Mortgage notes can be an important and valuable part of a well-diversified investment portfolio. In this article we’re going to take a deep-dive into the need-to-know basics, and look at some of the note investing strategies that I have seen succeed and fail for me and other investors in this space.
What is Note Investing?
Investors buy mortgage notes – also known as real estate notes – or make private money loans, primarily for the monthly income they produce. Notes are secured against a physical piece of property which means there is recourse for lender if something goes wrong. They are a great tool to diversify and grow a self-directed IRA or 401(k), or to generate a better rate of monthly income from accumulated wealth.
Investors buy notes from institutions, note brokers, from other note investors, by investing in note investment funds, or by making private money loans direct to borrowers.
Notes are also far more liquid than physical real estate. They can be bought and sold freely on the secondary market, and you do not need to be an accredited investor with $100,000 to find good deals. This means note investing is accessible to all investors.
Perhaps the most attractive thing about notes and private lending is the fact that a good note investment can generate a better rate of return than the cap. rate of the average rental property, but without any of the hassles of ownership. After all, lenders simply collect interest payments. They do not have to manage properties and tenants, or pay property taxes!
My Experience Investing in Mortgage Notes
My first introduction to note investing came in 2010 during the fallout of the global financial crisis. My team was involved in the purchase of around 100 non-performing mortgage notes from a US bank. there were a lot of such opportunities around at the time.
We were able to modify the terms of most of the loans with the existing borrower and resell them as performing notes. The rest were foreclosed and the real estate sold. This was also my introduction to using owner-financing to sell homes and planted the seed for the Path to Home Ownership Program we run today.
Our investment in 2010 was a LOT of work, but it was definitely one of the most profitable investments I have been involved in – before or since!
Today, I use notes to JV with investors that want passive income every time I buy a property (I have about 70 rentals right now). When I find a good piece of cashflow real estate that I want to own, my team puts the deal together (Realtor, building inspector, contractor, appraiser), and my private lender investor loans me the money to buy and rehab to house. It’s a great deal for me because I get to close on the best deals quickly, and I avoid up to $5,000 in hard money fees (which easily kills the entire deal when you are talking about sub-$100k real estate). It’s also a great deal for my investors/lenders, because they get passive monthly income from day one whilst I do all the work.
Our little model tends to work out pretty well – and we’ve completed close to 100 transactions so far with zero defaults!
There is a lot to understand in the note world, and this guide is not supposed to make you an expert. Heck, I’m not an expert, I’m learning things virtually every day. That’s’ the way it should be in my opinion. But I work with notes and private lenders every day, and hopefully you’ll find this information a good starting point, and even if you know a bit about notes already, you might learn something new.
What is a Mortgage Note?
When is a mortgage note not just a note? All the time, actually. There are effectively two parts to a mortgage note; a promissory note and a mortgage deed or deed or trust (the lien).
The note itself is a contract between the borrower and the lender stating the amount of debt and the rate of interest. The note also contain the terms of the investment such as the amortization schedule, term, and what happens if the borrower defaults.
The deed imposes a lien on the title to real property as security for a loan. If the borrower defaults on the terms of the note, then the lender can foreclose the loan and force a sale of the property to recoup (hopefully all) their money.
That said, you can still suffer a total loss of your investment on a mortgage note (even with a lien in place), and I’ll tell you about some of the circumstances in which I’ve seen that happen later in this article.
Related Content: What Exactly is a Mortgage Note? – Investors Edition
Notes vs Real Estate Investing
Being the bank in the real estate investment cycle takes far less effort than being a property owner. That’s probably w a lot of real estate investors make the shift from rentals to notes over the years. One great example of this is Dave Van Horn – he literally wrote the book on note investing. In most cases investors switch from rentals to notes because owning real estate is hard work. Make no mistake, whilst real estate can be very rewarding on many levels, it takes time, effort, patience and resources to do it right!
One of the things I learned very early on as a real estate investor is the importance of scale. If you’re going to invest in rental properties, then you need a lot of them (in my experience and opinion). Most people that I have seen own one or two houses have ended up selling them because they take up too much time, effort and money. In a lot of these cases these investors didn’t make much money either. Today, I get calls on a weekly basis from people that bought a bunch of turnkey rentals and just want out. Distressed investors are a great source of cheap properties for me!
