November 15, 2012

In SCUBA diving, the golden rule is to plan your dive, then dive your plan.

I love the simplicity of this sentiment because it can be applied to so many life situations. But equally as important as sticking to your plan is creating a good plan to stick to in the first place.

This hit home yesterday when I was catching up with a financial advisor friend of mine. We meet regularly to talk "shop" and see if our individual expertise can benefit our collective list of clients. Yesterday, we exchanged different strategies we are deploying that allow our investors to participate in potential market upside while minimizing the downside risk. Our markets are different, but our strategies are similar. He is investing in stocks using call options and I am investing in real estate using non-performing notes.

Instead of buying a stock directly, he will buy a call option on a certain position. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular position from the seller of the option at a certain time for a certain price.

In English, let's say a stock is selling for $45. I might buy a call option for $5 that allows me to purchase the stock @ $50 in the next 12 months. So if the stock price goes to $60, I can exercise my option and buy the stock for $50, then sell it for $60 and make $5 profit ($60 Price - $50 Purchase - $5 Call = $5). Since my original investment was only $5 and I made $5, I doubled my money in less than a year...a very strong rate of return. And if the stock crashes to $25? You don't exercise your option and only lose the $5 instead of the $20 you would have lost had you bought the stock at $45.

Call options are a good tactic, but what is the strategy? The strategy that he implements is to cover the call options with a portfolio of bonds that return enough cash to cover the amount of calls you make. So in the scenario above, someone that had $45K would buy $5K worth of call options and then put $40K in bonds which will generate $5K in cash flow over a period of time. If the stock price goes up to $60K, you make your $5K PLUS the cash generated by the bond investments. And if the stock goes down to $25K, your $5K call option is lost but covered by the bond cash flow and you break even. This is very stripped down, but you hopefully get the gist of how portfolio management works vs. just buying stocks.

Similarly, we execute a strategy using performing and non-performing real estate notes. A performing note is a loan that a bank made and decides to sell for a myriad of reasons. The note is performing since the borrower is still paying the bank the agreed upon payment. A non-performing note is when the borrower is NOT making payments to the bank. So when a bank sells notes, they sell the performing notes close to "par" value but have to heavily discount non-performing notes to entice an investor to purchase them. Makes sense, right?

So again, in English, assume a bank owns a note with an unpaid balance of $50K and is collecting $450 per month on a property worth $55k in today's market. They decide to sell it for $45K, which is 81% of market value. The investor is "buying" $5.4K ($450 x 12) of payments per year for $45K, which works out to be a 12% cash on cash return. And when the borrower sells or refinances, they have to pay off the full value of the $50k note which earns the investor another $5k in profit. Pretty cool.

But what if the buyer hasn't paid their mortgage for 8 months? The note is now non-performing so the bank has to discount it more steeply. They sell it to an investor for $20k, or 36% of the $55K market value. As the new note holder, the investor negotiates with the borrower and agrees to modify the loan. Instead of the $450, the borrower agrees to pay $300 a month. New loan docs are generated and the note now re-performs at $300 per month. The note investor is collecting $3.6K per year on his $20K investment which is an 18% cash on cash return. And when the note settles via sale or refinance, they still receive the original unpaid principal balance of $50K.

What if the borrower stops paying again? There are decent odds it will and that is the risk of buying non-performing notes. When this happens, the note holder has to forclose on the borrower and take the property. And while this takes time and money to accomplish, if the value of the property holds near the $55K range there is enough equity to break even and potentially make a BIG profit. But there's no cash flow to be made along the way and it could take years to realize it. Or, you may be lucky to break even if the house gets trashed or the value drops dramatically.

So from a portfolio stand point, it's risky to buy only non-performing notes. We advocate buying a mix of performing and non-performing notes to minimize the risk. Since the non-performing notes offer the potential for larger returns but are more risky, you buy a smaller amount of them. The goal is to cover any expenses you may have on your non-performing notes with your performing notes as you work to get the entire portfolio in a performing status. And you need to work with someone who understands this landscape and knows how to properly evaluate and work out the note.

Which strategy is best? That's like trying to pick between vanilla or chocolate. Each individual has their own preference and will have a favorite or "best" flavor which depends on their tastes.

But whatever flavor you choose, make sure you're working with an advisor or strategist who has enough forethought to develop a balanced, responsible plan of attack that you understand before investing. Successful investing is about consistently NOT losing money. A strategy that is solely based on maximizing returns without any regard for minimizing losses may cost you dearly if there's an extreme event. Hopefully your strategist understands this concept.

If you like real estate, performing and non-performing notes are a great way to build your portfolio and we know how to help you do it responsibly. And if you like stocks, make sure you have a strategy and aren't just picking random stocks. We're more than happy to refer someone to you if you need help.

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