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The Note Investor Podcast
Note Partials 101: Structure, Pricing, and What Happens If a Loan Defaults
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All right, welcome to Seller Finance and Creative Deals podcast. I'm Dan Depen, and today I'm going to be talking about partials and how they work. Partials is something that a lot of note buyers are familiar with, but as I talk to an increasing number of note creators, they're often not aware that they can even sell a note, let alone do something like a partial. So I'm going to deep dive into into that. But before I get into that, two months, just some updates on what I've been up to. I've been a little quiet on the podcasting front lately, but it's just because I've been still working on buying this Oklahoma City portfolio. So we're going to close on the vast majority of the assets, it looks like right here around the end of the month and then close the remaining couple assets in July. So if you have any interest in participating in that, drop me a note and let me know. So there'll be a couple opportunities later in July for that. I've also got the six week no accelerator program going on. This cohort is probably going to be the last one for the year, more than likely just because as we get into the fall I got some other stuff going on. But that's a lot of fun. I always enjoy that. That's my small group coaching program where we basically go through a lot of the stuff that's in the note launchpad course, but then also do it in the context of like actual deals. So there probably are probably aren't going to be opportunities to participate that until we get in to next year. But it's one of those activities that I really enjoy a lot. So between all my buying activity, I've also seen an uptick in underwriting activity through call the Underwriter. So that's very good. If this keeps up, I may bring another underwriter on as we get a little bit deeper into the summer. So that's what's going on with me. Feel free to drop me a note. I'm interested to hear what you guys are up to as well. But first, let's get into this little deep dive on partials now. So if you've been around note buying for any amount of time, you know, you probably heard of it in the note buying world. It can be one of the most popular topics that people talk about, but it also creates a lot of confusion. And part of that is, you know, if you talk to, if you look at like the way that 10 different note investors like to set up their partials, you'll probably get 10 different sets of specifics. Right. So I'll talk about what these are at like a big picture level and some of the options. There's not necessarily one like single right or wrong way to implement this method. So we'll talk about today is kind of what a partial is. Why they can be a big benefit for both the seller of the partial and the buyer of the partial. And then I'll talk about how to find buyers if you want to sell a partial. And then some of the structural choices that we have to make. And the big question, like the number one question everybody asks when this comes up is what happens if a loan defaults. So we'll talk about that as well. Okay, but first, what do I actually mean by partial? And so basically kind of the core definition of this is so we've got a loan, it's got some term remaining, right? Let's say we have a loan, it's got 20 years of payments left. When we sell a partial, it's when we sell a portion of the future payments at some fixed interest rate. So let's say I've got a loan, it's got 240 payments remaining. I might sell 48 payments of those to an investor and then after that investor has received their 48 payments, the rest of the payments go back to me. Now big important caveat on these. When we're doing partials, we're only doing these on performing loans, right? Because the whole thing kind of assumes that the borrower is making payments. There's this monthly cash flow that's coming in and you're selling a piece of that cash flow. If you've got a non performing note where the borrower's not paying or the borrower's not paying reliably, then this isn't the structure that you want to use to capitalize the loan. So just like going through an example, and I'll try to do this without visual aids and handwriting, but hand waving. But let's just say we have a performing loan. There's a 30k balance and this loan has an 8% interest rate. 120 payments left, their PNI is 363 98. Okay, and then let's say I buy this loan with this $30,000 balance. Let's say it's a land contract and I buy it for 75 cents on the dollar. So 75% of UPB, that'd be 22,500. Okay, so I've bought this loan for 22,500 and I'm going to collect 120 payments of 363.98 in this example. So let's say I'm going to sell partial, I'm going to sell some of those payments to another investor and I find investor, maybe they're usually often buying out of their self directed IRA that wants a 9% rate of return and they're willing to buy the next five years worth of payments, 60 payments. So if I take that 363, 98 and the 60 payments that the bar that the investor would be buying, if I discount that to a 9% rate of return for them, then that means that they would be willing to pay $20,192. So at this point I bought the loan for $22,500. I'm selling the first 60 payments for 20,192. So I'm effectively in this deal for about 2,500 bucks, maybe closer to 3,000 when you