Notes are a great way to invest in real estate. And, in this difficult real estate market, many real estate investors transition to note investments. Reason being, investing in notes provides a new opportunity to earn above market returns. What is note investing? Note investing is the origination of new, or the purchase of, existing real estate secured mortgages and/or trust deeds. Many investors use language such as “Buy Notes” or “Note Investing” because the terms of a mortgage are detailed in the promissory “note.”
The old adage of real estate, “location, location, location” also applies to notes. However, it may be more appropriate to say, “collateral, collateral, collateral.” Value the underlying collateral of your note investment as if you will own the property (because you just might). If possible, get an independent interior appraisal, visit or drive by the property.
If the property is older or unique, consider having the collateral inspected, as you would when purchasing real estate. And, inspections are easier to conduct when originating new notes than purchasing existing notes. Reason being, the inspection can be made a condition of the note funding. Once a note is funded, the occupant may not be as cooperative.
Just as you want clear title when purchasing a home, so too is the case when investing in notes. And for new notes, you’ll obtain a lender’s policy insuring your note will record in the desired lien position. Or, for existing note purchases, you will want to review the existing final title policy (not a preliminary report). Also, obtain an endorsement from the title company when the assignment is issued at closing.
Escrows are used to originate new notes, but are less common when purchasing existing notes. So, for a new note, escrow is often collecting borrower signatures, obtaining proof of insurance, and managing the closing of the original note. Or, for an existing note, there is less for escrow to do because the note has already been funded. Instead of a traditional escrow, many purchasers of existing notes use a sub-escrow which is managed by the title company. The title company obtains, from the note seller, the endorsed promissory note and a notarized assignment. The buyer sends the note purchase funds to title. When the documents and funds are in hand at the title sub-escrow, the assignment is recorded, along with the selected title endorsement(s). Then the funds are transferred to the note seller.
Note investors should make sure the borrower has appropriate insurance coverage. When coverage is in place, the note investor lists as the Mortgagee on the Evidence of Insurance certificate. When listed as a Mortgagee, the insurance company knows to issue a check to both the Mortgagee and the Borrower. If the borrower tries to change or cancel the policy, the insurance company will notify the Mortagee so they can take corrective action.
Although the investment in notes is similar to purchasing real estate, there are a few significant differences.
Lien vs. Ownership
The first difference is the most obvious. The note holder does not own the real estate, but rather holds a lien position against the real estate. If the borrower breaches the terms of the loan agreement, the lien holder can foreclose upon their interest and acquire title to the property.
Borrowers vs. Tenants
Note investors manage their borrowers, and real estate owners manage tenants. Individuals outsource both tasks. Note investors may outsource the collection tasks to a note servicing company just as real estate owners can outsource rent collection and upkeep to a property management company.
As a note holder, your main responsibility is to collect the payment and make sure taxes are being paid and insurance is current.
When making a decision on a note investment, the borrower’s credit and capacity to make regular payments, is equally as important as the value and quality of the collateral. And when you are evaluating the borrower’s credit, you’re “underwriting” the loan. Banks underwrite borrowers to a set of rigid standards set forth by either the government, or their own board of directors. Individual investors should set standards for their borrowers in accordance with their own appetite for risk.
In purchasing real estate, there is typically a purchase agreement and a Deed. The purchase agreement details the terms of the purchase. While the deed is recorded to put the public on notice of the new owner, and that the transaction closed. Also, a note purchase includes a purchase and sale agreement, which spells out the terms of the note purchase. And, instead of a Deed, the instrument that is recorded is called an Assignment. The previous note holder assigns the beneficial interest of the note to the new note owner.
When the borrower doesn’t pay, foreclosure is the recourse. The process of foreclosure varies by state and may be judicial or non-judicial. Real estate investors can think of foreclosure like an eviction of a non-paying tenant. Only more time consuming and more expensive. Foreclosures may require substantial upfront fees paid to attorneys and/or trustees and can be a stressful process for a note investor to undertake. Many investors shy away from note investments because they do not wish to have to foreclose on a borrower.
The risk of foreclosure is directly related to the quality the note investment and the quality of the borrower. Good quality borrowers are as important to note investors as good quality tenants are to real estate investors. In some cases, the note holder may escrow the taxes and insurance payment and is responsible for keeping these current.
Leverage is relatively easy to obtain on real estate and is one of the driving forces behind many investors’ desire to own the asset as an investment. It gives the owner the ability to enhance (or lever) the financial return. For example, if an investor purchases a $300,000 single family home and borrowers $210,000, the amount of equity invested is $90,000. If the property appreciates $20,000, the investor, would earn 23% on his equity ($20,000 / $90,000) from the appreciation. If this same investor did not apply leverage against the real estate, the return would be $20,000/ $300,000 for a 7% return on equity. In this example, the leverage applied to the real estate (e.g. the $200,000 loan) enabled the investor to achieve a 23% return vs. a 7% return.
Please note, leverage is more difficult to obtain for note investors. Although it is possible to obtain a loan against a note investment, it is far less common and reserved only for the highest quality investors, and usually at above market rates. Also, using a retirement account to hold your note investments could enhance returns.
Notes are not nearly as easy to find as real estate investments. Investors can look to buy notes directly on a note exchange such as LoanMLS.com, or you may choose to work with professional hard money lenders (a.k.a. private money lenders) specializing in note investments.
With a little education and due diligence real estate investors can find notes as an excellent way to diversify their holdings, and earn above market returns with consistent, long term income. This calculation is highly simplified and is for illustration purposes only.