What is Note Investing
Mortgage note investing is a great way to invest in real estate without having to own physical buildings.
Instead of buying a house or apartment block, you buy the mortgage note attached to it.
Thus, you become the bank, and instead of rental income, you receive interest and principal payments every month. The real estate acts as security for your investment.
Buying and selling mortgage notes for the income they produce (and other reasons) is nothing new.
In the United States, mortgage notes – also commonly referred to as real estate notes – are freely traded on a multi-billion dollar secondary market.
Anyone can buy and sell mortgage notes without restriction. You’ll find small, ‘Mom and Pop’ investors using their 401(k) or self directed IRA, as well as huge institutional investors (think insurance companies and hedge funds) all looking for ap piece of the note pie.
Here’s how it works (broadly speaking)…
In the case of retail mortgage lending, banks, credit unions and other lenders originate loans which are often then immediately sold on in order to recapitalize.
According to the Federal Finance Housing Agency…
Fannie Mae and Freddie Mac buy mortgages from lenders and either hold these mortgages in their portfolios or package the loans into mortgage-backed securities (MBS) that may be sold. Lenders use the cash raised by selling mortgages to the Enterprises to engage in further lending.
Frankly, you’re unlikely to ever buy a note like this.
They are typically sold in bundles worth 10’s or 100’s of millions of dollars to large institutional investors.
There are also many other origination points for real estate notes outside of traditional banks, including seller finance notes, private lending (or hard money) notes, and more. These are the note you’ll most likely find available for purchase as single notes.
Lenders and other investors also often sell loans that are in default. They do this mostly to avoid costly and time consuming foreclosure proceedings.
These are call non-performing notes, and investors buy them at a discount to face value in the hope of turning bigger profits by modifying the terms to get the borrower paying again, or foreclosing the loan and selling or refinancing the real estate.
So that’s the mortgage note investing business in very broad and basic strokes.
But what kind of notes should you buy? and how exactly do you go about investing in notes? Let’s find out…
Related: Note Investing 101 – Everything you Need to Know About Note Investing
What Type of Notes To Buy
Firstly, before we get into how to invest in notes, let’s clear something up…
What is most often referred to as a ‘note’, actually comes in two parts – a note and a lien.
Both constituent parts play a part in setting the likely value of a note and how well it suits your own investing goals.
As a note investor, your primary considerations should be the performance of the note, and the lien position/priority.
Related: What is the Difference Between a Mortgage and a Note?
Mortgage Note Performance
A promissory note is a contract between borrower and lender.
A note is considered to be a performing note when the borrower is up to date on their payments.
It becomes sub-performing when the borrower is late or misses a payment.
While largely subjective within the industry, a note officially becomes non-performing when payments are more than 90 days overdue.
Investors looking for passive income buy performing notes.
The price one might pay for a performing note depends on the quality of the borrower, payment history, the value of the underlying real estate, and the metrics of the loan such as the interest rate and loan-to-value.
Good quality performing mortgage notes typically trade for up to 95% of the face value of the note.
Performing notes with a lower quality borrower, sketchy payment history, questionable real estate, and/or unfavourable loan terms such as a high LTV will often trade for much less than face value.
Ultimately, the price of any particular note is set by the buyer and seller. One mans trash is another man’s treasure as they say!
If you have more time, expertise, and resources at your disposal, you may prefer to dip your toe in the world of non performing notes.
As I have already mentioned, a note is generally considered to be non-performing when the borrower falls 90 days or more behind.
As non-performing notes are ‘bad’ debt, they trade at significant discount to the face value of the note.
Again, the price is set by the buyer and seller, and investors buy these kinds of notes with the aim of creating value through loan modification, or even foreclosure (more on that shortly).
Remember, that non-performing notes might look cheap, but they often require a lot of time and knowledge to make profitable.
So, in summary…
Performing Notes – suitable for investors looking for immediate passive income.
Non-Performing Notes – suitable for investors with more time, expertise and resources to commit.
Pro Tip: Looking for Passive Income? Get Details of Performing Lending Investments Delivered to your Inbox Every Thursday
The lien provides the security for your investment. It records the amount of the loan, and the lender, on the title to a piece of real estate.
If the borrower defaults on the note, the lender can foreclose the loan and force a sale of the property. The lien then dictates how the sale proceeds are distributed.
There are many types of lien. In terms of your note investment, you will have either a 1st or 2nd position lien.
Lien position (and priority) dictates who gets paid back first from the proceeds of a foreclosure sale.
