Commercial Real Estate

Note Investing: Go Forth and Hypothecate!

Expertise: Personal Development, Personal Finance, Mortgages & Creative Financing, Real Estate News & Commentary, Business Management, Real Estate Investing Basics, Flipping Houses
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Many of you have dealt in notes secured by real estate. Most dealing notes regularly bought them at a discount. For those who have notes they’d like to turn into investable cash — without selling the note for a loss, or at least no profit, this could be your answer.

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The concept in a nutshell is relatively simple. You own a note secured by a trust deed — typically on improved real estate. You get monthly payments including interest. Sometimes it’s fully amortized, usually not. You’d like to get a lump sum from it for an opportunity that’s popped up recently, but don’t wish to sell for the discount you know is market price. You have an alternative — hypothecation.

What’s hypothecation?

It's simply you borrowing from a bank, or another investor, pledging the note as security for the loan. I've done it several times in the past, usually during down times. Let's do a quick, down ‘n dirty example, using elementary school math.

Your note has a balance of $110,000 — it began as a carry back second trust deed and note which you bought at a discount from the seller. Originally it was $120,000, payable interest only per month, at 10%. The payor has normally paid just the required payment, but every now and then paid a little extra. This has resulted in the new, lower balance. The terms of the note allow for this without penalty, but also says the note payments will remain at the original $1,000 a month ‘or more’ regardless of an principal pay downs.

It’s all due and payable in six years.

You go to the bank or investor and ask them for a $45,000 loan, pledging the note as collateral. This loan will be for five years, fully amortized at 12% give or take. The payment is the same $1,000 you’re gettin’ from your payor. Bottom line? You get the use of $45,000 while foregoing the grand a month income. It’s completely paid off about a year before your note is due. A year later you get paid in full, around $100,000 or so, depending upon how much the payor paid in principal pay downs.

NOTE: When I say pledge the note as security, I mean it in the same way we do with car loans. The car is security for the loan, but the bank doesn’t get the car, we keep it to drive. As long we we make the agreed upon payments we maintain possession of the car.

The bank or investor lending you the $45,000 was satisfied through their due diligence that the note was solid, with enough true equity behind it to be safe — measured using their standards.

Meanwhile, you used the $45,000 to buy property, or another discounted note, or . . . whatever. Your opportunity cost is measured in a couple ways. First, for the five years of the loan, you gave up the use of $1,000 monthly. Also, it would make sense, that the money borrowed should be yielding a bottom line of more than 12%. See last week’s post on leverage.

Don’t look at this as a soup to nuts review of hypothecation. Just know as a note owner that it’s an option on your menu. It’s been an incredibly productive tool for me when I used to own notes regularly. It allows you to do transactions in real estate or notes you wouldn’t otherwise be able to do, while allowing you to avoid having to discount your note to make it happen. I’ve often viewed it as havin’ my cake and eatin’ it too.

To Review

You have a $110,000 note with $1,000 minimum payments, due in six years.

You borrow $45,000 for five years, fully amortized at 12%, the same $1,000 a month in payments.

You invest the $45,000 — earning a yield in excess of 12%.

You still get your $110,000 a year after you paid off your loan.

Meanwhile, your $45,000 has grown for six years to — who knows how much?

In addition, you now have $110,000 to reinvest in whatever puts a smile on your face.

Make sense?

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.
    Keith Greene
    Replied over 8 years ago
    Okay, it was back in 1992 when I bought my first book on notes. I’ve been an avid investor since 1997 but am looking to move into something that seems a bit more likely in terms of a return or at least provides a greater degree of return. So, in a nutshell, how can one go about finding these notes/instruments in order to invest in? It seems likely that the return is there and that it’s not as volatile as the stock market or the Forex market. Thanks for any response.
    Alan Noblitt
    Replied over 8 years ago
    Jeff, Well-written article. Another option to selling a note at a discount is to only sell some of the payments — called a partial. This is actually how we buy most of our notes. It is a win for both parties, as the note holder doesn’t get hit with a big discount and the note buyer gets more equity buffer. If the note is decent and in 1st position, the investor’s yield will usually be less than 12%.
    Jeff Brown
    Replied over 8 years ago
    Keith — I’d ask some of the note experts here on the major blog portion of BP.
    Jeff Brown
    Replied over 8 years ago
    Thanks Alan — You make an excellent point. One of the benefits of hypothecating the note is that, generally speaking, it’s not a taxable event. Often times the partial sale of the note has tremendous impact tax wise on the note seller. That can be a great motivator. 🙂
    Mike Robison
    Replied over 6 years ago
    What about a maritial trust that has a million dollars in it. Would a beneficuary be able to use that trust as collateral?
    Jeff Brown
    Replied over 6 years ago
    I’ve never come across that, Mike. Still, aside from any regs of which I might be unaware, I don’t know why an open minded local banker wouldn’t at least look at it. It would also depend upon the ability of the lender to retain the integrity of the loan’s security.
    Michael Evans
    Replied over 5 years ago
    Does anyone know about Re-Hypothecation? I have been reading about leveraging Hypothecation, so that if you have a $100K note, you can leverage it 4x to borrow $400K. I don’t follow how you do this without using the same note as collateral on 4 loans (is that even legal, and if it is, who would lend you money against a note that is already being used as collateral)?
    Jeff Brown
    Replied over 5 years ago
    Hey Michael — Though I’ve heard of higher LTV on loans secured by notes, the highest I’ve seen first hand has been 60%. I’ve not seen what you’re talkin’ about. Ever.
    Micah A. from Kapolei, Hawaii
    Replied about 2 years ago
    Jeff, thank you for writing this article. I’ve been in the note space since June 2017 and have run out of my own money to buy more notes. I remember Dave Van Horn saying he did “collateral assignment of note and mortgage” to scale his business which I recently discovered is called a hypothecation. I have a performing senior lien that I’d like to hypothecate with my local credit union. Do you have any guidance as far as what banks would be looking for in the lien to make it a worthwhile loan? Wondering specifically about ROI for bank and how much they will lend against the UPB of lien. Are there and resources I can study before heading to my bank with this proposal? Thank you in advance.