Performing Mortgage Notes vs Private Lending
If you’re looking for more passive ways to generate monthly income from your investments, you’ve probably already heard of performing mortgage notes and private lending. Personally, I’ve done plenty of both, and while each can offer a great alternative to owning physical real estate, there are some key differences to consider.
Pro Tip: See NEW Performing Notes for Sale Every Thursday in the Priority Investor Email
This article won’t make you an expert on investing real estate in notes or doing private lending deals, but hopefully you’ll learn a little something about these two interesting asset classes that you didn’t know before. Knowledge, after all, is power.
Debt vs Equity
Before we dive into performing notes and private lending as standalone investments, it’s important to have at least a cursory understanding of how debt and equity interact in the real estate investment cycle.
Debt and equity co-exist when a piece of real estate is owned by one party who owes a debt to another party.
That debt is secured against the real estate with a deed recorded in the County records, usually a mortgage deed or deed of trust.
In the case of someone’s primary residence, it’s pretty simple…
A homeowner borrows money from a mortgage lender to buy their home. The homeowner puts down a deposit (equity), and the lender will originate a loan to the homeowner for the balance of the purchase price.
So, the lender owns the debt, and the homeowner owns the equity, which is the difference between the debt owned and the property value.
The same goes for investment properties, except the owner doesn’t live in the property, and it could be residential, commercial, industrial, or some other type of real estate.
So, both real estate and the debt attached to it are investable assets in their own right.
The property grows in value (equity) for the owner, and maybe also produces income.
The debt produces income in the form of interest, or capital and interest Payments.
Just like the real estate itself can be bought and sold, so can the debt. Infact, billions of dollars of loans are traded between investors every day in the United States and globally.
Passive vs Active
Because the property owner is responsible for the property upkeep, repairs, tenants, insurance and property taxes, owning the debt is considered more a more passive way to generate regular income.
That makes debt especially attractive to a certain type of investor seeking reliable, low maintenance income.
At the same time, investing in debt such as mortgage notes or private lending is still being considered relatively safe because the debt is backed by a physical asset that is insured against a total loss.
Aside from large insurance companies and other institutional investors that frequently trade in debt, it’s not uncommon for seasoned real estate investors to start selling off physical properties and start investing in debt as they come closer to retirement and become less inclined to deal with time-consuming property and tenant issues.
That’s not say say things can’t go wrong with debt investments, they absolutely can (and do), but I’ll cover that later in this article.
Now, let’s take a look at two of the most accessible ways you can add the income from real estate debt to your own investment portfolio or retirement account… performing mortgage notes and private lending.
Related: Mortgage Notes vs Rental Properties – Which is the Best Investment?
Mortgage notes in general can be great investments that pay monthly income at a much better rate than traditional assets like CDs or stocks, but there are many types of notes out there.
One of the main considerations is whether a note is performing or non-performing.
A mortgage note is considered to be ‘performing’ when the borrower is current on their payments. As such, a performing note can be a great income-generating investment.
In fact, large institutional level investors like insurance companies and hedge funds buy and sell huge numbers of performing notes all the time in the form of securitized investments.
For smaller, private investors like you and me who may wish to add the income from notes to our own portfolios, there are 2 types of performing notes that are most easily accessible to purchase….
…those are, reperforming notes and seller finance notes.
Related: Performing vs Non Performing Notes… Which is the Better Investment?
A mortgage note is considered to be reperforming when the borrower has previously fallen into default, but is now making regular payments again, albeit usually on different terms to the original loan agreement.
When a borrower falls into default on their mortgage, the note becomes non-performing.
The lender that owns the note might choose to sell their non-performing notes rather than go through lengthy and costly foreclosure proceedings.
Investors will buy these non-performing notes at a big discount to the notes balance and try to work out a profit by either modifying the loan to help the borrower start repaying, foreclosing the loan and selling the real estate, or taking possession of the real estate.
If they are able to strike a deal with the borrower to get them paying again by modifying the terms of the loan, that note become re-performing.
That process might include forgiving some of the debt, offering a period of forbearance, reducing the interest rate, or a combination of all of these things.
If they are successful, and once the borrower has been making regular payments again for a period of time (known as seasoning), the investor might then sell the reperforming note for a profit to another investor that wants the income.
These types of reperforming notes are freely traded on the secondary market, with no restrictions on who can but or sell, making them highly accessible for all types of investors.
Related: See Performing Notes for Sale Right Here
Seller Finance Notes
Seller finance notes are created when someone sells a house, but the buyer cannot get, or does not want, a traditional bank mortgage.
In this case, the buyer will pay the seller a deposit, and the seller will carry a note for the remainder of the purchase price.
So, the seller effectively becomes the bank, holding a mortgage note and collecting monthly payments from the buyer.
The seller may then sell the note to an investor to realize their capital from the sale of the real estate.
This is a common exit strategy used by real estate investors to sell their houses to folk that might not be able to apply for a traditional bank loan right away.
Like reperforming notes, seller finance notes are freely traded on the open market. Anyone can buy or sell them, making them accessible as well as profitable.
Buying at a Discount
One of the best things about mortgage notes is that they are more often than not purchased at a discount to the face value of the loan.
