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Real Estate Notes: Key Concepts to Consider

Dave Van Horn
5 min read
Real Estate Notes: Key Concepts to Consider

In a discussion at lunch recently with a young entrepreneur, who was intrigued by the note business, several key concepts came up, and I suddenly realized that many folks, especially newbies, must have similar types of questions.  There was a time that I knew virtually nothing about real estate, and I probably thought a note was a musical symbol.

When venturing into a new area of investing, it’s a good idea to learn the terminology, regardless of what you’re investing in. It was the same way when I first started learning to trade options. I took a course, where I had a coach, material to read, terminology defined, and people to chat with. Terminology was a big factor, especially when learning about options, and it’s the same way with Notes. There’s a language to every business, ever profession, and the language in Notes is definitely different than that of Real Estate. But, it’s a good place to start.

What is a Real Estate Note?

In its simplest form, the note (or Promissory Note) is a promise to repay a loan and the mortgage is the recorded document that attaches lien against real property that secures said note. A more detailed definition would state that a promissory note is a contract in which one party (the borrower) agrees to repay a certain portion of the loan to the other party (the payee) within a set period of time, under specific terms (interest rate on the loan or penalties for late payment).

Most of the time, when we correspond with investors and someone mentions a note; we are all referring to a secured note that’s backed by real estate. Now keep in mind, there all kinds of notes. Secured notes are backed by an asset like real estate or an automobile, but unsecured notes are not (for example: student loans, medical debt, credit card debt, or lendingclub.com). There can also be residential and commercial notes, as well as first liens and junior liens, just to name a few.

When we reference a mortgage, we usually mean a mortgage or deed of trust, depending on what’s common in that particular state.  If a borrower doesn’t pay on his/her note (or promise) and no alternate plan for repayment is made with the lender, then the lender would usually foreclose on the mortgage or deed of trust. The mortgage secures the note by recording a lien against the property.

So, what’s the difference between a performing real estate note and a nonperforming real estate note?

Some of these definitions can vary depending on who you are asking.  For example, if I asked an investor, “what’s a nonperforming note?”—he might say that it’s a loan when the borrower isn’t paying. But if I asked a banker, he’d probably say that a loan is not considered delinquent until it’s greater than 90 days past due.  In fact, when buying loans in bulk, whether the loan is current or 30 days late, they’re typically priced in the same bucket.  As confusing as this may be, most banks won’t start legal action until the borrower is later than 90 days on payment of the loan.

A performing note is a note and mortgage that’s paying—that’s pretty obvious.  But if a loan goes nonperforming, then it’s not considered a performing loan again until it’s been paying on time again for 12 consecutive months.  Up until that time, it’s considered a re-performing loan.  You can see how it can become semantics once you start discussing these types of “scratch and dent” loans.

So, what’s the difference between first and second notes, and why would someone invest in seconds?

The hierarchy of the lien position is a primary difference, meaning that the first (or senior lien) was recorded earlier than and has claim before the second (junior lien). And, the associated risk of position is a major difference too.

The first mortgage can’t get crammed down the way a second, potentially, could. A Cram down could occur when a homeowner files personal bankruptcy. In a property where the appraised value doesn’t secure any of the junior lien’s debt, that junior lien could be stripped by the bankruptcy court. First mortgages are always backed, at least partially, by the value of the property (equity), so they aren’t at risk of being stripped in a cram down. Knowing this terminology will help you understand some of the relevance of lien position and the level of risk associated with it.

As someone used to mitigating risk, sometimes I believe a first mortgage can be more risky since all of my capital is in one deal, instead of spread out amongst many deals.  Although, you can mitigate this risk by knowing the geography and having a good handle on fair market value.  Commercial deals could also be perceived in a similar way—a lot of money is in one deal.

There are other differences between firsts and seconds, like price point and the things that concern the buyer of the two different types of loans.  When acquiring firsts, the buyer may be fixated on taxes, escrows, insurance, and homeowner’s associations.  In seconds’ world, for the most part, the senior liens worry about those things.  Besides buying seconds at lower price points and spreading the risk around, there’s often less competition in this space. This can be a good thing sometimes for the note investors.

This last question I actually get pretty often…

What’s the difference between equity, partial equity, and no equity deals, especially with seconds notes?

Well, let’s look at an example:

Equity Deal                                               Partial Equity Deal                                   No Equity Deal

$100K FMV                                                 $100K FMV                                               $100K FMV

$50K 1st Mortgage                                     $75K 1st Mortgage                                  $110K 1st Mortgage

$20K 2nd Mortgage                                  $50K 2nd Mortgage                                $30K 2nd Mortgage

As you may be able to tell, notes with equity are more valuable, because there’s less risk.

Just so you know, we first started buying strictly equity deals, and that was easy because we were in an up market.  Today, less and less equity deals and more no equity deals are in pools.  It’s very common to pay a premium to get equity deals.

In the current market, senior lien status is much more important than loan-to-value, since the majority of seconds pools don’t have equity. Loan-to-value may be more important with equity deals. And it’s not only loan-to-value that determines price, it can also be how long a loan was delinquent.  Other factors could be how much volume you’re buying, whether it’s an active foreclosure, if the loan is in bankruptcy, etc. All of this can come into play as to how you value the assets you’re ready to purchase.

The biggest “Ah-ha” moment for us as a company, is that we sincerely thought you had to buy equity loans to make money—we had the same misconception that many people, who are getting started in notes, have about no-equity deals. But, one of the most valuable things that happened to us was when the market fell and our current holdings lost their equity. It forced us to work no-equity deals and hone our collections skills and processes. It also showed us how much the borrower’s emotional attachment to the home can influence the outcome of a deal.

Whether you start with equity deals and work your way into no-equity deals or start with first liens and work your way into seconds, notes really is a “learn by doing” business. It really comes down to three main things someone needs to be successful: education, networking with others doing the business, and maybe even getting a coach to help you accelerate your learning curve. I believe that in order to fully benefit from the education available in any field, you need to know the terminology first.

If you’ve recently started in Notes, are there any specific terms or concepts you would like described? Or, would you like further clarification of any terms/concepts mentioned in this article? If you’ve been in Notes for awhile, feel free to chime in as well. Let’s talk notes!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.