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Diversifying into Real Estate Notes? Better Choose a Strategy! Here’s How.

Dave Van Horn
4 min read
Diversifying into Real Estate Notes? Better Choose a Strategy! Here’s How.

Many times, when I’m starting a presentation about notes, I’ll ask everyone in the audience, “Who’s in the note business?” A few years back, no one would raise their hand; today it’s a little different sometimes.

Then, I’ll ask who has a credit card, a car loan, a mortgage on their house, or even a student loan. That’s when all the hands go up. Most people are in the note business; they’re just on the other side of it. They’re the person writing a check or making a payment to the lender.

If I’m at a real estate investor meeting, I’ll ask if there are any hard money lenders in the room, and there usually are. If you really think about it, hard money lenders are in the note business. They’re lending a short term, first mortgage to an LLC to rehab an investment property. They usually charge a significant rate of interest with points, too.

This is exactly how I got started in the note business. I went to a real estate investor meeting looking for more sources of capital to do my real estate deals, was introduced to hard money lending, and decided that instead of borrowing from hard money lenders, I would become one — and I started to lend private money.

Related: How to Get Started in Real Estate Notes: A Primer for Investor Newbies

Diversifying With Notes

Before you think about what note investing strategy is right for you, you should probably decide which note niche you’d like to consider investing in. For myself, I thought, “Why use notes to balance out my investing portfolio?

Many folks I know who went through the last real estate downturn really took it on the chin, especially if most of their investments were only in real estate holdings. My personal portfolio took a pretty good hit in overall equity. The main saving grace I had was that all of my properties cash flowed, and most I had owned for a long period of time. But, although I’ve always had a strong element of investment real estate in my portfolio, I still liked to have a nice balance of other holdings.

Today is no different, as I currently invest in a couple businesses, various real estate investments, notes, metals, and I’m even looking at some commodities. I also like to utilize other safe vehicles, such as insurance contracts and IRA accounts, as well as various entity structures and trusts.

Choosing Your Niche

When it comes to choosing a note niche, it’s probably good to start by evaluating risk tolerance, knowledge level, time commitment, and available capital to deploy.

For example, if you have limited time to commit to note investing or a low risk tolerance, seller-financed or performing notes may be a good fit for you, as they are more passive with less risk. A hard money loan is slightly more risky than an owner-occupied residential first mortgage, but it has a shorter term and higher yield.

A delinquent second mortgage may require a higher knowledge level or a different skill set than a performing first mortgage. There is a risk = reward equation, where the second lien may have more upside potential.

On the hand, a performing first mortgage may be easier to liquidate than trying to sell a large commercial loan or even a mobile home note for that matter.

There is an almost infinite number of possibilities for finding a niche in the note business. I knew a guy once who liked investing in used auto loan notes from his self-directed IRA. I even like unsecured notes, and when I tell people that, they think I’m crazy until I explain how Lending Club really works.

Choosing Your Note Investing Strategy

Now, once you’ve done your homework on what you might like to try, it’s time to think a little bit more about your note investing strategy. Oftentimes, available capital could dictate what type of strategy you may ultimately try to employ.

When my partners and I started PPR, we chose to start with second liens because they traded at a lower price point than first liens.

Although we were already familiar with raising capital, I had a friend who wasn’t. Since he had limited capital, he started out by brokering notes.

There are other options for attaining capital in the note business, such as servicing for others or managing or investing in a note fund. Other strategies can deal with performing or non-performing notes. For example, some folks prefer to work loans for other investors.

Related: An Introduction to Investing in Notes: Why You Should “Be the Bank”

I manage a note fund with PPR. But personally, I own performing notes and consider myself a buy-and-hold note investor. Even so, I often have to flip or wholesale some notes in order to recapitalize and be able to keep some other notes long-term.

It may seem that I know exactly what my niche is in the note space, but it wasn’t always like that. For me, I started with seller-financed seconds to liquidate some of my properties, and then I started into first mortgages for other rehabbers, until eventually I got into institutional, delinquent notes.

What did it for me was getting educated in the space and spending time with other people in the business. Then I just tried different strategies.

Just like in real estate, there are any number of ways to make money. And I’m interested to hear what investing strategies other folks on BiggerPockets are trying or are interested in.

Are you looking to add cash-flowing notes to your portfolio? What niche piques your interest?

Feel free to share below!

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