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Five Advantages of Note Investing

by Dave Van Horn on February 19, 2013 · 19 comments

  

Practically everyone, investor or not, is in the note business. Most people though are just on the wrong side of it. Nearly everyone owns a mortgage, or has a car loan, student loans, or credit card debt and they’re all on the “borrower side” of the note business, but even sophisticated investors often don’t fully understand what goes into acquiring, managing, and liquidating the kinds of debt we all have. Now when I talk about the “note business”, I specifically mean my specialty, which is Real Estate Note Investing.

So why should a real estate investor understand the “business” side of the note business? Besides cashing a check instead of writing one, here are what I think are the top five reasons…

Note Investing Advantage #1 Collateral –

Owning a secured lien tied to property, especially with equity, involves little or moderate risk mainly because you can foreclose on the property and recoup your investment. If it was an unsecured lien, you can also sue on the note and chase the borrower instead of the property. Now unsecured could be seen as more risky, but you also pay a lot less for them.  Unlike an eviction, in a default of a property with equity you’ll recover missed payments, late fees, attorney fees, and corporate advances at some future date. Collateral could also be considered in the form of residential, commercial, mobile homes, or a construction or rehab project. Junior liens with no equity or low equity are also often times viable because you have a secured lien with “emotional equity.”

Note Investing Advantage #2 Profitability –

Notes and mortgages usually offer comparable returns to hard Real Estate Investing after factoring in management and maintenance. Non-performing notes or notes bought at a discount can even exceed today’s Private Money mortgage yields that can range from 12%-18% plus points. So just like Real Estate, you make more money when you buy and you can make even MORE money when you rehab the note (just like rehabbing the property). And lets not forget, there’s a lot less competition when you’re a “lien-lord” versus a landlord because other than large hedge funds there are fewer individuals working today in the note space.

Note Investing Advantage #3 Opportunities –

Many times owning a note can give you low cost positioning into a deal. In a private note deal with a 1st mortgage, your maximum loan amount is typically about 65% of ARV (after repair value) meaning the most you’re getting the house for if you take the property back through foreclosure is 65 cents on the dollar. Even owning a 2nd mortgage can create other opportunities. For instance, owning a 2nd mortgage that was purchased at a lower price point than a typical 1st lien may give you the opportunity to buy out the 1st lien at a discount. Another profitable example when owning the 2nd lien is where you could just reinstate the 1st mortgage, foreclose, and take over the property (with a Sheriff’s Deed) “subject-to” the 1st mortgage and just continue to make payments on the 1st.

Note Investing Advantage #4 Volume and Control –

Speaking from experience, you can easily manage more loans than properties or rehabs (e.g. it’s easier to rehab 200 notes than rehab 200 properties). You can manage your note portfolio from your phone and computer, never having to leave your house! A loan servicer is also much more cost efficient than a property manager. Servicers are approximately $25 set up fee, and $15/month no matter how high the monthly mortgage payment (whether it’s $300 or a $3000 payment) as opposed to a property manager who wants 7% to 10% of gross rent. There’s little to no management once a note is re-performing, especially with a servicer in place who sends late fee notices, 1098s to the borrower, and they also do the accounting for both you and the borrower. It’s rare to deal with maintenance, tenants, and contractors. There’s usually less responsibility, for example Wells Fargo doesn’t usually do plumbing repairs. You are also dealing with a lot less vacancies because it’s a homeowner mentality versus a tenant’s. A homeowner generally has more “sweat equity” or “emotional equity” than a tenant.

Note Investing Advantage #5 Versatility -

“Almost anything you can do with a house you can do with a note.” You can flip or wholesale a note, just like a house. You can refinance the borrower especially once there is a pay history or through credit repair. You can also sell a note whether it’s performing or non-performing. You can even “rehab the note” which is to take a non-performing note and make it re-performing. And another way that isn’t talked about nearly enough is you can borrow against the note, also known as a Collateral Assignment of Note & Mortgage. This is where you’re re-performing note and mortgage is used as collateral for another private loan with an investor.

So these are just a few examples of why I think the note business is so advantageous right now and I’m only scratching the surface. I hope I’ve gotten you thinking more about the “other side” of the note business. It really can be a great business in itself or a powerful means of supporting the Real Estate investment business you already have. Leave a comment and let me know if you have any questions, I’m looking forward to elaborating on all of these advantages in articles to come!

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{ 19 comments… read them below or add one }

Ron Ridgway February 19, 2013 at 4:59 pm

I’m looking forward to getting my foot in on this venture.