In my experience, you need at least 20 units to ensure you have enough rental cashflow to accommodate the big, unexpected costs that invariably crop up against individual properties.
I personally own properties that looked like great cashflow deals when I bought them, but they have not cashflowed at all. Mostly because of things like replacing big capex items like a new roof or kitchen. But also things like replacing broken HVAC or furnaces. Tenants trashing the place is also an issue. Even trees falling on houses, and theft of large items like furnaces or non-payment of rent. There are plenty of ways to wipe out a year’s cashflow profits for your whole portfolio if you don’t own enough units to absorb and rectify the losses.
Note holders on the other hand are effectively acting as the bank. They get paid every month regardless of whether any rent comes in, or if the property is being repaired, or there are property taxes to pay. If the interest check doesn’t come in, they have remedy in the value of the asset. Being the bank is far less hassle than being an owner, trust me! Every one of the lenders on my non-cashflowing properties got paid, in full, on time, every time!
For me, real estate is my full-time job. I have the time and resources to do things right. I have an exceptional team working with me, and I enjoy it. I have contractors on 24/7 call. I have admin support, I have in-house property managers looking after rents and tenants, and I’ve partnered with some of the very best realtors that i have known for nearly 10 years.
This is why my investors choose to JV with me rather than go out and look for their own deals and do all of the work themselves. Sure, it can be done, but i have a well-oiled machine already in place to execute competently on the best deals.
What are Notes Used For?
Aside from the obvious buying and selling of property, there are a ton of uses for mortgage notes. If you own real estate and you need to access capital for whatever reason, you can use a mortgage note to acquire it (if you can find a willing lender). Here are some of the main uses of mortgage notes in real estate:
Traditional mortgage loan (house purchase)
Hard money loans
Private money loans
Home improvement/equity release
Joint ventures investments
Capital for business ventures
Seller financing (House sale)
One interesting way I use notes is to create an exit strategy for my investments. I can sell a house to a tenant on a rent-to-own basis. This allows them to buy with a low deposit and circumvent high street banks. I can then sell the mortgage note I’m carrying to cash out, I can borrow against it, or I can help the tenant to complete their purchase with a high street mortgage through my network of specialist brokers.
If you know where to look, you can buy all these types of note investing opportunities, or you can make new loans direct to a borrower. I’ll cover some of the places you can buy mortgage notes later in this article.
Related Content: What Are Notes Used For? Investors Edition
What Every Note Investor Needs to Know
If you’re going to buy a real estate note as an investment, the first thing you should do is figure out what you want to achieve. Do you want passive income with low risk? or big potential returns whilst accepting a higher level of risk? If you know what you’re looking for then you can search specifically for notes that fit your criteria.
If i’m looking to buy a note, the first 3 things I ascertain are; Is the mortgage note performing? Is the lien 1st or 2nd position? and is the loan amortized?
If you are looking for passive income with the lowest risk, you want performing notes with 1st position liens. If you want the potential to create big returns, then you want heavily discounted non-performing notes that you can either modify and keep/resell or foreclose.
Of course, there is a lot more to it than that, but this is a good place to start.
Performing vs Non-Performing Notes
A mortgage note is ‘performing’ when the borrower is current on payments. So, performing notes are already generating income when you buy them, which makes them an ideal investment asset for someone who is investing for income, and who does not want to commit much time, effort and resources to the investment. Many investors hold performing notes in their self-directed IRA or 401(k).
A non-performing note is one that is in – or close to – default. A note typically becomes non-performing when payments on the loan are overdue by 90 days or more. Non-performing loans are generally considered bad debt because the chances of them getting paid back under the current terms are minimal.
Investors usually buy non-performing notes form other lenders at a deep discount to face value. A lender might sell a non-performing note to another investor at a discount in order to cash out quickly and avoid lengthy foreclosure proceedings.
Once a non-performing mortgage note is acquired, the new lender will either attempt to modify the terms of the mortgage note with the borrower to get them paying again at some level, or simply foreclose the loan and rent or sell the real estate. This strategy can be extremely profitable, but takes time, effort and resources. Dealing with defaulted borrowers is no picnic, and you should definitely manage your own expectations in terms of timelines and success rate.
