Note investing is a profitable practice that involves purchasing real estate notes to generate profits. These notes can provide income through interest payments or profits from the sale of the real estate or the note itself. While there is more to note investing than meets the eye, this guide aims to provide you with the essential insights to get started on your note investing journey.
What is Note Investing?
Note investing entails purchasing real estate notes for the purpose of generating profits. Investors buy notes for three main reasons:
- Monthly Income: Notes produce regular monthly income.
- Physical Real Estate Security: Notes are secured against physical real estate, offering a level of security.
- Purchasing at a Discount: Notes can be purchased at a discount to the unpaid balance, increasing potential profits.
Private investors often hold notes in self-directed IRAs or 401(k)s to boost and diversify retirement income or improve overall returns. With interest rates at historic lows, investors are seeking alternative investments capable of replacing lost income, and mortgage notes fit the bill nicely.
Ways to Invest in Real Estate Notes
There are several ways to invest in real estate notes. You can buy them from banks, brokers, or other note investors. Some private note investment funds are also available. Investors can even originate their own notes by providing private money loans directly to borrowers or originating seller finance notes.
Liquidity and Profits
One significant benefit of mortgage notes over other types of real estate investing is their relative liquidity. Notes can be bought and sold freely on the secondary market, making note investing accessible to all investors. Additionally, investing in real estate notes offers the potential for great returns without the hassle of property ownership. Lenders collect interest payments without managing properties, dealing with tenants, or paying property taxes.
Each note is different, so your note investing strategy will vary from one note to another. You can buy income-producing notes, defaulted notes (known as non-performing notes), notes with senior position liens, junior loans, and combinations thereof. Your actions after acquiring a note will depend on variables specific to each note.
My Experience With Real Estate Note Investing
My introduction to note investing came in 2010 during the fallout from the global financial crisis. My team acquired around $10 million of non-performing notes from a distressed bank for just $1 million. We worked to rehabilitate most of the notes with existing borrowers and resold them at a significant profit. This experience led to the creation of the Pathway to Home Ownership Program, which helps families avoid foreclosure and achieve home ownership.
Today, I fund all my real estate investments with notes. I own approximately 70 long-term rental properties and rent-to-own houses through our Pathway to Home Ownership affordable housing program. When I find a house I want to own, one of my private lenders loans me the money for the purchase. My investor acts as the bank, holding a note with monthly interest payments. This model has allowed us to scale our business and earn passive monthly income for our investors.
What Exactly is a Note?
A mortgage note is comprised of two separate entities to consider: the promissory note and the lien.
The Promissory Note
The promissory note is a contract between the borrower and the lender. This document states the amount of debt, interest rate, loan term, and other terms of the investment. Each promissory note is unique to each deal, with terms set by the lender.
The Lien
The lien provides security for the note investment. It can be a mortgage deed or a deed of trust, depending on the property's location. Liens are recorded against the property's title at the County records office. In the event of default, lenders can use specified remedies to recoup their investment, such as accelerating the loan or initiating foreclosure proceedings.
Liens can be recorded in the 1st or 2nd position. 1st position liens are generally settled first when a property is sold, making them less risky but potentially less profitable. However, it is important to note that other liens, such as tax liens or judgment liens, can take priority and affect the total loss of an investment.
Real Estate Notes vs Rental Properties
Being the bank through note investing requires less effort compared to owning and managing rental properties. Many long-term real estate investors transition from ownership to note investing due to the time, effort, and resources required for property ownership.
While rental properties can be rewarding, they come with challenges such as maintenance, tenant management, and unexpected costs. Owning a substantial number of rental properties is necessary to diversify rental cash flow and absorb individual losses and vacancies.
Note investors, on the other hand, receive consistent interest payments without dealing with day-to-day property management issues. They benefit from passive monthly income while avoiding the responsibilities and risks associated with rental properties.
What are Notes Used For?
Mortgage notes have various applications beyond property acquisition. Real estate owners can use mortgage notes to release equity for any purpose, including:
- Traditional mortgage loans (house purchases)
- Hard money loans
- Private money loans
- Home improvement or equity release
- Joint venture investments
- Capital for business ventures
- Seller financing (house sales)
Mortgage notes can be used to fund acquisitions or be sold to cash out investments. Private lenders regularly use mortgage notes to fund real estate acquisitions, generating passive income for themselves.
What Every Note Investor Needs to Know
Before investing in mortgage notes, it is crucial to determine your investment goals. Decide whether you seek passive income with low risk or potentially higher returns with increased risk. Your goals will help shape your note investing criteria.
When purchasing a note, consider the following three factors:
- Is the note performing?
- Is the lien in the 1st or 2nd position?
- Is the loan amortized?
Performing notes with 1st position liens offer passive income with relatively low risk. On the other hand, non-performing notes carry higher risk but can yield significant profits if successfully rehabilitated or foreclosed upon.
Understanding the lien position and priority is vital, as it affects the recovery of funds in the event of default. Amortization, points, and loan servicing are additional factors to consider when underwriting a note investment.
Mortgage Note Investing Strategies
Investing in real estate notes offers several strategies tailored to individual investors' goals:
- Performing Notes for Income: Investing in performing notes provides passive monthly income with relatively low risk.
- Private Lending: Originate your own loans and lend to real estate investors. Private lending offers close relationships, control over terms, and good returns.
- Non-Performing Notes: While complex, investing in non-performing notes can be highly profitable if properly managed. These notes require extensive knowledge, time, effort, and resources.
- Discounted Notes: Notes can be purchased at a discount to their unpaid balance. Discounted notes offer potential profits but carry higher risks.
Investors should align their note investing strategy with their risk tolerance and desired outcomes.
Where to Buy Mortgage Notes?
Several sources offer mortgage notes for sale. These include:
- Banks
- Online exchanges
- Private lending opportunities
- Note brokers and hedge funds
- Note funds
Each source has its advantages and considerations. Buying from banks requires establishing relationships and doing substantial research. Online exchanges provide accessibility but often involve paying retail prices. Working with private lenders and note brokers offers opportunities but requires careful due diligence. Note funds offer a hands-off approach but typically require accredited investor status.
Mortgage Note Investing Risks
While note investing offers great potential, it is not without risks. Credit risk and real estate valuations are two significant factors to consider. Assessing borrower creditworthiness and the value of the collateral are crucial to underwriting note investments.
Investors must also be aware of the risks associated with each type of note. Performing notes carry less risk, while non-performing notes require substantial effort to rehabilitate or foreclose. Proper due diligence is imperative to make informed investment decisions and mitigate risks.
How to Get Started in Note Investing
To start note investing, you need to define your goals and risk tolerance. Continuing education is essential to master the complexities of note investing. Start small and gradually increase your investments as you gain experience.
Be cautious of expensive note investing courses and focus on learning from reputable sources. Note investing is not a get-rich-quick scheme, and success requires patience, knowledge, and ongoing learning.
Remember, note investing is just one aspect of real estate investing. Stay informed about market trends and continually refine your investment strategies to achieve long-term success.