PLP-106: What You Don’t Know About Subordinate Lien Investing With Jim Maffuccio

The Private Lender Podcast

The number one rule in real estate investing is return of investment. That is, for every dollar that goes out, you want to get it back, if not, more. That is why people just starting with real estate investing stay away from subordinate liens. But what really are subordinate liens? On today’s show, Keith Baker talks to Jim Maffuccio about subordinate liens and how he got started in this world of distressed second liens. The Founder and Principal of Aspen Funds, Jim’s role includes identifying and developing key investment opportunities currently focused on distressed residential real estate debt, as well as leading efforts in business development, building and maintaining key relationships with hedge funds, note buyers, and sellers, and key service providers in the mortgage note industry. If you want to know if investing in subordinate liens is the right path for you, you wouldn’t want to miss this episode.

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What You Don’t Know About Subordinate Lien Investing With Jim Maffuccio

This is the only show that's dedicated to teaching everyday people, like you and me, how to prosper with the most passive form of real estate investing known to humankind, while giving tips and ideas that can help keep your money safe with private mortgage lending. It's just as simple. If you're looking for practical tips and advice on being a successful private lender and on how to create wealth without banks or Wall Street, then you're in the right place. If you want to learn from my mistakes so that you can avoid them, jump around them and prosper much quicker, then pull up a chair and pour yourself a stiff drink and get ready to take notes because this show is made just for you. The show does not constitute an offer to sell, a solicitation of an offer to buy or recommendation of any security or any other product service or investment.

We're only talking here and rapping out loud. Do your own due diligence and make sure you stay compliant. Having said that, let's get into the heart of the matter. I've got the good fortune of talking with Jim Maffuccio from Aspen Funds. Not long ago, I decided that I was going to no longer interview real estate fund managers for various reasons. Mostly, because I had locked onto some green fund managers and they didn't exactly succeed. Knowing that I wanted to be conscious of who I led on the show, what we talked about, so on and so forth so I say, “No fund managers for a while, except those few crowdfunding, and things like that.” One of Jim Maffuccio of Aspen Funds’ assistant reached out to me and said, “Would you consider interviewing Jim on the show?” I immediately said, “No. Thank you, but I can't recommend anyone invest in subordinate liens and especially nonperforming subordinate liens.”

[bctt tweet="There are no bad notes, only bad prices." username=""]

I didn't feel like it was a good fit, but the more I thought about it, I was thinking, “Who’s better to speak about such a topic on this show?” It is a topic I'd like to cover, but it's one that I don't feel like I have much authority on. I have done some lien lending in the second position, but I don't feel like I have done it enough to talk confidently on it. I decided, “Probably, it wouldn't be a bad idea to have someone like Jim to come on and talk about the ins and the outs.” Just because I don't do something, it doesn't mean that I can't interview someone who does it. It doesn't mean that I can't learn from Jim's process to help you do the same. That's the whole purpose of this platform. At the end of the day, here we go interview with Jim Maffuccio of Aspen Funds. Let's get down to the brass tacks in his interview.

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Everyone, thanks for joining me. I want us to give a special thanks to Jim Maffuccio, who has come on to talk about his Aspen Funds and the particular niche that they've carved out for themselves in second lien notes. Jim, welcome to the show.

It is great to be here with you, Keith.

I'm excited because as everyone knows ad nauseam that I tell them, especially the people starting off that got their first self-directed IRA, “Stay away from second liens. Get good loan-to-value. Stay safe.” The number one rule is the return of investment before we talk about the return on it. For every dollar that goes out, you want to get it back. How did you get started in this crazy world of distressed second liens? That it's not even good ones, but distressed.

In a nutshell, I'll give you a quick background. I was a civil engineer. I graduated from LSU Go Tigers in 1979. I did go into the oil field. I went to work for Exxon in 1980. I did the corporate engineer thing for about 5.5 years. The entrepreneurship turned on in me and I got my real estate license in 1986. I jumped out into transactional real estate and then I got involved in development. I was developing small residential infill projects in Ventura County Coast, California. I went through the S&L crisis and lost everything. By 1995, 1996, I was tanked, broke, underwater, having a seven-figure net worth going into that and all kinds of projects went dumped and went South. It was because of a mortgage-related crisis. I got back into the game and in 1999, I started back in. From 2005 to 2006, there I was again. A bunch of leveraged real estate development deals is doing great and killing it. The market was on fire. I even had focused on affordable housing thinking that there was going to be some correction because values had ratcheted up in that timeframe.

The 2008 mortgage crisis took everything so deep and fast. For so long, nothing could stay underwater that long and survive. Once again, around the 2010 timeframe, I was completely broke with a negative net worth in Kansas City, a new city. I'd lived in Ventura County for many years and here I am, 55 years old with five teenagers, two of them are adopted internationally. I literally have no immediate source of income and no investors to speak of. I could probably go back to California at that point and raise money again, but when you're beaten down, that's not the thing you're after. I was flipping homes because every other home was boarded up and it was a heyday.