If the real estate is sold, a 1st position lien is settled first, and 2nd position lenders are paid back out of whatever is left.
This means 1st position notes are far less risky investments because 2nd position lender may get back nothing if foreclosure sale proceeds are grossly insufficient.
Related: A Guide to Lien Position and Priority for Note Investors
So, taking everything into account, if you want low risk passive income, you should aim to buy performing notes with a 1st position lien.
If you want to take bigger risks in the hope of turning a bigger profit – and you have the time and resources to spare – then look to buy non-performing notes in 1st or 2nd position.
Low Risk Passive Income – Performing notes with a 1st position lien.
Higher Risk Passive Income – Performing notes with a 2nd position lien.
Lower Risk Non-Performing – Notes with a 1st position lien and good (<65%) LTV.
Higher Risk Non-Performing – Notes with a 2nd position lien and/or higher (>90%) LTV
Either way, Once you’ve decided on the type of note you should be buying based on your own investment objectives, (and purchased a suitable note), what you do next will be dictated by the specifics of the note.
These specifics include the borrower, the original loan terms and current dynamics and value and condition of the real estate.
So now we start to get into the real nitty gritty of how to invest in notes.
Let’s go ahead and take a look at some of the mortgage note investment strategies other investors use to maximize their return on investment.
Related: Book a 1-2-1 Discovery Call to Discuss Your Investing Requirements
Note Investing Strategies – How to Invest in Notes
First off, let’s get something straight…
Investing in mortgage notes is not a sure fire way to earn a quick buck.
After all, if it was that easy, everyone would be doing it!
Bear in mind that in most cases, your workout starts with the borrower.
The reality is, you don’t truly know what their circumstances are until you engage them, regardless of what servicing notes or the collateral file might infer or insinuate.
Sometimes, you might be thinking you’ll flip a note to another investor, but you end up owning the real estate.
Other times it will be more profitable and/or appropriate to modify the loan with the existing borrower.
In some cases, such as with performing notes, seller finance notes, and private lending, you may be able to just sit back and collect the monthly payments right away.
The point is, the more potential strategies you have in your toolbox, the better likelihood there is of you working out a profit for any given set of circumstances.
My only piece of advice is…
Be prepared to put in the time, effort and resources!
Let’s take a look at all of those possibilities and more…
…here are the 7 most common note investing strategies used by private investors.
Note Investing Strategy #1: Flipping Mortgage Notes
Many investors get into mortgage note investing with the aim of making a quick buck by purchasing notes at wholesale prices to sell on closer to retail.
In reality it is not quite that simple.
There are lots of hedge funds and note brokers out there already doing just this, and I’ve personally witnessed many new investors get sucked into buying trash notes for way more than they are actually worth.
That said, you can make good money buying notes in bulk direct from lenders and reselling them to other investors IF you can find a tape of good quality loans from a lender at the right price (good luck with that!).
Buying tapes of notes from lenders requires building solid long-term relationships with the note sellers.
That means the decision makers at banks and other lenders that are responsible for disposing of non-performing notes, as well as other note investors that regularly buy, sell and trade notes.
This takes a lot of time and effort (and people skills).
Don’t expect to find swathes of good quality notes at a great price publicly listed for sale on the internet, they just don’t exist!
That said, you might buy a note secured against a house in an obscure neighbourhood, then find a note buyer that only wants non-performing notes in that particular area because they only want assets in their own back yard.
Chances are, that note will be worth more to him than it is to you,
One man’s trash is another man’s treasure, so you have an opportunity to extract a profit through value arbitrage there.
You might also find a motivated seller keen to liquidate some notes at a bargain price.
At the end of the day, as with any commodity, if you can buy at a price below what the next guy is prepared to pay, then you have locked in a quick profit (if you can find that ‘next guy’ to sell them to).
Related: Where to Buy Mortgage Notes Right Now – The Ultimate List of Note Sellers
Note Investing Strategy #2: Rehabbing (Modifying) and Reselling
Let’s take a moment to consider non-performing notes specifically.
What many non-performing note investors aim to do is rehab or ‘modify’ the note.
Much like a house rehabber will buy a broken house, fix it up and sell it, note investors do the same with the mortgage loan.
This usually involves getting the borrower paying again, most likely on new loan terms.
Once that note is re-performing the note can be resold at a profit.
A word of warning, this can be a very time consuming and difficult process.
You are dealing with borrowers in financial difficulty, facing the prospect of losing their home.
They may be difficult to contact, or unwilling negotiate. Sometimes they may just be straight unable to accept your new terms due to their current situation.
