S.E.C. Real Estate Observer

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Discount without Loss Technique

Editor’s Note: This article first appeared in the October 1975 issue of the Real Estate News Observer.

At some time in their careers, many real estate practitioners take paper in lieu of cash fee or buy paper (notes, mortgages, trust deeds, or contracts) at a discount. Often, this is done to build a steady cash flow. The idea is to build a monthly cash flow because most real estate people normally do not get paid on a monthly basis—sort of “chicken today, feathers tomorrow.”

The acquisition of good paper is a wonderful technique to maintain a clear and positive mental attitude. This allows the licensee to pay monthly obligations when the obligations are due. However, what happens when the licensee needs to raise a lump sum of cash and conventional bank financing is not possible?

Normally, the broker will take a note and discount it to an investor to raise the necessary cash. The formula works, but the broker has lost a certain percentage forever; the discount reduces his overall net worth.

A typical example of this loss would be if a broker needed to raise $5,600 in cash. He might take a strong $8,000 trust deed and sell it for $5,600 and suffer the $2,400 paper loss. This paper loss is a reduction in his overall net worth. What formula could be developed to eliminate this loss on his financial statement?

Some would be tempted to say, “Borrow against the paper.” Many banks will not loan against junior paper such as second mortgages and trust deeds. Also, when borrowing, the broker has one other problem: He has to pay back the loan, and this establishes a negative cash flow. Borrowed funds have to be returned, and this becomes most difficult if the bor¬rowed money is not used for in¬vestment but rather is used to pay a short-term obligation.

Let’s review another technique that might solve the overall problem. If a broker needs $5,600 cash for non-investment purposes, he might use the “Discount-without-Loss Technique.

Take a trust deed in the face amount of $15,000 and sell it for the same discount outlined in our original $8,000 trust deed example — 30% discount. If a broker discounts a $15,000 trust deed 30%, he receives $10,500 in cash. He has at this point suffered a $4,500 loss on his financial statement. However, the broker has $10,500 in cash, of which he needs $5,600 and has $4,900 net cash to reinvest. Add $100 to make this an even $5,000 cash.

Now he uses the $5,000 cash to buy another trust deed at a dis¬count for the largest discount possible. If the best trust deed he can purchase is $8,000, he would pick up $3,000 and suffer a net loss of only $1,500 on his statement. This difference between the $1,500 loss in this technique and the $3,000 loss in the other is not $1,500; it is 50%.

Under certain circumstances, it is possible to pick up the total loss. The broker should be looking for investors who do not require such a large discount as 30% and for sellers of paper who will sell for discounts larger than 30%. Under these circumstances, the broker would not have to suffer a net loss in his financial statement or net worth at all.

Other than the technique in¬volved, the concept is to instruct any estate building broker to think out methods to avoid taking losses, to raise cash, and to maintain cash flow.