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John Thedford February 19, 2013 at 5:58 pm

Thank you so much for your article. I just started originating 1st lien mortgages. I WISH I had done this years ago. I believe it is a sure way to great wealth! I look forward to more articles on the subject, maybe some more in depth articles if you can offer advice on finding and buying performing or non-performing notes. One area I have almost no knowledge in is buying notes at a discount. I know the internet is full of information and I just have not invested the time to learn about that yet. BTW, my first rental property happened when a borrower contacted me first when he decided to sell. I bought the property well under market, spent some money on rehab, and set it up as a rental.

Thanks for your insight!
John Thedford
Naples, FL

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Joshua February 20, 2013 at 9:14 am

Do you have more detailed examples of how these work or know where I can find one? I’d like to see a step-by-step article to help explain what exactly this is and how it works. Thanks!

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John Thedford February 20, 2013 at 11:10 am

Hello Josh: are you asking about originating loans or buying notes? It is almost the same thing except that when you buy a note, someone has already created it and you are buying it from the note holder. As far as originating notes, that is, in my opinion, fairly easy. You need to know and understand the difference between being 1st position, or being 2nd or even 3rd position. You also need to know and understand LTV and your risk. Years ago, I lost money because I didn’t want to buy out the first. Now, I only do 1st positions. Notice that he states you can get returns of up to 12%-18%. In my opinion, that is a GREAT return! If you use the rule of 72, you will see how fast you can double your money with compounded rates. I LOVE notes!

Best of luck!
John Thedford
Naples, Florida

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Joshua February 20, 2013 at 11:31 am

John:

Thanks for the response. I understand the LTV, positions, etc. What I don’t understand is why/where these notes come from? That is, is a note holder really just offering a loan with the RE as collateral no matter the reason for the loan, sort of as a home equity loan or am I offering the note in place of using traditional lending?

If so, am I not losing leverage if I’m having to front my money for a note rather than invest such large sums into standard real estate over the long haul?

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John Thedford February 20, 2013 at 11:51 am

Notes can come from any source. An individual might have sold their residence and carried paper on it. An investor might have purchased a note at a discount and then needs cash or just want to try and resell it at a profit. Where they came from, as far as I know, doesn’t necessarily affect the value. If you want to buy an existing note, then you need to look at the position, the amount vs the value of the collateral, and the asking price. I know some people make a lot of money buying notes. You also need to, if possible, find out the payment history. You can buy performing or non-performing notes. I personally originate my loans. If I don’t like the property or the LTV, I just tell them no thank you. I am actually doing one tomorrow that should have a very high yield and is at less than 20% LTV, and 1st position. It appears very safe with a high yield. Safey matters! Remember, there are a LOT of people wanting YOUR money. It is yours to invest as you see appropriate. I DON’T like taking chances, and you will probably never see me in any casino!

John Thedford
Naples, Florida

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John Thedford February 20, 2013 at 11:55 am

p.s. …I didn’t answer your question on leverage. I don’t believe leverage is the goal in note investing. That is, buying a property and getting financing offers leverage. You might put down 20K on a 100K property. Then, if the property goes up 10% in the first year, your ROI is VERY high. I like both. I like buying rental properties, and I like originating and holding 1st lien position notes. Then can both be profitable. I do notes for one reason (monthy interest income), and buy and hold SFR for not only monthly income, but also for tax advantages AND appreciation.

Best of luck!
John Thedford
Naples, Florida

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Joshua February 20, 2013 at 12:02 pm

John:

Thank you for the quick and great responses! Perhaps I’m a little slow on the uptake in understanding these notes.

I’m not sure I understand the why. Are notes really just similar to a Hard-Money Lender but with better rates and for the long haul? For example, I have a great property I’d love to buy, but banks are requiring 20-25% even though I have perfect credit, a great investment track record, etc which makes purchasing additional properties “expensive” when it comes to needing upfront cash. I would think someone like me is a low risk and so only requiring 10% per 100k would be acceptable, but banks and underwriters don’t care because “that’s the policy”.

Are you stating that investors like yourself, who offer/buy notes, help people like me or is there another angle I’m not understanding here? Thanks for taking your time on me, perhaps this will help others with similar questions as I do. =)

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Susan Cain October 28, 2013 at 3:14 pm

Joshua,

Your scenario of not being able to borrow from a Bank is why Hard Money Lenders exist. A short-term, high-interest loan can get you started quickly. (The cost is insignificant when you sell or re-finance.) These loans are great for both lenders and borrowers. Everyone is in and out fast.

