that have been self employed for a number of years, have not had a W2 income in a number of years and have been writing off depreciation for a number of years. So banks don't understand those concepts and they don't bank well to that. So a lot of times real estate investors are not bankable. And in fact I was not bankable for my first 15 years as a real estate investor because of those very things. Another reason or the second reason people would use us over a bank is that their project isn't bankable. Now what I mean by that is maybe they're buying a property that is busted up, it's ugly and they're getting it for a really good price, but they're going to go in and Fix it up and add value to it. Banks don't lend on a maybe. Banks don't lend on potential. Right. They lend on what's actually there. So in that case, the project would not be what we call bankable. And then the third reason that people would use us over a bank is the timeline isn't bankable. Now what I mean there is how long does it take to get a bank loan? It could take three months, four months. It could take up to five or six months in a complex transaction. So what if a seller offered you a screaming good deal on this piece of real estate, but one of the caveats was you could only have it for that price if you close in three weeks? Now, the timeline is not bankable. This person that's buying the property is saving tons and tons of money on the price, but they don't have time to go to the bank. And so we can move very quickly. We understand real estate. We're not lenders. We're real estate investors that lend.

I love that explanation. I think you did a fantastic job of doing that. If someone had an opportunity, though, to utilize the bank, let's say they were bankable or this kind of situation, why would they still. Would they go with the bank normally or go with you and. Because what is the difference in those type of loans?

Sure. And I would tell them if they're bankable, the timeline's bankable and the project is bankable. Go to the bank because they're going to save money doing that. The bank gets their money typically from the Fed. Right. At ridiculously low interest rates. I can't compete with that. My investors that invest in my note funds, we've spoiled them and we give them phenomenal rates of return. And for me to continue to do that, I have to charge ridiculous interest rates. And I'm happy to do that for those folks that don't have another alternative. Right. Because they need to move quick or bank is just not an option for them. So we charge a lot more for our money than what a bank would charge. You know, if the bank today is charging 8 and a half percent on a commercial loan, our commercial rate is going to be 13%. It might be 13, nine. It might be 12, nine. But it's, it's, it's way more than what the bank would charge. So I tell people all the time, if you have the bank as an option, by all means do that, but bring one to me when the bank won't do it.

How do you know? When you look at some of These loans, whether it's a good idea to invest or lend them your money. You mentioned that you're an investor more than you are just a pure lender. How do you ultimately decide whether someone is worthy or actually in terms of a good investment in terms of lending money to.

Sure. So those are what we call the risk reduction levers. So we have a lot in lending, we have a lot of levers that we can ratchet down to ratchet the risk down. One of the biggest ones that we use is loan to value. Right. So if somebody brings me a property and we'll just use round numbers so we can all follow along, let's say they bring me a million dollar property that they want to borrow against and they only need $600,000 but that property is worth a million. Well, that is a 60% LTV or 60% loan to value, which for me that's, that's a really low ltv. And what it means to me is I don't really care if they pay me back or not. I really don't. Right. Because at the end of the day, if they don't, we're going to take legal action and we're going to own that property at 60% of its current value. So we set ourselves up with these risk reduction levers and, and several others are how much cash we make them bring to the deal. You know, we call that skin in the game. Right. What is their credit rating? I mean we look at that, what is their current personal financial statement look like? What's their balance sheet look like? So we all of these things and we try to ratchet that risk down for ourselves so that at the, at the end of the day, if they don't pay us well, that's okay too because we now have a property at way less than the current value that we can dispose of to easily get our capital back.

I mean, I think it's just a cool way of investing. I mean, why would some investors invest in notes versus let's say just owning the properties themselves? I mean what, you know, what are people drawn to when they started investing in the step of asset class?

Yeah. So look, and again, I do both, right? I do equity investing, we buy shopping centers. That's our equity investing. But I love the node investing too because it provides a consistency that owning the real estate does not. For example, in our real estate investments we assume that we're going to hold these for five to eight years. So it's going to be five to eight years before we fully realize the potential of that investment. But with note investing, we don't have to worry about potential. We have current interest income every month, so we can literally pay our fund investors monthly and they see those consistent returns on a monthly basis that they would arguably not see in our shopping center deals that they would invest in. So what we find is a lot of our investors will invest in both, right? They'll put some in our growth fund, which is one type of note. They'll put some in our income fund, which is a totally different type of note, and then they'll throw some towards the shopping center deals, knowing full well that that is going to be realized potential later, but the note investments are going to provide them that consistent current income.