I was flipping homes and put some people to work doing that. At the same time, studying the market because whenever there's a crisis, there's always opportunity. I had an epiphany in 2010. I saw the place to get in involved in the rebound, in the coming recovery was the distressed debt. Everybody was going after the REOs, further downstream, foreclosure auctions, and then further upstream from that, the pre-foreclosures and I worked in short sales. I did some of all of that, but I thought, “At the end of the day, where the distress starts is when a loan goes into default.” These institutions have to get rid of this paper before they go off a cliff.

I started looking into that. In 2010, I went to a note investing conference in Denver and 95% of the content was about senior liens. Buying the defaulted first mortgage and then running through. It's a checker’s game figuring out, “Are you going to exit through the property or are you going to exit through the borrower or making some modification with the borrower?” There was one guy off to the side and in one of the breakout rooms talking about second liens. As soon as I saw what he was doing, the lights went on and I went, “This is where I'm sticking my fork into because I needed something that I could come into with minimal investment, most multiplier effect, and the greatest leverage.” Buying the seconds, particularly when the first mortgage is performing was genius.

When I saw it, I was like, “This makes all kinds of sense.” Whereas hard dollar equity is super important in anything real estate related. What we learned was we could make more money in terms of multiple on the loans where there wasn't so much equity above our position. If any, it is because there's this thing called emotional equity. These are people that are paying their first mortgage so you know they have an income. They want to stay in their home and we've bought this nagging second lien that's on their property for pennies on the dollar. We have a whole lot of room to work things out with the borrower, whether it's a onetime fast settlement or a loan modification. That's on the ones where we have very little to no equity.

We make our best multiples on those, but they're low numbers. We may buy a loan, for instance, for $50,000. That's the payoff balance that the borrower owes, but we may pay $5,000 for that loan. Maybe the first $10,000 of our position is covered with equity, but everything beyond that is blue sky. We can go to that borrower and enter into a loan mod or settle that loan and make it 2X, 3X on our money pretty quickly if we have a reasonable and cooperative borrower. The good, the bad and the ugly of this thing are we've been doing it several years full-time.

We've built a company, we have twenty people and we're focused on second mortgages. After doing thousands of these, we made between 2.3X and 2.5X on our purchase price. If we buy $1 million worth of these defaulted second mortgages, we will pull in $2.5 million of revenue. It typically takes anywhere. We start getting exits in six months and typically out to three years. It's patient money because there's an elaborate workout process we go through, but it's pretty good multipliers. I wish there was more of the product. That's a nutshell of what we do on that side of our business.

We then do have another side of the business, which is an income fund where we are buying re-platforming mortgages, whether they're seconds or firsts, and we buy some hard money loans from other originators as well. That's the way we can keep our truly passive investors that want mailbox money. We can keep them happy with a nice preferred return. We do all the brain damage of keeping the loans on track. When they break, we fix them. Since that's our core competency if we have a default rate of 10% to 12% in our income fund, we know how to do workouts. We know how to get that thing back to performing status.

I'm going to back up a little bit. Is your fund for accredited investors only?

At this time, it is accredited only.

For education, you run through the SEC Code 506(c).

That’s where our funds are. That's the particular exemption that we fall under.

Are you buying tapes of houses of seconds? Is it a cherry-pick piecemeal? How do you get your deal flow?

It's everything from buying one-offs, but more typical for us because of our size is we are buying larger pools. In the second’s world, you're not going to find a lot of quality products like on the note exchanges. It's a relationship-based deal. It's not a normalized market. A lot of the institutions that generated this paper, they charge it off their books typically after 90 days. It's treated differently than a first mortgage. It's almost treated like consumer debt. I don't fully get that end of it, but it's charged-off and it's worthless to the institution. A lot of them won't even sell that paper, it'll just expire. The statute of limitations will time it out.

It'll never see the light of day because they have higher priorities. Some of them look at the political cost of selling this paper out on the street and then ending up with some cowboy that's mistreating the precious consumers and that's happened. We're very compliance minded. We have a great reputation. We've been vetted at a pretty deep level by a government entity that we bought some paper from through an intermediary. We have the FDIC looking into our processes. We came out with an unofficial report, but got the thumbs up, like what we were doing was good because we're not out to take people's homes.

We have to start foreclosure probably 65% of the time, but we only end up foreclosing less than 2% of the time. Most of the time, it's agreeable at that point in time the borrower realizes, “I can't afford this house.” We're people-oriented and minded. To us, a win-win is when we can cancel a whole bunch of debt for a borrower, keep them in their home, create a reperforming asset that we can then 2.5X or 3X of what we paid for it. That's very typical. Those are our numbers. It's a wonderful thing. It is a win-win, truly.

