Performing Notes – What Why and How
With interest rates stuck at historic for the foreseeable future, investors are seeking out alternatives to stocks, bonds, and cash that can generate reliable income at a better rate. In this article we look at one option delivering north of 8% p.a. in 2021: performing real estate notes.
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Related: Note Investing 101 – Everything you Need to Know About Note Investing
Real Estate Notes 101?
Notes have all sorts of purposes in the real estate World. This includes primary residence purchases, 2nd home purchases, investment property purchases, equity release loans, hard and private money loans, and owner financing deals.
Banks, credit unions, hard and private money lenders, real estate investors and other lenders all originate mortgage notes, and these can all be purchased by investors on the secondary market. Before we dive in to performing notes as a standalone asset class, it is certainly worth taking 2 minutes to understand the fundamentals of real estate notes in general.
The Note and the Lien
For a start, there are two parts to every real estate note investment: a note and a lien. The note (promissory note) is an IOU – a contract between a lender and a borrower. The note contains the terms of the loan including, amount, interest rate, and repayment schedule among other things.
Related: What is a Promissory Note and What Terms Should It Contain?
The lien is a deed that records the debt against the title to a piece of real estate in the County records. This will usually be a trust deed or mortgage deed (depending on the State). The deed acts as security for the lender and allows them to take control of the property if the loan is foreclosed.
Mortgage liens and trust deeds are recorded in either 1st or second position. 1st position liens are paid out first if the loan is foreclosed and the property sold, 2nd position liens are paid out last IF there are any funds left. This is why notes with 2nd position liens are higher risk, and therefore attract a higher rate of interest. It is also important to remember that there are also other types of lien that can get in the way of even a 1st position mortgage in a foreclosure.
Related: The Complete Guide to Lien Position and Priority
What are Performing Notes?
Notes are considered ‘performing’ when the borrower is current on all payments. Performing notes with a good borrower and good collateral command the highest price from investors wishing to own them, often trading for face value of just below. Conversely, non-performing notes – where the borrower has fallen into default by 90 days or more – are traded at significant discounts.
Performing notes are typically bought by investors seeking reliable, consistent income. This includes financial institutions and investors like insurance companies and hedge funds, as well as private investors who buy them to add a reliable stream of income to their retirement accounts.
Related: Performing vs Non-Performing Notes – Which is the Better Investment?
Why Performing Notes in 2021?
The economic landscape in 2021 is defined by the same monetary policy that we have been used to since the global financial crisis back in 2008. A big part of this is low interest rates. While low rates are great for borrowers, they suck for savers and investors. Cash deposits with most financial institutions are losing money today in real terms.
With that in mind, investors of all shapes and sizes are looking further afield for their investment income. Remember, the most powerful force in investing compound interest – reinvesting income for even more income – and with rates on traditional interest-bearing investments so low, performing real estate notes are a perfect fit.
Cashflow and Security
Investors also love mortgage notes because they pay a high rate of income and they are backed by real estate. There is something real and tangible that can be sold to recoup your investment in a worst-case scenario. In the current climate of general uncertainty, investors tend to navigate to more secure assets such as real estate.
Another reason performing notes make a great investment choice in 2021 is the fact that traditional mortgage lending criteria is getting tighter. This means it is harder for the average American to get a home loan, and many will look for more creative financing solutions. This will create some great opportunities to buy owner financed notes and private lender originated notes with a great rate of interest
Related: Note Investing vs Rental Properties – Which is the Best Investment?
Profits from Performing Notes
As I have already mentioned, interest rates suck right now – at least for investors – and it does not look like changing any time soon. So, any asset delivering north of 1% makes for pretty good news right now. Fortunately, performing notes can give you much, much more.
The rate of return from performing notes varies wildly from one loan to another, and it isn’t all about interest rates. The amount of discount you get when buying a note will have just as big an impact on your overall investment returns. Your return on investment from a performing note will also vary based on whether the note is interest only or amortized.
As a rule of thumb, note investors tend to shoot for an average annualized return of about 10%. That will include some really great home runs, and some notes that did not work out at all. If you are going to originate your own note as private lender, interest rates are usually somewhere between 8% and 12% and the loan will typically be interest only with a balloon payment.
How to Buy Performing Notes
By now you understand what a performing note actually is, and you have an idea of the kind of returns you can expect, all you have to do now is figure out how to go about finding performing notes for sale.
There are effectively three sources to find performing notes:
Note Brokers and Investors
These are larger or more experienced investors that buy tapes on non-performing loans from financial institutions and work with the borrowers to get them to ‘re-perform’. They then sell these performing notes on to investors who are looking for income.
Seller Financed Notes
A seller financed note (or owner financed note) is originated by someone selling a house. This happens a lot when a buyer cannot get a traditional mortgage right away. The buyer will pay a deposit to the seller, and the seller will carry a note for the balance. The seller often then sells the note to recoup their capital.
This is where an investor will take the position of the bank, loaning money to an investor to buy a property. I buy all the properties for our affordable housing programs with loans from private lenders who tend to use their self-directed IRA or 401(k) to fund their investment. You can learn more about our private lending program here.
So, there you have it, the what, why and how of performing mortgage notes. I hope you have found this article useful. If you want to see exclusive details of performing notes for sale, you can subscribe to our Priority Investor weekly email here
Related: Find Performing Notes for Sale in 2021
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