First of all, great explanation of that. I think this appeals to a lot of people, especially where people are listening to this, because people are looking for cash flow. At the end of the day, I think in our community we all want to hit the home run, of course, but what really matters is cash flow because it ultimately impacts how we live, the amount of shifts we take, what we're able to, how we're able to travel. Puts pocket money in your pocket every single month. And so I think something like note investing, at least for me, which I've done some of the, has been really great in terms of providing that reliable cash flow that you mentioned. Now I have a question. You mentioned a couple different types of notes and I kind of breezed over it before, but I kind of want to go back to it. You mentioned a couple categories of notes that I think might be important to pause on and help people understand. You mentioned something called performing notes, non performing notes, re performing notes. What are those three categories so that people can understand?

Sure. No, I'm glad you circled back to that because it's very important that people understand a note is not just a note, right? There are multiple facets and multiple categories of notes. So a performing note is simply a note that is performing as agreed, meaning the borrower is paying their payments and they're paying them on time. That makes it a performing note. A non performing note, you know, by contrast, is one that they are not doing what they had agreed to do. Either they are not paying their payments or they're not paying them on time, or they're not keeping up the property insurance or the property taxes in some way. The note is in default, right? And most generally it's for payments, but it could be more than that. And then a reperforming note is a note that was non performing, but now they have started performing for whatever reason. Maybe there was a workout, a modification or something done. So when you look at these from a risk profile, which is what I'm, that's my job is to look at risk profile, you would say that the performing note has the lowest risk. The reperforming note, yeah, it's performing now, but it didn't before. So there's a, maybe a chance that they go back to non performing. So that has a little higher risk. And then obviously the non performing, well, that's going to be the highest risk of all because there's probably going to be legal action involved there and that costs money.

Let's talk about that legal action real quick because I know that some people hold notes individually and I've always heard about that or talked about it, but I thought about, it's nice when you're getting paid, but if you have to take that legal action that you mentioned to go take over the property, like how difficult is that process? People always talk about it in terms of challenging, in terms of how long that process typically takes for that to happen. If somebody like me were able to undertake that, what would that look like?

Well, it's going to depend on two things. The asset class that the note is on, is it a owner occupied single family note or is it a commercial business use note? And then the second factor is going to be what state is it in? Because for foreclosures are governed by state law and we have 50 of them plus the District of Columbia and they are all different. So one of the things that we do at Investor Loan Source, our lending arm is we only write notes in what we call the business friendly states. So we're not writing notes in California. No offense to you, you folks in California, but that is just from a state law perspective. It's not a friendly place for us to lend. New York, those types of places we stay out of. Where do we like to lend? We like to lend in the middle of the country. We like to lend in flyover country from Texas and Colorado to Virginia and Florida and pretty much that whole region excluding Illinois. We, we kind of cut it out on our map of lending. So what we're trying to do is we, we try to stack the deck in our favor so that when we do have to take legal action, we can take it much quicker than in some other places. And let's be honest, there's enough business in the 28 or 30 states that we do business that we really don't have to go to the more Risky areas.

How often do you find yourself doing that with, with some of your loans? Because I know you guys have a good amount of loans under, under your belt at this point. How often do you actually have to go that far down the line?

Right. It's, it's rare. It is. But, you know, with market cycle shifts, what we see across the board nationally is foreclosure rates will eb and flow. They'll go up and they'll go down. So in our income fund, which it only holds notes on properties that are already fixed up and they're already leased out, so those properties have an assignment of rents, so we can actually go in and start taking the rents from that borrower if they don't start paying their note. We have such a low foreclosure rate. We've probably, I don't have the exact numbers here, but honestly, we've probably done between 60 and 80 million dollars of those types of notes over the course of the last 10 years. And we have had three foreclosures. Three. Wow, it's so low, it's almost not even calculable now. Conversely, our other fund, our growth fund, holds notes on fix and flip properties, on redevelopment and development properties. These are properties that don't have a current income and do have a construction need or component to them. The foreclosure rate in that fund is usually around one to one and a half percent per year. So it's substantially higher than the income fund, but still it's not high when you look at it as a percentage of all the notes that we write.

Got it. And what do you think are some of the mistakes that people make? Maybe you can save a lot of headache for people that are listening to this when they go to invest in notes in that asset class. What are some of those common issues or mistakes or things that they overlook before investing in, in that. In. In notes themselves so that they should know about?

I think there's two things that come to mind. First is what I, what we've already talked about a little bit, and that is understanding the differences between the different types of the. And the vastly different risk that each one of those carry. The second thing I think is underwriting. You know, it's just like somebody that buys a single family rental or a little apartment building that they rent out. If you don't do proper screening and proper background checks and so forth, you're going to end up with horror stories, right? You're going to end up with situations where you're like, man, this doesn't work. I hate rentals. I can't believe how horrible it is. But it's not really that it was bad. It's that you didn't do it correctly. Right. In node investing, it's the same thing, only we have borrowers instead of tenants. But the stories are the same. The, the situation is the same. If you don't screen and if you don't look for the right types of things, it's called underwriting. When you're looking for tenants, it's called screening. When you're looking for a borrower, it's called underwriting. But at the end of the day, that's the same thing. So I think those are the two things. Our legal director has two checklists before she will approve alone. The first one, this is phase one. She has 123 things on that checklist. Phase two is 168. So that's how many things we look at before we say, yes, we will do this loan.