It takes a lot of time, effort and sometimes money to successfully turn non-performing notes around.
There are also a lot of different laws and rules in different States. You must be very careful that you don’t break any of the strict regulations around dealing with loans and borrowers.
All that said, this note investing strategy can be very profitable. For example…
You buy a $100,000 non-performing loan for $40,000. The real estate is also worth around $100,000.
You negotiate with the borrower a new balance of $80,000, with a new interest rate and monthly payment they can afford.
After a period of ‘seasoning’, you sell the $80,000 re-performing note for $60,000.
Congratulations, you just made $20,000 profit (50% ROI)…
—but it probably took you a year, and a lot of work, as well a a bunch of money in legal fees etc.
Again, don’t be fooled into thinking this approach to note investing is easy, it most definitely is not!
Rehabbing and Holding Notes
If you are thinking how to invest in notes for the income they produce, you might consider buying non-performing notes with a view to rehabbing the notes and holding for the income.
In this case, you would follow the same process as above, but then instead of selling, you would add the note to your own portfolio.
Once lesser known fact about real estate notes is that, just like physical real estate, you can borrow money against your note.
You can also sell a partial note, which is effectively when a note holder sells a certain number of future monthly payment to another investor for a fixed price.
By releasing some of your equity profits, either by borrowing or selling a partial, you free up capital to go buy your next note without having to sell your original note in its entirety.
While it takes a lot more work than simply just buying performing notes in the first place, this strategy can be a great way to build long-term passive income and expand your note portfolio without always having to add tons more cash for new acquisitions.
Own or Sell The Real Estate
When buying non-performing mortgage notes, it is often the case that you will be unable to modify the loan with the existing borrower. You may be unable to contact them, they may not want to negotiate, or it just may not be possible for you or them to come to an agreement that works for both of you. In these cases you will most likely have to either sell or take ownership of the real estate.
There are lots of ways to do this. Of course the most obvious option is to foreclose the loan. But this can be costly and time consuming in many States. So, you may want to look at other options. These include taking a Deed in Lieu or getting the borrower to agree to a short sale. However you go about it, exiting a note investment through the real estate can be tricky. Be prepared to put in the time and resources to get the job done profitably.
Originate or Buy Seller Financed Notes
Creating and/or buying seller financed mortgage notes is a great was to add passive income to your investment portfolio or retirement account. This is something I do all the time with my own real estate investments. I create seller financed notes and sell them to note investors.
When I buy and rehab a house, I may sell the property to an owner-occupier and carry a note. I would do this if the buyer cannot get a traditional mortgage for some reason. So I will take a cash deposit from the buyer and give them a mortgage for the balance.
Once the buyer has been paying me their monthly payments as per the terms of the note for a while – that’s called seasoning – I will then sell the note to an investor who wants the income for their portfolio or retirement account. I get my money back (and profits) to reinvest in my next deal. The note investor gets a good quality performing note secured against recently renovated real estate.
Buy Performing Notes
Now we are getting into the more passive note investing strategies. This type of note investing is probably best for you if you want low maintenance investments that pay monthly income.
Buying performing notes is the easiest way to build passive income, providing of course you can find a source of good quality mortgage notes for sale. This is something we offer to investors in our private lending program at Garnaco. You can find out more about that here.
Aside for our own notes, there are plenty of other places you can find performing notes. There are a number of online note trading platforms, note brokers, even banks and other primary lenders. As always, make sure you do your due diligence on the borrower and the real estate.
Become a Private Lender
Our final note investing strategy is a great way to originate your own mortgage notes that pay a great rate of interest. by making short to mid-term loans to real estate investors who need fast cash to buy properties, you get to set your own loans terms, and you get to choose your borrower too.
Of course, you really need to know what you’re looking at when you make a private loan. you need to be sure that the real estate value with cover your investment if your borrower defaults. And you should also be confident that the borrower’s plans for the property are realistic.
I use private lenders all the time to help with acquisitions for our affordable housing and long term rental investment programs. We have bought and renovated over 100 houses since 2016 using this private lender funding model, and it works great for us, our lenders, and the families who buy and rent our affordable homes. You can find out more about that here.
So you wanted to know how to invest in notes? Well, that’s all 7 note investing strategies covered. We’ve looked at how to invest in notes of all types, and hopefully now you will have some idea of the kind of things you can do to maximize your profit potential when you get into note investing.
Conclusion and Resources
Informed investors make better decisions. If you want to learn more about how to invest in mortgage notes and other investments that generate monthly income, you can further your research using the following resources: