Investing in real estate notes is not as mainstream as flipping or wholesaling, but it’s nonetheless a viable exit strategy for savvy, diligent investors. In fact, real estate notes have proven they belong in an investor’s portfolio if the appropriate steps are taken. All things considered, only one question remains: is it time for you to invest in real estate notes?
Aptly named, real estate notes derive their name from promissory notes; the legal documents borrowers claim they will pay back their debts with. Real estate notes are, therefore, issued along with a mortgage, and put the borrower’s intent in writing. More specifically, however, real estate notes are essentially “IOUs” that provide legal documentation of a borrower’s willingness to repay the amount borrowed. Not surprisingly, they contain a promise from the buyer; one that says they will pay off their mortgage, and how they intend to do so.
It is worth noting, however, that real estate notes are not recorded in the county land records like their mortgage and deed of trust counterparts are. Instead, the loan originator holds the promissory note over the course of the outstanding balance. As long as the borrower owes, the lender will hold onto the note. Not until the debt is paid in full will the note be relinquished and returned to the borrower.
In the event one party lends to another, it is generally considered good practice to have some form of documentation memorializing the transaction. The document should identify the parties, the amount borrowed, the time for repayment, the rate of interest, conditions of default and any other necessary terms. Perhaps even more importantly, however, the document represents much more than an IOU: it represents an opportunity for savvy investors. If for nothing else, it’s entirely possible to invest in real estate notes for sale. As it turns out, buying and selling real estate notes is a viable investment strategy, as long as you know how to go about doing so.
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As I already alluded to, real estate notes are essentially IOUs issued on behalf of borrowers to suggest that they are willing and able to pay back their debts, which begs the question: how can today’s real estate investors turn another person’s promise to repay their debt into an investment opportunity?
In order to understand how investing in mortgage notes transpires, you first need to know where they come from. As I already said, notes set the terms for which a borrower is expected to pay back their loan. However, the institutions responsible for drafting the notes don’t always hold on to them; they sell them on a secondary market. In fact, it’s rare that a loan originator will hold on to the original note for fear of default. Most lenders will sell their notes, especially their delinquent notes, to institutional investors to reduce their risk exposure.
There’s a legitimate marketplace where interested investors can buy the same notes these lenders are selling, and often at a fraction of the price of the homes the notes actually secure. Investors who buy the real estate notes then become the beneficiaries of the notes themselves. In other words, the new note holder can renegotiate with the corresponding homeowner to collect on the same promise they originally made to the bank. Instead of making payments to the bank, the homeowner now makes payments to the note holder — the investor.
The “investing in real estate notes vs real estate” debate, therefore, isn’t a debate at all; the two exit strategies are completely different. Where investing in physical real estate will have investors secure a physical asset, investing in real estate notes will have investors take control of the mortgage notes, and proceed to collect installment payments.
Real estate notes originate once a borrower agrees to mortgage financing. More importantly, since most buyers finance their home purchases, the majority of buyers are tied to a note or mortgage agreement. However, once the note is created by the lender, it is often sold to government entities like Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA). The same government entities then proceed to sell delinquent notes to institutional investors, not unlike Goldman Sachs and Lone Star Funds, but the ride doesn’t stop there. Institutional investors then sell to subsequent investors, who then sell to individual real estate investors like you and I.
Buying real estate notes is not so much the result of a direct transaction, as it is the result of a series of transactions. There are typically a number of interested investors that will hold onto a note before it gets into the hands of smaller real estate investors. Of course, it is possible to buy notes directly from the original banks, which can reduce the acquisition costs. “Delinquent notes can be bought cheaply, often for about a third of a home’s market value,” according to an article by MarketWatch.
The benefits of note buying extend beyond the end-investor, and actually extend to the community in which the delinquent note was purchased. More specifically, the concept of investing in mortgage notes can prove to be a win-win for each party involved. Investors, for example, are given the opportunity to secure an investment at a discounted price. Without a doubt, the single greatest reason investors covet real estate note investing is because of the discount that can be had. As I already said, mortgage notes can be purchased at a fraction of the home’s market value — oftentimes as much as a third of the home’s value, in fact. What’s more, investing in real estate notes is more like investing in a financial asset than a physical asset, so those of you who would rather invest in a more hands-off style, notes may be just what you were looking for. Meanwhile, many investors may be able to help the homeowners of the notes they now hold. It’s entirely possible that a homeowner could negotiate a better payment schedule; one that would help them avoid foreclosure. That way, the owner stays in the house and the investor still collects their payments.
Investing in real estate notes can result in quite the lucrative career, but I digress. As with any other investment vehicle, there are risks that warrant your consideration. After all, private mortgage notes can be dangerous to invest in if you don’t know what you are doing. Even if you know how to make money with real estate notes, there are obstacles to account for, which begs the question: are mortgage notes right for you?
Of course, there’s no universal answer; only you can determine whether mortgage notes will be good addition to your investment portfolio or not. However, I recommend minding due diligence and weighing the positives and negatives of this particular strategy before committing to it.
If you want to know how to make money with mortgage notes, you are not alone. There’s a great deal of investors intrigued by the idea of investing in real estate notes, and for good reason: they are a viable exit strategy with proven results. However, real estate notes aren’t for everyone; they do carry risk that not all investors are comfortable with. That’s why it’s important to do your homework and know what you are getting into before committing to this particular strategy.