The BIGGEST Mistake Investors Make When Buying Cash Flows

In 1996 I was in the room with some of the brightest investors of our time.

They batted around terms and strategies that left my head spinning and my hand sore from writing down as many notes as possible.

I distinctly remember, just before ending the day, someone (not me) made a comment that brought everything to an abrupt halt.

“If I buy a note that pays for 10 years at 12%, I don’t have to worry about investing again for another 10 years.”

What got me was the number of people that agreed. Buy a cash flow note, collect payments for 10 years – THEN buy another note and enjoy another 10 years at 12% (or whatever)???!!!

Surely these people knew the math?

Well, some did, but several did not. Here is what I told them…

You don’t get 12% for the entire ten years. Actually, if you don’t reinvest the money, you will only earn around 5.45% (per the example we were using). Here is the math.

The Note

120 payments

9% Face Rate

$39,470.85 Balance

$500 month

The Purchase

120 Payments

12% Yield

$34,850.26 Invested

$500 month

Think of the purchase as 120 mini buys. Each time you receive a payment, you have been paid in full for that specific segment. If you just stuff the money in your mattress, the clock stops ticking.

The Reality

Here is what it looks like if you do nothing with the payments each month for 10 years.

N                                    I/yr                        PV                        PMT                        FV

120 payments                5.45%——–$34,850.26               0                        $60,0000

You MUST reinvest to maintain the yield you think you are getting – especially when buying a cash flow that pays back incrementally.

Needless to say, a few left the meeting scratching their heads while others were ready to reinvest right away. On the plus side, I didn’t have to pay for my own dinner that night!

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  1. L Truett Phillips says

    I wonder if you might email me for a private exchange of ideas…

    heres the question…
    is it possible to find financing to buy discounted notes…?
    is it possible to find and discount/buy a note at such
    a price that there is a positive cf spread…? for the buyer…
    rsvp/asap/ thanks …ltp

    • Hello LTP. You can email us directly at at any time.

      In answer your question…

      Yes, there are some banks that are open to lines of credit secured by collateral such as private mortgage notes. Of course, in this market, that is getting a bit tougher, but even when “times were good” it was usually the small local banks that were more likely to work with investors. Believe it or not, a “relationship” with a bank actually worked in your favor (a rare thing nowadays).

      Mathematically, you can certainly make money off the spread…assuming the cost of funds is cheap enough and that you don’t take “profit” off the line out of the gate (ie: take what you need to get the deal, no more – otherwise you are borrowing more money than you need to).

  2. L Truett Phillips says

    IN your example you fail to say if the note was IO or amortized… this simple ppoint makes all the difference… makes it more “mysterious ” than it really is…
    .. its very basic analysis… when you fill out a client questionnaire..
    your info sheet should have all of these points… a checklist… amortized or IO..?
    The other comments were pretty much on the ” Mark” to speak…
    Everyone knows the interest chart…( cant do it on email.) .. but y’know.. most of the inbterst is paid in the first half of the amortized loan..
    this is why many note investors prefer the in terest only format…
    adap @date certain … can resell at less discount… whaddaya say..?

    • LTP…just a couple points.

      1. You are correct, I did not specifically mention interest only or fully amortized. However, had it been interest only, the payment would have been $296.03 (at the 9% stated above) instead of $500 per month.

      Also, in the calculator layout part, it would have had to have the present value ALSO in the Future Value (ie: not change in principal balance over the term). This is what makes it easy to see that the note is interest only. (you kind find another shortcut here).

      2. Buying “interest only” payments can be good sometimes, certainly in minimizing the perceived discount as you suggested when buying the full note. The downside is that there is no increased commitment from the payer. This increases the risk of the note substantially as the LTV never really gets better. No matter how attractive the projected return is, it is not worth it if they payer does not pay!

      Thanks for your comments.

  3. Thanx Fred,

  4. Hi Fred … In order to help my understanding I worked out the math. Is this correct?

    Original loan was a 30-year Amoritized Loan at 9% which is an amount equal to approx. $62,140.00. We are interested in purchasing the last 10-years which equals principal of approx. $55,573.13. Present value of the note = 39,470.00. After applying our required 12% yield the purchase price to offer = $34,850.00.

    With our additional risk we are only making an additional $4,620.00 over the 10-year period than the previous owner of the note, correct?

    So the further we are into the “Tail End” of a note the more effect this re-investment has on our portfolio as a larger percentage of the payment is being applied to the principal. So actual Yield return would be less dependent on the early years of Note investment when compared to the tail?

    This really puts things in perspective when thinking about this as 120 Mini-payments. If there is no re-investment the money is not working for us rather just lying around collecting dust. It shows me I have a lot of vacuuming to do!

    • I think you are just about there Mark, you are just making the example harder than it needs to be.

      1. We are really only looking at an immediate payment of 120 months. So it doesn’t really matter where in the note we are (as long as we get the NEXT 120 payments).

      Let’s just say the original note was…

      N ……………………. i/yr ……… Balance …….. Pmt ……. FV.

      120 Payments …… 9% …… $39,470.85 …… $500 …… 0

      We buy it for $34,850.26…….

      N …… …………………. i/yr …… Invested …… Pmt …… FV

      120 Payments …… 12% …… -$39,850.26 …… $500 …… 0

      *Sorry, these numbers don’t align with the words above, just take them in order.

      Now, as those 120 mini-investments (payments) come in, we are paid our 12%. The clock stops ticking. The deeper we get into the payment stream, the less money is earning interest (those payments still due us) versus the money earning nothing (already paid back to us).

      Does that help?

  5. Fred… Being a newbie I would appreciate just a little more understanding of your example. I believe you are referring to the yearly increase in the cost of living (i.e. inflation) ? If you could expand the explanation a bit it would appreciated.

    • Hello Mark, great to hear from you.

      In this example I was pretty much referring to the note itself and the return (or lack there of if you don’t reinvest). If you don’t reinvest the money, people oftentimes don’t get the return they thought they were getting over the long term. In the example above, it is kind of like 120 individual buys (at 12%). When I receive the first months payment, the clock (and return) stop ticking (on that payment only). In other words, it doesn’t keep earning 12% as that payment has been paid in full.

      If I don’t reinvest the money coming in, my return is less and less. Course hopefully (in this case) 5.45% beats inflation.

      Hope that helps.

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