Real Estate Notes 101

With interest rates stuck at historic lows, sensible investors are seeking out alternative sources of income. For many years, real estate notes have been an important part of well-diviersifed investment portfolios of financial institutions, hedge funds, and small private investors alike.

In this article, you are going to learn everything you need to know to leverage the power of real estate notes generate reliable income, manage risk, and drive superior long-term returns.

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Contents

What Are Real Estate Notes?

Notes are all around us, and chances are you already use them every day. All sorts of debt and credit agreements use notes, including car finance, student debt, personal loans… even dollar dills are a form of note.

In short, a note is simply an IOU – an agreement between a borrower and lender. Real Estate notes – also known as promissory notes, mortgage notes, or just notes – are effectively IOUs that use a piece of real estate as collateral for the loan.

A note and a mortgage are two separate parts of one transaction

There are, in fact, two parts to every real estate note: a promissory note and a lien. The note is a contract between borrower and lender and contains the terms of the loan. The lien (usually a mortgage deed or deed of trust) is a separate instrument recorded in the county land records against the title to a piece of real estate. The lien must be settled if the loan is foreclosed.

Related: What is the Difference Between a Note and a Mortgage?

The Promissory Note

Every promissory note is different because the terms are set between the individual parties at the time the loan is written (or, originated). As an absolute bare minimum, a promissory note should contain the following:

  • Amount of the loan
  • Borrowers’ names
  • Property address
  • Interest rate
  • Repayment schedule
  • Late charge penalty amount
  • Term to maturity (number of years)
  • Any balloon payments

The note is held by the lender and returned to the borrower marked ‘paid in full’ when the loan has been repaid. Real estate notes can be bought and sold freely on the open market, so lenders can sell the note to another investor at any time.

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

Performing vs Non-Performing Real Estate Notes

If you are thinking of buying real estate notes as an investment, you definitely need to be aware of the difference between performing and non performing notes.

A real estate note is performing when all payments are current and up to date. Investors buy performing notes for the regular monthly income they produce.

Performing notes generate monthly income

A non-performing note is in default, i.e. the borrower has stopped making payments and is 90 days or more past due. These notes are bad debt, and so they trade at big discounts to face value. Investors buy non-performing notes to make a profit by modifying the loan to get payments moving again, then selling the note for a higher price, or foreclosing the loan and exiting through the real estate.

Related: Performing vs Non-Performing Notes – Which is the Better Investment?

Mortgages and Deeds of Trust

The lien provides security for your real estate note investment, recording the debt against the title to the real estate in the county land records. Usually, the lien will be a mortgage or deed of trust depending on the State the real estate is in. This gives the lender the right to take ownership of the real estate if the borrower defaults on the terms of the accompanying promissory note.

While the specific terminology to be included in a mortgage or deed of trust varies from State to State, every lien should contain at least the following:

  • Borrowers’ name(s)
  • Real Estate address
  • Legal description of the Real Estate
  • Amount of the debt

Once a loan is fully repaid, the lender should record a release (or satisfaction) of mortgage or a reconveyance of deed in the county land records. This releases the lenders charge over the property.

1st Position vs 2nd Position Liens

If you are even thinking about investing in real estate notes, this is important! The position of your lien on the title to the real estate makes a huge difference to the amount of risk you are taking, and the chances of you getting your money back in a worst-case scenario.

Mortgages and deeds of trust are recorded in either first or second position. A first position lien must be settled first if the loan is foreclosed and the property is sold. Second position liens are only settled after the first position has been paid in full. This means that if there are insufficient funds from the proceeds of the foreclosure, investors/lenders with a second position lien might lose some, or all, their money.

The Lien Provides Security for a Real Estate Note Investment

There are also other types of liens that could stand in the way of even a first position lien in a foreclosure. For example, property tax liens almost always take priority over any other liens, as do some mechanics liens and other court ordered judgements.

Because second position mortgages are higher risk for lenders, they often attract higher interest rates, and trade for a discount to face value, when sold on the secondary market.

Related: The Ultimate Investors Guide to Lien Position and Priority

What are Real Estate Notes Used For

Notes are used in real estate for a wide variety of reasons. Banks and credit unions originate notes when they provide a mortgage or 2nd mortgage to a homeowner. Hard money and private lenders originate notes when they lend money to real estate investors. Sometimes, a seller will carry a note when they sell a property – providing seller financing to the buyer.

You can find all these types of notes for sale on the secondary market.

  • Owner Occupier Mortgages
  • Investment Property Loans
  • Seller Financed Notes
  • Hard Money and Private Lending Notes
  • Equity Release Loan Notes

In my business, we use notes originated by private lenders to fund the acquisitions of properties for our affordable housing program. We also sell our homes to families using seller financing, and then sell the notes on to other investors.

Related: Real Estate Notes vs REITs – Which is the Better Investment?

