Real Estate Notes vs Rental Properties

Real estate is probably the best all round investment you can make, but there are many ways in which you can participate depending on your investment objectives, attitude to risk, and the amount of time, effort, and resources you are prepared to commit. In this article we at the pros and cons of real estate note investing vs owning rental properties.

Related: Find Performing Notes for Sale in the Garnaco Private Lending Program

Contents

Related: Note Investing 101 – Everything You Need to Know About Note Investing

What is a Real Estate Note?

A real estate note is effectively a contract between a lender and a borrower. There are two parts to every note investment: the note itself, and a lien. The note is a contract defining the terms of the debt such as the amount of the loan, interest rate and repayment schedule. The lien is a deed – usually a trust deed or mortgage deed – that is recorded in the County records on the title to a piece of real estate in the name of the lender. This lien acts as security for the lender’s investment.

Real Estate Notes Generate Passive Income

Notes can be performing or non-performing. A note is performing when the borrower is current on their payments. A note become non-performing if the borrower has stopped paying, usually for at least 90 days, although sometimes less.

Mortgage notes can be bought and sold freely on a secondary market. Investors buy performing notes for the income they produce. Non-performing notes can be bought at a significant discount to face value, and investors buy these to create both capital gains and income by ‘rehabbing’ the note, or to foreclosure and own the underlying real estate.

Related: What is a Promissory Note and What Terms Should It Contain?

Top 3 Pros for Note Investing

There are lots of reasons investors choose to invest in mortgage notes. I have seen more than one seasoned real estate investor sell off their rental properties and start investing in notes instead. This is mostly because owning rental properties is a lot of work, and note investing is usually less hassle. Here are the top 3 benefits of real estate notes.

  1. Passive Income – The main reason investors choose notes over ownership of physical property is the fact that the income is way more passive. Landlords have to find and manage tenants, oversee maintenance and repairs, and deal with property taxes and insurance, while note investors simply collect their interest check each month.
  1. Liquidity – Mortgage notes are far more liquid than physical real estate. They can be bought and sold on the same day with a minimum of fuss and paperwork. Real estate on the other hand is heavily regulated and can take a great deal of time and effort to sell.
  1. Returns – While performing notes and private lending generate reliable interest income in the region of 8% to 12%, non-performing note investments can be a financial home run when the stars align. Because non-performing notes can be purchased

Top 3 Cons for Note Investing

No investment is without risk, and real estate notes are no exception. From difficult due diligence to problem borrowers, there are just as many ways to lose money as make it. Here are the top 3 disadvantages to note investing.

  1. Foreclosure – The ultimate remedy for any lender when a borrower falls into default is to foreclose the loan and force a sale of – or take over – the real estate. This can take a great deal of time and can also be very expensive. Costs and timelines vary from State to State, and in some cases, it can take literally years.
  1. Due Diligence – Often there is not a whole lot of information available about the borrower or the real estate when a mortgage note comes up for sale, so conducting proper due diligence and deciding on a reasonable price to pay can be difficult. Sometimes decisions must be made quickly, without the opportunity to properly inspect the condition of the property and assess its true current value.
  1. Borrower Default – The income from real estate notes is contingent on the financial capability and willing of the borrower, and this can change at any time. People lose their jobs, or divorce, or have some other life event that prevents them from paying their mortgage. If the borrower stops paying, the note becomes non-performing and instantly loses a considerable amount of value.

So, that covers the top 3 pros and cons of real estate notes. Now let us look at owning rental property as a comparison.

What is a Rental Property?

Owning rental property is the go-to investment strategy for most people first considering real estate investing. You can own many different types of property as rentals, including residential, commercial, industrial and land. Owning rental properties simply involves buying a piece real estate and leasing it to a tenant.

Pros of Rental Properties

Rentals generate cash flow, value appreciation, amortization gains and some significant tax benefits. Here are my top three Pros for owning rental properties. 

  1. Leverage & Amortization – One of the biggest advantages of real estate is the use of leverage. You can control a large, appreciating and income-producing asset with a relatively small deposit by utilizing a mortgage loan. This significantly amplifies your cash-on-cash returns and also means you benefit from amortization. This is when the rental income or business income for a piece of real estate pays off the mortgage over time. So, the tenant or business effectively paying off the debt for the RE investor.
  1. Cashflow – Cash flow is one of the biggest reasons for investors to own real estate. The most powerful force in investing compound interest, so rental income – or business income generated by the property – is a great way to build up a regular and frequent supply of new cash to reinvest in other (or the same) assets for even more growth and income.
  1. Capital Appreciation – As well as producing income, well located and well managed properties tend to appreciate. This happens as real estate prices inflate over time, but you can also add your own value by improving or expanding the property through renovation work. The opportunity to add value like this is a huge advantage to real estate investing over other assets like stocks.

There are of course many other benefits of rental property investing, but now let us take a look at some of the potential downside.

Cons of Rental Properties

While owning rental properties can be very rewarding, it takes a lot of time, effort, and sometimes money to make it work. Here are my top 3 downsides to investing in rental properties.

  1. Expenses – Rental income covers the cost of ownership and provides cash flow profits for rental property investors. But landlords must continue to pay the bills regardless of whether rent is received or not. These ongoing out of pocket costs include mortgage payments, property taxes, security, insurance, marketing for new tenants, and eviction costs.
  1. Repairs – Real estate requires constant maintenance. While many of the necessary repairs can be small and manageable, there are other large capex items that could wipe out all of your cashflow for years if they need replacing. Things like a roof, furnace or HVAC can be very expensive indeed, and as a landlord you are obligated to fix them immediately. This can also take up a lot of time as well as money. Despite what you might hear, rental properties do NOT generate passive income – it is very much active!
  1. Tenants – Much as borrowers can be a problem for note investors, tenants can be equally problematic for rental property investors. Late or non-existent rent, damage, and other issues can cause real problems for landlords.

So, having looked at the pros and cons for both noting investing and rental properties, which is the better investment? Let’s find out.

Which is the Best Investment?

It’s not exactly comparing apples with apples, but there are plenty of similarities between real estate notes and rental properties. Both generate income and carry the potential for capital appreciation, and both carry similar risks.

As I mentioned right at the very beginning of this article, how you choose to invest in real estate will depend largely on your own personal investment objectives, attitude to risk, and the amount of time, effort, and resources you are prepared to commit.

Note Investing vs Rental Properties Investment

If you are looking to real estate to provide truly passive income and you have no desire to deal with property-related issues, then performing notes with good quality borrowers and collateral are the way to go. For a more hands-on approach with a bigger potential upside, non-performing notes might be the answer.

If you have a long-term plan to create generational real estate wealth, then there is no better choice than rental properties. Long-term capital appreciation, and amortization gains will eventually see you owning your rentals free and clear of debt, enjoying 100% of the income, or selling them to cash in your gains for retirement.

Whatever you choose to do, real estate is still a fantastic asset class for most investors.

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