INVESTING IN PRIVATE MORTGAGE NOTES VS. INVESTING IN DISCOUNTED MORTGAGES
Much has been written about the high yields and relative safety of investing in discounted mortgages, especially second and other junior lien instruments. Furthermore, since both private mortgage investments and discounted mortgage investments are based on investments in real estate debt security instruments, i.e. mortgages or deeds of trust, these two investment opportunities do have many similarities. Information on techniques and formulas for investing in discount mortgages can be found in numerous books and on many web sites devoted primarily or exclusively to this type of investment. However, significant differences between these two types of investment do exist. Investing in discounted mortgages or trust deeds involves purchasing a private mortgage note or deed of trust at a discount. The amount of the discount will determine the yield The greater the amount of the discount the higher the yield. Most of these mortgages are the result of owner financing on single family homes with interest rates comparable to the going market rate at the time that the mortgage was written. A mortgage carrying an 8% interest rate might be sold for a 30% discount from face value; a mortgage with an interest rate of 10% would carry a smaller discount all, other things being equal. Further, there are yield enhancement strategies available to the aggressive investor resulting in the potential increase in the investor’s total return. Although a discussion of the details of these yield enhancement strategies are beyond the scope of this book, they relate to the investor’s ability to convince the mortgagor to increase payment size or to pay early by offering some type of incentive. The greater the discount from face value at the time of purchase, the easier and more numerous the incentives that can be used to convince the borrower to agree to a restructuring of the note. Investing in private mortgage notes entails significantly less risk for the investor than investing in discounted mortgages. First of all, the investor can choose his level of comfort when investing in private mortgage notes by deciding to invest in either 1st liens or 2nd liens. The vast majority of mortgages available for purchase as discounted mortgages are 2nd or junior liens. Second, almost all discounted mortgage investment opportunities will be found in the single-family home market, making this type of investment susceptible to any downturns in the residential owner occupied real estate segment. Investing in private mortgage notes allows the investor not only to choose amongst at least 6 or 7 different real estate segments such as residential, office, warehouse, retail, etc., but also allows the investor to diversify amongst these different markets if desired. Finally, the discounted mortgage investor must accept a mortgage instrument alreadywritten, unlike the private mortgage investor who will have an attorney representing his best interests produce the note and deed of trust documentation. Although the investor in discounted mortgages can decide not to purchase a particular mortgage because of a poorly written note or deed of trust, the investor will find most opportunities presented to him in this field to have deficiencies in paperwork to one degree or another. The private mortgage note investor controls all the risks associated with a bad or improperly drawn mortgage instrument by having a real estate attorney he knows and trusts prepare and exam all documentation required to perfect his lien holder interest. Return or yield on both vehicles should be about equal on average. The yield on private mortgage loan investments will be the actual interest rate on the note while the yield on discounted mortgages will usually encompass a lower interest rate offset by a discount in purchase price from note amount. Since the market controls return on investment, and since both these investments are considered mortgage investments, the yields should be similar. Often the private mortgage note will yield more with the difference being made up by the discounted mortgage’s bonus if it is paid off early. However in an efficient market this should be accounted for in the amount of the discount.Since the range of return is wider in discounted mortgages than in private mortgage note investments, it may be possible for some investors to select the higher return discounted mortgages and thereby enjoy a greater return than the private mortgage investor. Utilizing the various yield enhancing techniques can further any advantage in total return enjoyed by the discounted mortgage investor. However, it has been this author’s experience in purchasing mortgages at discount that it is rare indeed to find a mortgage discounted to such an extent that a significant differential in return can be detected by the discounted mortgage vs. the private mortgage note. Both private mortgage note investing and investing in discounted mortgages can be time consuming if the investor goes the solo route and much less time consuming if the services of a mortgage broker are used. Since the note and deed of trust used by the private mortgage lender will be boilerplate, i.e., drawn up by an attorney representing his interest and basically the same for all transactions, less time will be spent vs. the discounted mortgage investor who must examine every document relating to each mortgage investment to determine quality and safety of the documentation and how it will relate to any price offered. Knowledge required for successful investment in either discounted mortgages or private mortgage notes would be essentially the same with much dependent on whether the individual investor utilizes the services of a mortgage broker to facilitate the investment opportunity. However, it is in the area of availability that investing in private mortgage notes have a large advantage over investing in discounted mortgage. While the demand for private mortgage money remains high and investment opportunities abound, access to discounted mortgages by the individual investor has been greatly lessened in the last five years. Large investment concerns have pooled capital and now buy the vast majority of discounted mortgage notes that come on the market. These note buyers have set up, support, and in many cases finance note brokers who now have a vested interest in selling these discounted mortgages to the investment concerns. The investment concerns do not offer the notes to the individual investor, they hold them for the high yield and return on investment. Lessening still the individual investors ability to purchase these discounted mortgages, legal case law has been established that holds the note broker liable in many cases for losses suffered by the individual investor purchasing notes from the broker. As a result the vast majority of note brokers refuse to sell discounted mortgages to the general public, preferring instead to act as buying agencies for the larger investment companies. Don H Konipol has a BS in Economics and an MBA in Finance from the University of Michigan and is General Partner of the Managed Mortgage Investment Fund LP, a private limited partnership that invests in short term, high yield private mortgage notes. He is also General Partner of Tribeca Mortgage LLC, a private fund set up to invest in and sell high yield trust deeds. He can be reached at 832.577.8838 or by email at [email protected].
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