That's impressive. You know, obviously you may be a little biased, but how do people go about figuring out who they want to work with when it comes to investing in notes? Like when somebody comes to you and says, just for, you know, for our sake, we want to know what questions to ask and they come to you and they say, why should I work with you or your company? Like, how do you go about answering that type of thing so that people can do their proper due diligence on who to work with?

Sure, sure. Well, I think track record is, is number one. I, I would definitely work with somebody that has a long track record. And then with notes, our fallback position, again, I'm constantly talking about risk and how can we mitigate it? So our fallback position is not really taking the property and disposing of it, although that is what we would typically do. But what if, what if the worst thing in the world happened? What if the economy just went to hell, right. And, and there was mass foreclos? How would we be able, as, as a, as a fund manager, to protect the principal in our note fund? And my answer to that is we would take those properties back, we would finish fixing them, and we would rent them out until the market came back up. We would be able, by doing that, to protect the value of those notes because we want to wait until the value of the property comes back to dispose. That would be our fallb. If everything went to hell, that would be our fallback position. And we think we are very well positioned to be able to do that if we needed to because we're real estate investors first. We understand flipping houses, we understand renting houses. I've, I've had 86 of them personally at one time that I rented out. We built a property management company around that to manage them. So we know the management aspects of it as well. And we've done the same thing with apartments and now we're doing the same thing with shopping centers. So working with somebody that not only knows notes but knows the asset side of it as well. And there are more than just us out there with that experience. But that I think for me, if I were node investing is what I would be looking for.

That's helpful because oftentimes we're not sure what questions to ask. And I think you gave us an armed us with a bunch of questions to ask when we talk to somebody, figure out who we ultimately want to work with. The other thing that I didn't get to ask, I want to make sure we do this before you have to go is the tax situation. Because again, many physicians are in a positions where they are getting taxed very, very heavily and always looking for ways to invest in real estate and, and do that kind of thing. And sometimes the income from it, there are ones that are a little bit more tax favorable, some that are not. But again some are more passive, some are not that kind of thing. So how are these, how's the income from, from these notes treated?

Yeah, this, it's real simple. There aren't a lot of tax benefits to, to our note funds. Now if you have structured accounts, for example, through a self directed IRA company or something like that, we're very good with that. In fact, we have probably eight different self directed IRA companies that have clients with us. So we're very knowledgeable on that. But from a depreciation standpoint there is none because you don't own anything but the paper and you can't depreciate the the paper. So all of the interest income that we receive is then passed through on K1s to our passive investors as interest income. So that's, that's exactly what you're going to have for your tax return every year is just steady interest income on a monthly basis.

It's simple because when I notice I'm investing in funds, what I would I have noticed and what I like about it is that it's truly passive, is that it is truly passive. The work is really done up front when deciding who to invest with, who to work with. And that's where the work is done. After that the hope is that you just get it's kind of mailbox money where you get those deposits and checks on a monthly basis. The tax benefits oftentimes again like you mentioned, I know a lot of people, myself included, will put these in some self directed accounts to be able to take advantage or I guess at least take the income in the most tax friendly way. So I appreciate you taking the time to teach us about this. I learned a lot from this. I know that people listening to this have learned a lot as well too. What's the best way that if people are interested finding about more about you, your company, what you do, where's a good place for people to do that?

Sure. So Our website is ils capital funds.com and we have another arm as I keep mentioning, which is our lending arm. I always encourage people that are looking to invest with us to look at the lending arm as well and do your due diligence on that as well because that that's where the notes are being generated that are going to go into the fund that you're thinking about investing in. That website is www.ilscash. that's our lending arm. And then if you wanted to know more about me, my family and, and our philosophies, my business partner as well, you would look@ils Legacy.com which is our overarching website. And we do a lot of things other than just real estate. We have meat processing plant and hunting ranch and other things as well. So if you want to more about us and our philosophies, our beliefs and, and so forth, that's where you would do that.

Amazing. Well, I appreciate your time on this again. Thanks for the education. I'm sure we'll be talking again more about this and would love to continue to find out more about who you are, what you do, your company, and how ultimately people in this community can participate and you know, take advantage of what you offer. So any case, thank you so much Tom. Really appreciate the time and, and hopefully we'll talk again soon.

Soon. All right, thank you for having me. I appreciate it.

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