This adds a significant an=mount of additional value for investors.
A $50,000 reperforming note with a 6% interest rate may be purchased for $40,000.
So the buyer invests $40,000 to own the note, but gets 6% interest on $50,000, and is also repaid $50,000 over time…. So that $10,000 discount turns into profit as the note is repaid.
This means the ROI on discounted notes is often far higher than the interest rate on the loan.
Beware of Amortization
Another thing to remember is that most mortgage loans are amortized.
That means that each monthly payment comprises a combination of capital and interest. So, the balance of the loan reduces after each payment, so not all of your monthly payment is considered a profit.
Luckily, there are a bunch on online calculators that can help you figure out your actual return on investment based on the price of the note, the monthly payments, and the number of payments remaining on the loan.
By way of a quick example…
A note with an unpaid balance of $50,000, a 6% interest rate, and 15 years remaining, will have a monthly payment of $421.93.
So there will be 180 payments of $421.93, or a total return of $75,947.40 over 15 years.
As the investor, you have to figure out what price is worth paying for that return based on the overall risk attached the the borrower and the real estate.
You might consider that $35,000 is a good price to pay. Or you might pay a lot more if the borrower is high quality, the loan to value is low, and the real estate is in great condition.
Also remember that borrowers have the right to pay off their loans early, and while that gives you your money back to reinvest, it could seriously dampen your return on investment, too.
Related: Where to Find Mortgage Notes for Sale in 2022
Doing Your Due Diligence
When it comes to buying any kind of mortgage note, your due diligence process is paramount.
Having a solid, well-researched DD process will save you from making bad decisions that could turn out to be very costly.
There are essentially 3 elements to a note purchase…
- People – This includes the note seller and the borrower
- Property – This mentis the collateral and security for your invest
- Paperwork – Also known as the collateral file. This is super important because you could rely on your paperwork to save your investment if things go bad
Your due diligence should be designed as a kind of process of elimination that identifies the kind of note/property/borrower you’re happy with, and eliminates those that don’t fit your goals or risk tolerance.
The first thing to do is to set your goals and boundaries in terms of the types of asset you would be happy to own, and work back from there.
This includes things like the the type of borrower you are happy to work with.
Are you interested only in primary residence mortgages, or will you consider investment properties, or even notes on land?
Will you have a minimum credit requirement of your borrower, such as credit score, or limits in terms of missed payments, defaults and judgements etc.?
The same goes for the property…
Are there markets and locations you do not want to be a lender in?
For example… you should know the difference between judicial and non-judicial states.
Remember, you might end up owning the property if the borrower defaults, so you’ll need to be comfortable with that.
You also want to know what the property is worth in as-is condition, right now. And if possible, what sort of condition it is actually in.
Then you want to make sure that the title is clean.
One very experienced note investors once told me that area she saw new investors make the most mistakes was not focussing properly on taxes, title and liens!
Finally, you need to make sure your paperwork is solid.
You will have to rely of the enforceability of your mortgage deed and promissory note if the borrower defaults and you’re forced to foreclose the loan.
This is a somewhat technical process with a lot to take into consideration, so my suggestion is to find some good quality note investing education such as you will find at noteinvestor.com
Related: My Guide to Note Investing Due Diligence
If you’d rather not hunt for a reperforming note or seller finance note that fits your personal criteria, then you might consider originating your own loans and opt to do some private lending.
At it’s core, private money lending is pretty simple…
A passive investor (lender) loans money to an active investor (borrower) to purchase a piece of real estate.
More often than not, the active investor will have a plan. That will likely include adding value to the real estate through renovation, and an exit strategy such as a sale of the property or refinancing with a traditional lender.
Effectively, the passive investor originating the loan to the active investor replaces the bank, and this is goof for both lender and borrower for a number of reasons…
Active real estate investors (like myself) rely on private money to buy and renovate real estate because private investors can fund a loan much quicker than a bank. Often that means the difference between getting a great a deal or losing it altogether.
Private money terms are also much more flexible…
A private investor will write a short term loan of 12, 24 or 36 months, whereas a bank mortgage will be 15, 20 or even 30 years. That shorter terms is far more appropriate for a short term real estate project.
Banks are also very slow, with strict criteria in terms of the borrower and the type of property and project they will lend against. Private investors on the other hand are way more flexible!
So, as a real estate investor, if you want to get a deal done, and you need fast cash on flexible terms, then private lending is absolutely the way to go in my experience.
For the passive investor (private lender), this is a great way to loan their own money out for a relatively short period of time, earn great rate of interest, and still enjoy the capital security of fully insured real estate as the backstop for their investment.
They also get to pick and choose the borrower, lending terms, property and project that best suits their own parameters in terms of preferences, risk and goals.
If you decide that private lending might be a more suitable monthly income-generating investment option for you, there are really two main types of loans you can originate…
Pre-Rehab Private Money Loans
This type of loan is the bread and butter of private lending as described above.
The active investor will find a property they want to buy, and will ask the private lender to loan them the money for the purchase and renovation work.