Related Content: Performing vs Non-Performing Notes – My Experience and Advice
The position of the lien securing your mortgage note becomes most relevant at the point of default and/or subsequent foreclosure. There are 1st position and 2nd position liens.
In the case of a foreclosure, the 1st position lien takes priority over all other liens against the property and is paid off first when the asset is sold. The 2nd position lien is a junior loan and is repaid only after the 1st position loan has been repaid in full.
As a very rough example, if a house is sold for $100,000 (net of costs, fees and taxes), and has a 1st position lien for $80,000 and a 2nd position lien for $35,000. The 1st position lender gets back 100% of their money. The 2nd position lender gets back $20,000 of their $35,000 loan.
2nd Position liens carry far more risk of loss than 1st position liens in most cases. Again, this is why 2nd’s can often be bought for cheap, and if successful in modifying or foreclosing, can also be very profitable.
Related Content: Understanding Lien Position and Priority for Note Investors and Private Lenders
Amortization refers to how the repayment of both loan principal and interest is scheduled over time. There are mostly 2 types of loan; amortized and interest only.
When a loan is amortized, each monthly payment pays off some interest and repays some of the principal loan amount. Every amortized loan comes with an amortization schedule detailing how each monthly payment is apportioned. There are plenty of free amortization calculators online given a quick Google search.
It is important to understand that interest on an amortized loan is usually recalculated every month based on the most recent ending balance. So, as each monthly payment reduces the principal balance, less overall interest becomes due. Crucially, this means that the return on investment on an amortized loan will be LESS than the interest rate, unless the loan is purchased with a significant discount to face value.
For example, a $100,000 mortgage note with an interest rate of 6 per cent (6%) which is fully amortized over 15 years, will pay back a total of $151,894 (180 payments of $843.86). This is a total interest income of $51,891, or $3,459.60 per year. That works out to a simple annualized return on investment of 3.46%.
Some loans can be amortized over a long period with a balloon payment set earlier on. For example, a loan might be amortized over 30 years to keep the monthly payments as low as possible, but with a balloon payment for all outstanding principal at 10 years.
Using the same example of a $100,000 note with 6% interest rate, amortized over 15 years, but with a balloon payment at 10 years, the total repaid to the lender over ten years would be $144,183. That’s 120 monthly payments of $843.86, plus one final balloon payments of $43,023). This gives the lender a profit of $44,183 over ten years, or a simple annualized return of 4.42%.
So you see, that balloon payment really makes a difference to the lender. It’s a shorter term investment with a better rate of return.
Interest Only Notes
Where a loan is not amortized, 100% of every monthly payment consists of interest. The principal balance is NOT reduced. Typically, a balloon payment for the full amount of the principal becomes due when the loan term is up.
For example, a $100,000 interest only loan with an interest rate of 6% will pay $6,000 per year in interest, plus repayment of the $100,000 principal at maturity. This is a fairly obvious simple annualized return on investment of 6%.
Getting Into the Thick of It – Assessing Note Investing Risks
Once you figure out which type of note might suit your circumstances (performing or non-performing, 1st position or 2nd etc.), you can then start to look a little deeper into the specific terms. All of the things I am about to cover matter, and contribute to the overall risk associated with an individual mortgage note. Once you have a basic understanding of these factors you will be in a much better position to make informed investing decisions that meet your own criteria.
LTV and ITV (Loan to Value and Investment to Value)
LTV and ITV are both key considerations for investors when looking at a mortgage note. The LTV (loan to value) shows the face value of the loan as a percentage of the collateral property value. A lower LTV indicates a lower risk of capital loss for the lender. ITV is the ‘investment to value’ ratio. This is the purchase price of the mortgage note as a percentage of the collateral property value. The LTV and ITV will be different if you are buying the note at a discount.
In order to figure these key metrics out, you need to know what the underlying real estate is actually worth. So, you need a recent, independent appraisal of the property’s value. Whether it’s a full appraisal, an alternative appraisal product, or a BPO, make sure someone has visited the property and seen it with their own eyes. Please don’t make the mistake of relying on online listing portals like Zillow and Trulia. 9 times out of 10 they are highly inaccurate. I’ve made this mistake before, and it’s proven very costly indeed.
If you are able to ascertain that a property is worth, say $100,000 in current condition, and the mortgage note face value/balance is $75,000, then the LTV is 75%. If you are buying that mortgage note for $50,000, then the ITV is 50%.
An LTV/ITV of 65% or lower is generally considered decent as the lender is likely to be able to recoup all or most of the loan in the case of a foreclosure.
Related Content: Understanding Real Estate Valuations for Note Investors and Private Lenders
What is Seasoning a Note?
Seasoning refers the length of time a borrower has held a loan; i.e. how many payments have been made to date. A well-seasoned loan is generally considered more attractive as there is an established and proven payment history with the borrower. If you are making a new loan to someone, you might look at the payment history of other loans held by the borrower. This is just like rental properties. If you are buying turnkey (which I DO NOT recommend by the way), you want to see that the tenant has been paying their rent on time and in full on a consistent basis.
The term of a real estate note is simply the length of time due to maturity of the loan. Loans can run from as little as 1 month to 30 years. Professional mortgage note investors tend to shy away from notes with a term longer than 15 years due to the general uncertainty associated with such long-term investments.
This is where it starts to get fun! Discounts are the best way to generate a better investment return from your mortgage note. You pay less than the outstanding balance for a discounted mortgage note, but the full balance of the loan remains payable.
A ‘note’ of caution however (pun intended). If a mortgage note is discounted, then there is very likely a good reason for it. Professional or institutional investors will pay face value (or very close to face value) for seasoned, 1st position loans with a good interest rate, strong borrower and good collateral with a low loan-to-value. So, if a note is discounted there will definitely be a reason. That could be the sellers need for quick cash, but it might also be an underlying issue with the borrower or collateral, or both.
A discount can make a big difference to investment returns, but there is often work to be done in order to maximize returns to a discounted note. Common reasons for a discount can include;
- Current lender needs quick cash
- Borrower is in default (a non-performing loan)
- Questionable collateral (the quality of the property may have deteriorated since the loan was made)
- There are lots of other liens (the borrower has gotten themselves into a credit hole)
- Property taxes are due (the property owner may have fallen delinquent on taxes, this could lead to a total loss for the lender)
- Other circumstances that might indicate a higher risk of lending at that time
If you are going to buy a discounted note, make sure to do your research and find out the real reason it is discounted. Often you will find that the bigger the discount, the bigger the problem, although that is not always the case.
What are Points on a Real Estate Note?
Another way a lender can increase their returns on a mortgage note is to add points. Points are very common in the hard money loan industry. A point is an optional upfront fee that the borrower pays to the lender when taking out the loan.
Points are calculated as a percentage of the loan amount, with 1 point being equivalent to 1% (one percent) of the loan. Points should be rolled up into total interest in order to accurately calculate overall return on investment.
If a 3-year interest only mortgage note with an interest rate of 6% pays 3 points to the lender, then the actual annualized return is 7%. These points could be paid upfront at loan origination, or annually at each anniversary of the note.
Borrower Quality (AKA Credit Risk)
The credit worthiness of the borrower and their ability to meet loan repayments is fundamental to assessing the risk – or even viability – of a note investment. In my experience it is much better for the lender to know the borrower on some level.
Where the borrower is an individual, obtaining a credit score is a good start, with a credit score of 550+ being broadly accepted as a starting point of creditworthiness for the purposes of private lending. Where the borrower is a company, you may also want to view a balance sheet. Obtaining 2 – 3 months bank statements for both individual and corporate borrowers is also a good idea. If the borrower is a real estate investor, asking for proof of their experience and prior projects.
I speak at length with all of my JV partners before I sell them a note. They know me, they can ask questions, they can see my credit report, balance sheet and bank statements, and they generally feel comfortable lending as a result. We also have a decent number of rentals, so we provide an occupancy report and rent roll to all of our lenders every quarter.
Real estate notes are secured against physical property, so you will always need a good idea of the value of the real estate. If your are making a loan to an investor that intends to rehab the property, you want to know both current value and ARV (after repair value) in order to properly asses your risk.
For loans made against rental properties, you may want to look at the ability of the property to generate enough income to cover repayments on the loan. This is known as the debt service coverage ratio or DSCR (also debt coverage ratio or DCR). DSCR is calculated as the ratio of cash available (net operating income) to debt servicing for interest, principal and lease payments. The higher this ratio is, the lower the risk associated with the note.
It seems obvious to say, but the more valuable the real estate in relation to the loan amount (in terms of both resale value and ability to generate income), the better!
Whether you buy an existing note, or make a new loan, you will need to start collecting repayments. You can either collect payments direct from the borrower or use a loan servicing company. I have owned notes that are professionally serviced, and also where the borrower pays direct. For our own lenders we use ZimpleMoney to debit our main operating account monthly and pay interest [payments to all of our lenders. This automation saves us a ton of time a admin – especially as we’re servicing quite a lot of notes at any one time.
A note servicing company will collect and record every monthly payment, including the escrow amounts, and disburse the correct amount to the appropriate parties. Additionally, a note servicing company has the resources and time to pursue late payments on a routine basis. If you are intending on investing in a lot of notes, the collection process can become very time consuming and tedious, so a note servicing company might be a good option to consider.
Note servicing takes away a lot of the hassle, but costs money. You will have to weigh up the cost/benefit of that for yourself.
Note Investing Strategies
I’ve alluded to some of the more common note investing strategies already in this article, and for the most part investing in notes is not that far removed – strategy wise – from investing in real estate directly. It’s just that the lender doesn’t have to deal with the tenants, toilets and trash, or pay property taxes!
If you are buying a non-performing note then you are most likely going to set about ‘rehabbing’ it. Just like with a physical property, a note investor will buy a note, try and add some value to it, then keep it for the income it generates or sell it (or sell the real estate). If you are keeping your note for the income, you can still borrow against it to release some capital and buy your next note. Basically, buy, rehab, refinance repeat – just like rental properties!
If you are investing for passive income, then you are more than likely going to buy a performing note and just sit back and collect the monthly payments. You can make a new loan – such as with my joint venture loan notes – or you can buy a performing note from an investor that has already rehabbed it when it was non-performing. Just like you can buy rehabbed, turnkey houses that generate instant cashflow. It’s the same thing with notes – you just don’t have the real estate related issues to deal with.
Two things to bear in mind if you are considering the buy/rehab/sell model with non-performing notes is the amount of expertise and knowledge you need, and the cash burn. Managing non-performing notes requires time, expertise and resources, and it does not always work out how you hope it will. There are a ton of roadblocks that can stymie you attempts to modify a loan, and you may end up just trading out of it after already committing a lot of time, effort and money trying to rehab it. That said, there are huge potential profits to be had.
In my opinion and experience, if you want to go down the non-performing route like I did back in 2010, then you should spend a ton of time learning the game in much more detail than this article allows for. And, just like with rental properties, I believe you need scale. If you buy just one note you can lose your shirt if it goes wrong. If you have a few notes then you can better absorb any losses on one individual investment.
So, remember; For low risk passive income, buy performing 1st position mortgage notes with a decent LTV and ITV (65% or less), a good quality borrower and independently appraised collateral. For more risk, but with the potential for better returns, buy non-performing notes at a discount and attempt to rehab the loan with the borrower, or foreclose and deal with the real estate.
Where to Buy Real Estate Notes?
There are plenty of places to buy mortgage notes, if you know where to look. Here are 5 of the most common places you can find notes for sale:
Buying Notes Direct from the Borrower
If you can find them, one of the best ways (in my opinion) to invest in a mortgage note is by dealing directly with a borrower. You can either buy an existing note or make a new loan. By dealing direct there no mark-ups from brokers and no fees for advice, brokerage or management. More importantly, having direct contact with the borrower will prove extremely useful at both the due diligence stage (valuing the collateral property and assessing the borrower), and especially in the event of a default. Being able to speak directly to the borrower and understand any issues surrounding a default if one occurs is extremely valuable in your decision-making process when it comes to either cutting the borrower some slack or starting the process of foreclosure.
Hard Money Lenders
Hard money lenders provide loans to real estate investors for acquisitions and renovations. They often use a combination of their own capital and investor money to make these loans.
As an investor, you can loan money to the hard money lender who will then use it to make a loan to a real estate investor. The hard money lender will then pay the investor an interest rate, usually making their profits from upfront fees and interest rate arbitrage. Hard money is usually the most expensive funding option for real estate investors, with high rates of interest and large upfront fees. This makes hard money less viable for smaller loans as the fixed upfront fees are often prohibitive.
The benefits for income-seeking investors are clear. The Hard money guy (or gal) is (ideally) experienced and capable and chooses which loans to make. He/she undertakes all of the due diligence and paperwork. Their business depends on them making good decisions for them and their investors.
Buying Notes from Note Brokers
Note brokers are usually note investors in their own right. They buy mortgage notes from various sources including primary lenders such as banks and hedge funds.
Usually they will buy non-performing notes at a big discount to face value due to the volume they acquire, and the fact they can buy quickly with cash. Some brokers will then just mark up the notes and sell them individually to other investors. Most brokers however will rehab any of the notes that they can and resell them to income investors as performing notes.
One of the main benefits of dealing with a broker is the availability and choice of loans they have available for sale.
Note Investment Funds
A note fund is typically a corporate entity operated by a fund manager who invests in mortgages. The fund raises money by selling shares, units or memberships, and that money is used either to buy mortgages on the secondary market, or is lent out as mortgage loans to a range of borrowers. Some funds might use the money to invest in other mortgage funds.
Mortgage funds are a great hands-off way to get into mortgage note investing, but every fund is different; investing in different types of mortgages and borrowers. The fees charged by fund managers also varies significantly, and you are entirely reliant on the performance of the fund n=manager for the security and performance of your money.
Two things to consider with mortgage funds are access and liquidity. Access is often reserved only for accredited investors with large sums to invest, whereas anyone can buy or sell an individual note. Where an individual mortgage note can be sold on the secondary market, shares or units in a mortgage fund often have strict restrictions on sale and liquidity.
Buying Notes on Exchanges
In the United States, mortgage notes are freely traded on the secondary market. As I’ve mentioned, this is one if the major advantages of notes over direct real estate investments for the passive investor. A note can be sold very quickly. There are many online exchanges which have notes available for sale. Taking a look at the notes available on some of these exchanges can be a good way to compare the value between prospective notes purchases.
How to Lose Money Investing in Real Estate Notes
Mortgage notes can be an attractive investment. As hopefully you’ve seen here, you can use them to collect passive income, or put in a bit more time, effort and resources and turn them round for big profits.
When I was involved in the turnaround of that portfolio back in 2010, the non-performing mortgages were bought for 10 cents on the dollar. Those that were rehabbed and resold recouped at least 40 cents on the dollar on the original balance. That’s a 400% return on investment. But, like I said, it was a LOT of work.
Today, my performing JV mortgage notes pay at least 9% p.a. for my investors, so it’s in no way comparable, but offers a nice, low risk, low-maintenance way to collect a great rate of returns direct into a self-directed IRA or 401(k).
But, I have also seen mortgage note investments lose money. A lot of money in fact. Unfortunately this has usually been as a result of mismanagement and/or fraud on the part of borrowers.
In 2016 I saw a major rental property investor that I had personally raised funds for go bust. He hadn’t managed the assets well at all. Most of the homes had fallen vacant, and the asset quality had deteriorated badly due to neglect. He had also left 3 years of property taxes unpaid. Most of his 200 or so private lenders that had bought notes secured against his properties lost everything as the houses were lost to a tax sale. In that case I managed to save a few of them that i had funded, but it has definitely been a case of throwing good money after bad in this case.
Recently I saw a similar thing. A couple of rental investors had let back taxes rack up, and left properties vacant. This one might be even worse though as it turn out they had used fake appraisals and pictures to acquire loans from private investors on houses that were in fact derelict, or in some cases just empty land lots.
So yes, you can lose money investing in mortgage notes, just like you can lose money investing in real estate. My advice is, learn as much as you can about notes from the huge range of resources you can find online, or better yet find a mentor. The decide on whether you want to use notes to generate income or to turn a capital profit, then go hunting for the right note that will fit your criteria.
Passive Income MD