I received a question from one of my subscribers wanting to know what are the advantages of wrapping a note rather than taking back a second lien. The two main advantages are a wrap note gives you more control, and therefore security. This aspect is a topic for a different issue. The other advantage is how a wrap note can increase your yields dramatically. The “number crunching” of wraps will be my topic in this issue. The best example I can give is to reprint an section from The Note Professor Notebook.
From Page 91 of THE NOTE PROFESSOR NOTEBOOK
I call a wrap around mortgage, or wrap, for short, a gift, because you will be earning interest on money you do not lend. Great gift, don’t you think? A wrap around mortgage is also called an All Inclusive Trust Deed, and a “Tootsie Pop” mortgage.
A wrap is nothing more than a junior lien that “wraps” around senior liens. In essence, a wrap works like this. The buyers would make you a monthly payment for the wrap note. You then would make the underlying payments, and have a cash flow of what is left. Because your wrap lien includes the underlying senior liens, you will be collecting interest on the spread between your junior lien and the senior liens. Hence, the “all inclusive” term. By collecting interest on money you do not lend, you will greatly increase your yield, as we will later plainly see. For example, if you had a property worth $100,000 with a mortgage of $70,000 you would have equity of $30,000.
We will assume the underlying lien is assumable, and that the terms are at 7% with payments of $629.18 for 15 years. Bob and Betty Buyer have offered you $100,000 with 10% down, and want you to finance the rest. You have two options to make this deal work. One is for you to take back a straight second with the Buyers assuming the 1st. The other is to take back a wrap around mortgage, where the Buyers would be paying you monthly payments, and you would be paying the underlying lien. Which would offer you the better yield? Lets’ look.
If you structure the deal where the Buyers put their 10% down and assume the 1st lien of $70,000, you would then carry a 2nd of $20,000 dollars @10% interest with payments of $214.92 for 15 years. With this method, you would be receiving a 10% yield. Here is what the note would look like:
N = 180
I/YR= 10
PV = -20,000
PMT = 214.92
FV = 0
Let’s look at what happens if you were to structure this deal using a wrap around mortgage. You would be carrying a $90,000 note that would include the senior lien of $70,000, plus the $20,000 you are financing. Your wrap note would look like this:
N = 180
I/YR= 10
PV = -90,000
PMT = 967.14
FV = 0
With the $967.14 payment, you would make the underlying payment of $629.18. Subtracting the $629.18 from the $967.14, you will enjoy cash flow of $337.96. By structuring the transaction as a wrap, you have increased your cash flow from $214.92 to $337.96. That is $123.04 more a month!
But Tom, how is this possible? Both the 2nd lien note and the wrap were at 10%. The answer is simple. In the first example, you are receiving 10% on only the $20,000 you financed. By using a wrap mortgage, you are not only receiving 10% on the $20,000 that you are financing, but also the spread of 3% (10%-7%) on $70,000 on money you did not lend. Let me say that again, and in another way, in case you did not pick up on it. YOU ARE RECEIVING 3% ON $70,000 THAT WAS NOT YOUR MONEY!
Let’s see what your yield will be: Remember you have $20,000 loaned out, and receiving a cash flow of $337.96 monthly for 180 months. After we identify the variables, we will solve for I/Yr. Your deal looks like this:
N = 180
I/YR= 19.09
PV = -20,000
PMT = 337.96
FV = 0
Wow! You are enjoying a whopping 19.09% yield while Bob and Betty Buyer are paying only 10%. Do you understand why I call wraps a gift? There is a gift of an extra 9.09%.
There are several ways to structure wraps. This example is the least complicated, where you had N on underlying liens coinciding with the N on the wrap. You could also have the wrap longer than the underlying, where the underlying lien is paid off at some point, and you keep the entire wrap payment. That can be real fun. You could introduce balloons, graduated payments, or an endless amount of combinations. These combinations can give you even extra gifts.
Yes, there are disadvantages to wraps, which is a topic for another discussion. In this lesson, I wanted to bring out how a wrap basically works, and how you can use a wrap to increase you yield.
As always, obtain competent legal and tax advice when venturing into the world of owner financing, especially wrap around mortgages. Be especially aware of Dodd Frank and SAFE ACT regulations.
Try the wrap technique then CONTACT ME and tell me how you came out.
CONTACT ME And remember, if you know of someone who has a note to sell, I DO PAY REFERRALS.
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Tom Henderson
a.k.a. THE NOTE PROFESSOR