Once the renovation work is complete, the RE investor will either sell the property. Or, if they intend to hold the property as a rental they will refinance with a more traditional mortgage.
Either way, the private lender is paid back, and the active investor collects their profit.
While these types of loans are extremely common in real estate (I’ve used them buy over 100 houses), there are risks.
The property used as security for the investment is in a pre-renovation condition, and there is always the risk that there could be problems with the project.
A big overspend, overrunning on time, problems with contractors, or uncovering a major structural defect might sink a project entirely.
That’s why the interest rates on these types of loans are usually quite high. It’s also why the lender will usually only lend a portion of the required funds in order to limit their exposure.
That said, if the project works out, then the private lender can make anything from 8% to 15% p.a. on their money with a pretty quick turnaround.
Bridge Loans and DSCR Loans
For the investor with less appetite for risk, originating loans secured against renovated properties – often rental properties – might look more attractive.
These types of loans are used by real estate investors to bridge the gap between the private money loan used to purchase a property, and the refinance or sale of the property (bridge loans).
In some cases, the private lender will offer a longer term rental property mortgage known as a DSCR loan.
Investors looking for lower risk passive monthly income like these types of loans because there is no development risk.
The property is already renovated, and so if the borrower defaults the lender knows that the property can most likely be sold to recoup their investment in as-is condition.
A DSCR loan – or Debt Service Coverage Ratio loan – is a type of loan secured against a rental property.
The lender uses the cost of servicing the debt (interest payments) as a proportion of the net operating income generated by the property to assess the risk of lending.
A DSCR of 1, means that the property produces net operating income equal to exactly 100% of cash required to service the debt.
A DSCR of 1.2 (pretty much industry standard) means the property’s net operating income is 120% of the cost of debt servicing.
So, the higher the DSCR, the lower risk of the borrower defaulting because there is an excess of net operating income.
This asset-based lending is becoming more popular with private investors seeking lower risk alternative to pre-rehan private lending, and riskier mortgage note investing.
Doing Your Due Diligence
Due diligence for private lending deals is a little different to note investing.
For one, you are originating the loan yourself, so in many respects you have more control of many aspects of the people, property and paperwork.
For example, you get to choose the borrowers you will, or will not, work with.
You can also decide whether you would rather invest in higher risk pre-rehab projects in exchange for a better rate of interest, or whether you prefer to fund loans secured against fully-renovated and stabilized properties.
The there is the property….
Of course, with a private lending deal, you get more access to a greater level of information about the collateral property than you would when buying a mortgage note.
For example, the borrower will have had access to the property, so you will get to see inspection pictures, videos, and a Scope of Work (SoW) showing the current condition and the planned renovation (including a cost breakdown).
But perhaps the riskiest elements of any type of lending are the ‘taxes, title and liens’.
So, I wholeheartedly recommend you close your loan through a proper title company or attorney. This will achieve three huge risk mitigation factors for you…
- They will provide a full title report to identify/resolve any issues prior to closing
- They will properly record your deed in the County records
- They will provide you with lenders title insurance
Simply by closing your loan properly you will eliminate or mitigate many (but not all) of the risks associated with asset-based lending.
Finally, you have control over the quality of your paperwork.
Remember, you might rely on the paperwork to recoup your investment if things go wrong.
You can have your own attorney review any paperwork provided by the borrower, or you can have your own attorney draw up a promissory note and mortgage deed/deed of trust for you.
So, much like the due diligence process for buying a mortgage note, your DD process for vetting a private lending deal should be designed to eliminate people, properties and projects that do not meet your personal investing criteria.
You can learn more about how to set your own private lending criteria, and build your own due diligence process in my 101 article here….
Related: Private Lending 101 – A Complete Guide for Investors
Finding Private Lending Deals
There are lots of ways to find good private lending deals to invest in.
If you want to stay local, you can attend local REIA meetups. There is no shortage of capital-hungry real estate investors in those places.
Then there are lots of online platforms that connect lenders with potential borrowers nationwide.
You can also connect with existing private lenders that broker out loans that cannot fund themselves, either due to a lack of available capital, or because the deal doesn’t fit their buy box.
Of course… you can always check out my own private lending program where we post fully-vetted, investor-ready deals to invest in every week.
Related: See Fully-Vetted Private Lending Deals Here
So, there you have it…
…two great ways to invest in real estate that produce reliable, passive monthly income that are accessible to anyone with capital to invest.
But which one is best for you?
For me, I personally prefer private lending because that puts me in the driver’s seat when it comes to choosing the people and projects I lend to.
If I’m buying a performing note, many of those decisions have already been made!
I also like the short-term nature of private lending deals compared to the often longer term nature of mortgage notes. For me, I like to see return ‘of’ investment as well as return ‘on’ investment from time to time.
That said, mortgage notes are fairly liquid, and unless you are investing in a bridge loan or DSCR loan, private lending carries more risk around the real estate which ultimately acts as the security for your investment.
In either case, whether you are buying performing mortgage notes, or lending money to a real estate investor, my advice is to educate yourself first as to the risks involved, how to conduct your due diligence, and then go find good people to work with!
Pro Tip: See NEW Private Lending Deals Every Thursday in the Priority Investor Email
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