consider due diligence expenses and other kinds of things. Right. But basically I'm into this deal for, let's call it 2500 $3000. And now I'm going to collect no money for the next five years, but then I'm going to collect payment 61 through 120 on the back end. This can be for the partial. So for the partial buyer for a minute, they're getting a fixed 9% rate of return. They've only had to deploy like $20,000. Right. So there are a lot of investors with money in self directed IRAs where that's a really nice thing for them. For you as the investor, I'm going to collect eventually 60 payments of 363.98. Granted it's not going to start until five years in the future, but I'm only out of pocket a couple thousand bucks. And, and that strategy can be really effective within a self directed IRA as well. Right. Because let's say we have money in a self directed IRA and I set this up where, you know, I'm in this deal for a couple thousand dollars now I can do a whole bunch of these and that self directed ira. And in that context, for me as the investor, I'm not getting payments for five years, but if it's a retirement account I'm not touching for 10 plus years or whatever, well, I really don't care in that standpoint. Right. So these are really nice structures that can work for both the partial seller and the partial buyer. Okay. Now getting into the variations a little bit. So typically when we Say partial. We're talking about selling complete payments, right? So in my made up example, I said we're selling payments one through 60. That's kind of traditional. It's also possible to sell fractional payments. So let's say my payments are 363.98. Maybe I want to settle a percentage of each payment and then a certain number of payments, it gets a little more complicated. But you know, there's different ways you can peel the onion on that. So for the seller itself, right. Like in general, it, as I just explained, it's a really good strategy out of a self directed ira or if you're creating these notes yourself, it can be a really good way to help recapitalize afterwards. And then if you're doing it out of an llc, it can still be nice because now you're refinancing your way most of the way out. If you set it up as a fractional, where you're keeping like bits of income, it can be a way to make, create small cash flows every month while either refinancing yourself out of the dealer, mostly refinancing yourself out as well. And in general, it's just a good way for operators to scale. So that's a way, you know, what tends to happen whether people are buying notes or creating notes. You know, I've observed this pattern where investors get their model kind of figured out, they crack the code on what they're doing, they want to scale up, and then no matter who you are, you run out of money eventually you need to recapitalize. And so this is beyond just selling the entire note. This is one of the nice ways that people can do that as well. And so for the buyer too, right? Like they have a ton of advantages. So in my example, they're getting a 9% rate of return. It's a high single digit rate, which is pretty good, right? Like 9% is probably in line with the long term stock market average with dividends, but with a lot less volatility. The other benefit to the buyer, because they're buying the front end of the payments, those are the least risky payments, right? So if we think about a loan with 120 payments left and the borrower's been paying well, you're most likely going to receive the first, the next payment in that stream. The one you're least likely to receive would be the one all the way out at the end at 120. So from the buyer standpoint, they're buying the least risky piece of the loan. It's also a nice way for buyers sometimes to get exposed to note investing and sometimes like for a smaller amount. So if you want to dip your toe in note investing, but you don't necessarily want to have to do all the due diligence to buy the note up front, this is a way to get involved if you can buy a partial from an experienced operator that you trust. So it can be kind of like the gateway drug to note investing sometime. And the other good thing, if you're the buyer, when the seller is holding the back end of the loan, they've still got skin in the game. So they're less likely to try to sell you some bad note or some note with some fatal flaw. Because if it's a flawed note, well, you know, they're not going to get paid their back end, which they're going to be counting on. And this can be a really useful tool for people involved in seller finance, mainly because in seller finance in particular, people weren't in this problem where they scale up and they need to recapitalize. Right. And so you can capitalize by either selling the entire loan, you can take, you can borrow against your loans, which is something that I personally like to do quite a little bit. That's my hypothecations that I've talked about. But selling partials is one other way that you can do this without having to exit the note entirely. And the nice thing is for the seller, you've still got that back end and you've still got the upside of the early payoff. Right? So let's go back to my example. We've got the loan with 120 payments. We sell 60, we're retaining payment 61 through 120. Well, what happens if the borrower refinances or just cuts a check and repays the loan? Well, in that case, the partial buyer gets payments one through 60. And then you as owning the back end, you know, you're getting paid for your principal for 61. 61 through 1 20. Right. So, so you're still retaining some upside even if you're foregoing some cash flow for a while. So you know, it, it's just a lot of benefits for both the buyer and seller overall. And even if you're going into originating a loan or buying a loan and not planning on selling it or doing this, it's nice to know that you have this as an option. Because the other thing that happens is a lot of people who are involved in notes or seller finance or other forms of Creative finance, you know, they tend to be wheeler dealers, they tend to be involved in all kinds of different deals, both in real estate and not. And so it can be a quick way to raise some capital from your loan without completely exiting the thing as well. And again, a really nice way to build leverage within a self directed retirement account as well. So let's say you're on a loan, you'd like to sell a partial against it. How do you go about finding a borrower or sorry, finding a buyer for your partials? And there's not necessarily like a big liquid market out there. You could list them on paper stack. I believe that does happen from time to time. But generally like your paper, best source for finding buyers of partials is going to be your network and your relationships as well. So you know, hopefully you've got a network of other note investors and other real estate investors and operators or you know, people that live in adjacent worlds like so people who invest in other forms of real estate or you know, have self directed IRAs that they do things with. You can also meet them at, you know, your local RIAs and local investor groups. So some of my, some of my first investors that I still have were from a local NVER note meetup that Beth Hale used to run. Used to run like seven, eight years ago. It's not around anymore, but I still know a lot of those folks. So meeting people face to face is another good way because most people have money either in a self directed IRA or otherwise that is kind of sitting in cash earning zero. So getting these kinds of returns, while it's not a, you know, home run for the partial buyer, it's a lot better than money sitting at zero. And then another question is, you know, what should the interest rate on the partial be? I threw out 9%. That's kind of typically what I see most of the time. You see 10% sometimes, used to see 10% a little more often in the past. In a perfect world, if you can sell them at 7%, that's like ideal. I go to a lot of conferences and you'll talk to people who talk about finding investors to buy partials and do other things at 6, 7%. I've personally never seen that. Maybe I have the wrong investors. Maybe I just got the more savvy investors that work with me, I don't know. But usually like in that like 9% range, maybe a little more, maybe, you know, plus or minus is kind of typical. But the cheaper the cost of capital you can have, then obviously, you know, the more deals you can do and the more you can scale up. And the other thing too is as you're, you know, building your network and finding buyers, buyers for partials or perhaps lenders for hypothecations. You know, make sure that you treat everyone in your network as a very long term relationship. Like we're not into one off transactions. You know, the note world is, is very small and I've been very fortunate. Like a lot of the investors I've worked with, I've worked with for several years at this point. Right. And so when you work with them as well, you want to make sure your communication is real strong. Get back to people within a business day on things and just be clear about what skin in the game means. Right. Like, so you're doing a lot for the partial buyer. You're, you found the note originally, you acquired it, you did the due diligence, now you're offering the opportunity to buy this payment stream and you're still going to have skin in the game because you're holding the back end of it. Sometimes investors don't like it if you're all the way refinanced out or most of it refinanced out. But the reality is if you built expertise in the note space and you're scaling up like, you know, you have to do that, right. So what they're getting is they're really finding a way to leverage your, your expertise. So now I mentioned too that there were going to be some, you know, there's a lot of options and the specifics of how you structure these. So question number one is who holds the loan servicing? So in a, what I'm going to call a traditional partial, not that I'm really sure there is such a thing, the loan servicing tends to transfer, you know, to the partial buyer when they own it and then the servicing would transfer back to the seller at the end. I've also done them where the seller held the servicing and actually collected the payments and then basically forwarded those to the partial buyer. You can do it that way. In a perfect world though, the partial buyer would just have the servicing. And some loan servicers, like Madison Management is one example, have specific programs for this. We can give them your partial agreement and so they'll automatically switch over the servicing when the partial period ends. Although you may talk to some servicers who, you know, don't want to touch partials at all. So mileage varies. But however the servicing is going to be handled, you're going to want to call that out in your partial agreement. And now the next question is whether you're going to sell full payments or fractional payments if you're going to do it. I prefer full payments just because they feel that it's a lot more simple. Right. I mean, the buyer is just getting their straight P and I for 60 months. Super simple. And then typically, too right. They may be getting those payments net of the servicing fees, too. Right. So you want to specify in there how you're handling the servicing fees. Typically, the person who's receiving a particular payment pays the 3 or $35 a month for servicing. If you're doing a fractional, like let's say somebody's going to buy, call it 50% of 24 payments. You know, now it's getting a little more complicated. Right. And in general, like, there's nothing wrong with doing a fractional. But I find as I get more experience in this, like, the more simple, the better overall. Right. And then as far as setting up the paperwork, you're going to want an attorney to write up your partial agreement. I've seen a bunch of different ones out there. The one. And I've actually not done a partial in a while because I've shifted primarily to doing hypothecations because my business model is a little bit different, although partials are widely used. But, you know, I had my partial paperwork just like my hypothecation paperwork created by Brian Gallagher, who's a really good, creative attorney out of Maryland, somebody that can help set this stuff up. But in that agreement, that's where you're going to define all these specifics. So how are you going to handle servicing, payment timing, how are you going to handle default? And what exactly happens if the borrower pays off early? So, you know, you can get partial agreements from other people in the industry. I think I got. I've seen like five or six different ones. But make sure you read through it and you understand all the particulars because they tend to be different. They're not really cut and paste. And now the big question is, okay, what happens if the loan defaults? So I feel. And there's different ways you can do this. So. So one way is you can say if the loan defaults while the partial buyer has it, then the partial buyer needs to work that out to get their payments. But the way I prefer to do it is to have the seller be on the. On the hook for the workout because that means the seller has additional skin in the game. And typically your partial buyer is somebody who's either getting their feet wet with notes or isn't an expert and like working out a delinquent note and doesn't want to be. That's why they're buying a partial in the first place. But so typically, like my favorite approach is if the loan defaults, the partial payments to the buyer can pause and then the seller's on the hook to do the workout, whatever that means. Could be taking it through foreclosure, modifying a loan, getting a forbearance agreement in place, whatever. But then the interest to the seller continues to accrue during that workout phase. And then when the loan reperforms or you know, you get to an exit through a foreclosure or whatever, you know, then you're either paying back the partial buyer or the partial payments are going to resume once the loan gets back on track. And then the other approach would be the partial buyer handling the workout, which is typically what's going to happen if they are also holding the servicing. Because if you transfer servicing to the partial buyer, then the seller doesn't have the servicing and can't really do the workout. So that's why when I've done these, me as the partial seller, I'll hold the servicing and then be on the hook if you have to do the foreclosure. But that's by no means the only way to do it as well. So okay, so I think I covered all the bases now so you know, to kind of wrap this up. So you know, what's a partial? It's when we're selling a partial amount of the payments remaining on a loan and the devil's going to be in the details on how you set these things up. It can be a really powerful tool for sellers to either recapitalize and scale and or maximize leverage within a self directed ira. For buyers, it's really nice because they don't necessarily have to be as sophisticated, they don't necessarily have to be on the hook to handle a workout. If a loan defaults and you know, find your buyers through your network, that's really the best way to go. There are some, you know, platforms like Paper Stack where you can potentially find these things, but for partials in particular, that's not always the best way to go. And you know, make sure you understand your partial agreement, get it written by an attorney and that both you and your partial buyer understand all the details of how you're going to handle everything, the servicing, how payments are distributed, what happens in a default. And so just make sure everybody's on the same page, so you don't have something happen down the road, and now all of a sudden, like there's confusion or some dispute after that. So again, just another way, it's kind of related in a way to hypothecations, although they're different. Maybe next time I'll talk a little bit more about hypothecations, although I think I got some other topics I'm going to get into as well. So anyhow, hope that helps you understand partials a little bit better if it's a concept you're not that familiar with. And I will see you all next time. Thanks.