Buying and Selling Real Estate Notes

Real estate notes are a great investment, especially considering how low interest rates are right now. A good performing note pays reliable, consistent monthly income. Performing real estate notes are popular with passive investors, often looking for an alternative home for funds in their retirement account.

For those investors looking for more risk with the chance of bigger profits, non-performing notes can be bought at a big discount, with successful loan modifications often very profitable indeed.

Anyone can buy or sell real estate notes

Anyone can buy, sell, or own real estate notes as they are freely traded between investors on the open market. All types of investors own notes, from big financial institutions such as insurance companies and university endowments, all the way down to small Mom-and-Pop investors looking for a better rate of return on their retirement funds.

When you buy or sell a real estate note, there will be plenty of paperwork. Two of the most important things you will need are an assignment and an endorsement.

Mortgage Assignments

The assignment records the transfer of a mortgage deed or deed of trust in the county land records when a real estate note is sold.

The assignment will contain several key pieces of information, including:

  • Legal description of the real estate
  • Name of the original lender
  • Name of the note buyer
  • The date the deed was assigned to the new owner

While it is not required for a lender to tell the borrower if they sell a note. It is the responsibility of the new lender to inform the borrower that they now own the debt and provide them with details of how to start making payments.

Endorsements

The other important part of a real estate note sale and/or purchase is the endorsement. This legal document records the transfer of the actual promissory note from the seller to the buyer.

The seller will endorse the note, providing formal recognition that the buyer is now the new owner of the note. Just like a check, a note can be endorsed in blank. This makes the note a bearer instrument, so whoever holds the note owns it and can enforce it.

Related: What is the Difference Between a Note and a Mortgage?

Buying Real Estate Notes Direct from Banks

While passive investors tend to buy performing notes, those that are prepared to get their hands dirty tend to purchase non-performing notes. Obviously, one of the best sources for non-performing loans is institutional lenders like banks and credit unions.

Banks will sell off their non performing real estate notes in 2021

In many cases, it makes sense for a lender to sell a defaulted loan at a discount to get it off their books and get some cash in, rather than commit to a costly and lengthy foreclosure process.

The thing is, the note investing business is a people business. It takes time, effort, and resources to build good relationships with the right people at banks who might consider you as a buyer for their non-performing notes.

There are some useful online tools that can help you to identify the right cont6acts at banks with notes to sell. One such service is Bankprospector. This online tool identifies banks and credit unions that are selling notes and real estate by providing you with direct contact details for the seller’s decision maker. Of course, once you have contact details, the rest is up to you!

Online tools like BankProspector can help you to identify lenders selling real estate notes

When buying mortgage notes from banks, you may have limited information available to conduct your due diligence and make an offer when a tape of notes comes available, so you also must spend time in advance,  learning as much as you can to make the best decisions possible in these circumstances.

Finally, you must understand that the note buying universe is quite small, and word travels fast. Your reputation is everything, so if you bid on a tape of notes being offered by a bank, make sure you follow through. Rarely will you ever get a second chance.

Buying Real Estate Notes Online

If you do not have the time, energy, or resources to go about building your own network of banks and other lenders from whom to buy notes, there are other options. In fact, there are plenty of places you can buy real estate notes online. These include:

  • Online Exchanges
  • Note Brokers and Hedge Funds
  • Crowdfunding Websites
  • Hard Money Lenders

Experienced note investors who buy from banks often list their reperforming notes for sale on an online exchange like Paperstac as an exit strategy. These can be a good source of recently modified reperforming notes.

Investors can buy and sell real estate notes on online exchanges

There are also lots of note brokers and hedge funds offering notes for sale online. You should be wary of note brokers, particularly those offering non-performing notes for sale. Often, these big investors will buy large volumes of notes from banks, keep the best ones, and then sell off the trash to the public. You can see my complete list of places to buy real estate notes here.

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 What Happens if a Borrower Defaults on a Real Estate Note?

The terms of the particular real estate note and mortgage deed or deed of trust will determine exactly what happens if a borrower defaults on the terms of the note. Usually, there will be some sort of financial penalty, and a period in which the borrower can make up the missed payment.

While every note is different, typically a note falls into default proper after 90 days of missed payments, at which point the lender will start the process of enforcing the terms of the note and mortgage. This will likely mean starting the foreclosure process.

A borrower falls into default on a mortgage when they are 90 days or more behind on payments

A foreclosure is the legal process in which real estate secured by the mortgage is sold to satisfy the underlying debt. Lender’s often have other remedies to avoid costly foreclosure, such as taking the deed in lieu of foreclosure, selling the property in a shirt sale, or allowing the owner to sell the property ‘subject to’ the existing loan.

Related: The Ultimate Guide to Assessing Private Credit Risk

So there you have it. I hope you found this article useful, or readable at least. If you would like to learn more about my private lending program for investors, just click here to watch the video and see live deals.

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