What are the advantages of buying mortgage Notes? Why Invest in Mortgage Notes?
Purchasing mortgage notes can be an excellent investment for someone looking for passive income secured by real estate. As with any investment, you should fully understand what you are buying before you dive in.
Regular Monthly Income
When you buy a note, you become the bank. Buy a performing note, and you can expect payment on time by a credit-worthy borrower. You are getting some of your money out plus a little bit of interest, and it is all secured by that real estate, making it an attractive way to invest in performing notes.
Capital Stack Security
The various levels of financial sources funding a property build the capital stack. Equity is at the top, homeowner association (HOA) and maintenance fees are at the bottom, and first and second mortgages rank in priority between them.
When real estate prices correct and come down, the equity gets cut out first. Mortgage holders maintain their position within the asset, but mortgage note investors are not impacted in this scenario. Note investors will not enjoy potential appreciation benefits, but the note investment remains secure.
EXAMPLE OF CAPITAL STACK LOSS:
Property Investment: $100,000
Money Down: $20,000
Mortgage Balance: $80,000
Property Value After Market Correction: $70,000
The property owner lost $20,000 and is now deeper in debt by $10,000, called a deficiency. The lender has not lost anything but retains foreclosure rights on the property. However, to recoup the deficiency, a lender may wait until the market works in its favor.
Other factors to consider when evaluating whether buying a specific mortgage note is a good investment include:
The Seller – Sadly, there has been a scourge of hucksters and fly-by-nights who have sold a variety of bad assets with false promises. Make sure you are dealing with a trustworthy seller.
The Property – Since the property is the collateral for the note you are buying, you must have a reasonable understanding of the property’s value and the prospects of future value.
The Borrower – Although as a note investor, you have remedies for non-paying borrowers if your investment is concentrated in a single asset, you need to have reasonable assurance that the borrower is unlikely to damage or destroy your collateral.
The Market – Since the market, including the foreclosure laws and timelines for the municipality, may impact the value of the collateral or the costs to recoup your investment in the event of non-payment, you should be comfortable with and understand the market where your collateral sits.
With properly aligned goals, education, and expectations, buying mortgage notes can be a great investment.
How Do Mortgage Notes Make Money?
Making money on a real estate note investment depends on the type of notes you buy and the acquisition strategy.
HOW DO PERFORMING NOTES MAKE MONEY?
If you buy a performing real estate note, you receive payments according to the payment schedule, term, and interest rate. You accept those payments while enjoying the security of having your payments backed by the real estate.
HOW DO NON-PERFORMING NOTES MAKE MONEY?
There are other ways to make money with real estate notes. Note investors buying non-performing notes employ a variety of advanced strategies, including:
Loan to Own – Some investors will buy a non-performing note to exercise the power to foreclose and take possession of the real estate.
Loan Modifications – Private investors often have more flexibility than institutional lenders in the options they can offer delinquent borrowers. Some investors buy a non-performing note at a discount to provide more favorable repayment terms to the borrower. The note is then re-established as performing, and the investor enjoys regular payments.
Selling Partials – The note investor sells payment portions to a third party for a margin above what was originally paid.
Selling Re-Performers – The note investor buys the non-performing note at a discount off the unpaid principal balance (UPB). Next, the investor works with the borrower to get the loan re-performing, and finally, the investor sells the now re-performing note to another investor at a markup.
Flipping or Brokering Notes – The highest value task in the note investing business is finding the note. You can profit from flipping notes, even if you don’t have money of your own, by finding real estate notes for investors who have the capital.
Foreclosure – It is true. I had a client who bought a commercial property note for a pretty steep discount. Since the original lender, a community bank, had already begun the foreclosure proceedings, my investor client assumed the role of the foreclosing lender and hired us to market the asset for a foreclosure sale. The result was a profit of well over $300,000 in a matter of weeks, having sold the property at the foreclosure sale to a third party. My client never got in the chain of title and only owned the paper for about six weeks from start to finish.
I am sure we will hear from seasoned investors about additional ways to make money with real estate notes. If that is you, let us know in the comments below.
What is the Risk of Investing in Mortgage Notes?
Real estate note investing, when done right, should be LESS RISKY than real estate investing. Just as investing in bonds is considered safer than equities or stocks, the same is true for investing in real estate notes vs. investing in real estate.
As a note investor, you are trading the upside potential of appreciation in exchange for limiting the downside risk. This is not to say that there is “no risk.”
The amount of risk in a note investment depends on the loan underwriting, the Loan to Value (LTV), the position (senior, junior) of the debt, the good faith of the borrower to some degree, the locale’s regulatory environment, and the quality of the documents, assignments, and allonges.
There is, of course, always risk in any investment, and as an investor, it is up to you to evaluate the risk for any investment you make.