The bigger the risk, the bigger the reward, but it sounds like if you're paying pennies on the dollar, you are a couple of things. One, you're setting yourself up properly. Two, if anyone's out there reading, originating their own private loans, you don't want to sell a loan to Jim. You want to avoid selling the loan to him, especially if he reads my show and take any of my advice. Don't use this as an exit strategy, but it's always good to know it's there if you need it. You mentioned something that I liked. You said that these people have emotional equity in the property. They're performing on the first lien. I'm curious, are these usually like home equity lines?

They could be. I'd say probably 30% or 40% of our home equity lines. Others are fixed rates seconds that people took out whenever they took them out. There are two components, emotional equity and pragmatic equity. Emotional equity is, “We've bought this home. We put our own finishes into it. We've lived here to 10 to 15 years. We know our neighbors. We like the school. Our kids have friends. We're not going anywhere if we can afford the monthly payment. If we can afford to stay, we're going to stay.” People or your typical household don't wake up in the morning and look at Zillow and say, “Look at this, honey, our equity has gone down $5,000. Maybe we should sell this asset.”

It's a home sweet home. Most of our assets are across the middle of the country. We have some on the coast, but we're in 38 states with our portfolio. I ran the numbers on the pool of seconds that we bought and it was an average of 32 loan pools. The average FMV or home value was $250,000. You can see it right in the median pricing for the nation. This is a bread and butter housing. It's more or less workforce housing and people don't want to leave. They're not going to leave because they're upside down $20,000 or $30,000. They're going to leave because they can't afford the monthly nuts.

The other thing is, “What are their alternatives if they do leave or if we do end up having to foreclose?” In a lot of cases, the homes that are securing our position would rent for more money than what their mortgage payment is first and second combined. If you think about where are they going to go, if they've been through the 2008 to 2014 cycle, there's a good chance they've modified their first because when they had trouble paying our loan, they also had trouble typically paying the first. Some of these people are still sitting on 2%, 3%, 4% money on their first. The best alternative financially, even for them is to stay home or stay in their house. We have a lot of tools to help them because of the discounts we buy.

Most of the loans we buy these days, we're buying in the 20% to 25% of the unpaid principal balance range. Those loans would typically be ones where the seniors performing and we have enough equity to cover our investment. We've paid all the way up to in the 60% range of UPB if we have a loan that we pay $40,000 but it's an $80,000 balance. Even above our $80,000 balance, there's another $150,000 in equity. You tell me where the risk is in that. I would rather own that second than the underlying first. If you think about it, I've leveraged my position. The first mortgage is like my financing, but I don't have to pay.

It's a crazy sub-to.

That's exactly what it is. That's one of the reasons this is a pretty lucrative game because many people, including a lot of institutional players, either don't realize that you can or aren't willing to foreclose from the second position. When we foreclose from the second position, there's a false narrative out there that says, “We have to pay off the first.” That's not the case. In most states, we have the right to reinstate the first and keep it current. Even though it's not our loan, we're not the borrower on the loan. We foreclose from a second, we get the deed to the property and it's a sub-to deal. It's exactly what you said. There are states where the first does not have to let us reinstate and they can pursue foreclosure. Those are typically the states that take a couple of years to foreclose.

That gives us plenty of time to clean the property up and sell it. We've made some incredible profits on the handful alone ones that we did foreclose and where we flip the property. We've foreclosed from second and then turned around and resold the property back to the borrower because it took that to wake them up to realize that we were serious about securing our position. Those have ended up being wonderful stories because you got the original borrower. That's back in place on their property and they're performing again. We had to put $200,000 down, which got us back our investment plus some, and then they're making us do monthly payments. They've been great borrowers ever since. We have all kinds of stories as you can imagine in this business.

I did not do this so this is one of my tales of woe. What I tell people is if you're going to lay a second on a property, you want to talk to whoever owns the first position. I did not contact them

[caption id="attachment_2935" align="aligncenter" width="600"] Subordinate Liens: When we foreclose from a second position, there's a false narrative out there that says we have to pay off the first. That's absolutely not the case.[/caption]

first and put the second on the property. Lo and behold, the first is the one to foreclose and then wiped me out and I said, “Don't call the attorney representing them. Is there something we can do here?” The guy who had the first position was even more fed up with the borrower than I was trying to track money. He's like, “You want to make it whole. It will be $47,000 and it's yours.” I was like, “The property is not even worth that. Fine, done.” It's automatic that you're taking it over, you foreclosed out the second position, but the first lien is superior, therefore, it stays in place. Do you have conversations with any when you purchase the seconds? Do you say, “We've bought this, here's our plan if we have to foreclose,” or is it all in the paperwork?

Typically not because the first is serviced by the major and national servicers. They won't give you the time of day. These loans are owned in trust. There's not like a single investor they can go talk to. Their servicing agreement tells them what they can and can't do. The handful of times that this happens, we just make the payment. We send them the check or in most cases, pay online. I don't even know if they know where the money's coming from. They don't care. By the way, you touched on something super important. When we buy these...