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Jeff Brown February 20, 2013 at 12:30 pm

Welcome to the group, Dave.

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John Thedford February 20, 2013 at 1:04 pm

There are lots of private individuals that offer hard money. If you can’t get the bank to work with you, then you might try finding an private lender. You will find rates all over the place from 8% or 9% all the way up. Keep in mind, private lenders motivation is not to help investors. Their motivation is making money by charging interest. They are no different than banks. Banks make money by lending. Of course, private lenders usually don’t have the high operating costs that banks have. I recently did a loan to someone when the bank stated their minimum loan is 50K. This person only wanted around 15K. So, they found me, I loaned the money, and we both got what we wanted. I got a note receivable making interest (secured by their home), and they got the cash they wanted. Generally speaking, hard money lenders are going to charge more than the banks. If you need money, try posting on craigslist seeking hard money. You might end up with a good source of funds. Watch out for all the scammers, etc on CL. I had tons of replies when I was seeking cash, and many were bogus. I ended up finding hard money through a local attorney.

So, if you are looking to purchase a property and the bank will work with you, consider doing it. Then, when or if you find property number 2, take that as it comes and then worry about finding more cash. Many investors have the same problem: finding more cash to buy more properties.

Best of luck
John Thedford
Naples, Florida

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Dave Van Horn February 20, 2013 at 1:58 pm

Thanks Jeff, I appreciate it. I look forward to writing more!

And John you can get some ideas on where to buy notes here in this recent article: http://www.biggerpockets.com/renewsblog/2013/02/18/cash-flow-notes/

We also break down a deal a bit in a forum post here on BP:
http://www.biggerpockets.com/forums/70/topics/82958-beginning-notebuying

I’m hoping to write more on finding and analyzing notes, but a lot depends on what type of notes you’re interested in (1sts, 2nds, secured, unsecured, commercial, residential, etc.) There’s even multiple sub-categories within these categories (low-end 1sts, no equity 2nds, etc.) Leave me a comment on what you’re thinking and I’ll do my best to help you out.

Best,
Dave

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Joshua February 20, 2013 at 4:14 pm

John, Dave:

Thanks so much. It all make sense now! I know we’ve only scratched the surface but I think I’ve learned enough to grasp the concept of how & why.

Thanks again for taking the time to help and I look forward to hearing from both of you again in the future!

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Michael February 22, 2013 at 6:16 pm

Hi Dave,

I thought this was a great article and very informative. How would you suggest someone who is interested in this side of the business learn more about notes and help getting into the business of note buying who is not sure about where to start, etc? Where could I go to understand the entire process and how to get started?

Best regards,
Michael

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Dave Van Horn February 25, 2013 at 11:19 am

Hi Michael,

Glad you enjoyed the article! How to learn more about the business is a bit of a tricky question because it all depends what type of note investing you’re interested in. I specialize specifically in delinquent residential mortgages so I can point you to some sources of free info on that.

Where are you located? I could probably tell you the best meetings to go to in that area. If you’re on the east coast you might be able to attend out Notebuyer and Investor Q&A on March 21st, you can RSVP here: http://www.meetup.com/Distressed-2nd-Mortgages-Group/

If you can’t make it, you can also stream in online for free! (the link is on the page above) You can also view all of our past Q&A’s on that site as well.

I also did a radio show recently that you can listen to here that gives a good overview of Note investing and what we do: http://www.regoddess.com/radio/

If you’re interested in more info you can also always call Kim Cooney, the head of our investor relations department at PPR at 877-395-1290.

Hope this helps,
Dave

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Treathyl FOX February 26, 2013 at 2:28 pm

As it turns out the SAFE Act didn’t adversely impact the advantages you’ve listed. Just saw a reent report indicating that Texas is the Number 1 state for owner finance notes. Found your article because it was posted in a Google+ community.

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Mark Huffman October 28, 2013 at 4:01 pm

A very interesting article. Here in California we would invest in Trust Deeds. The Norris Group has some good ones for investment.

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Dave Van Horn October 29, 2013 at 1:33 pm

Thanks Mark. It’s funny that you mentioned the Norris Group. I actually have a conference call with them later tonight.

Best,
Dave

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Craig January 21, 2014 at 9:13 am

Great post on a very interesting topic. Any good books out there to take you from A-Z on Note Investing? I’d guess this is a great place for ‘gurus’ to really prey. Would be very cautious in getting started. But it does look like an ideal compliment to holding long term rental property. Thanks.

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