Personal Development

7 Common Challenges Real Estate Note Investors Face

Expertise: Business Management, Mortgages & Creative Financing, Landlording & Rental Properties, Real Estate Investing Basics, Personal Finance, Real Estate Deal Analysis & Advice, Commercial Real Estate, Personal Development, Real Estate News & Commentary
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Every once in a while, someone asks me about the disadvantages of investing in notes, especially as it pertains to risk compared to other asset classes, such as real estate.

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While all types of investing have their own particular disadvantages or risks, your perception of and approach to those risks may change as you gain experience. For example, when I got started in real estate and purchased my first investment property, my understanding of how to mitigate the risks was minimal compared to when I purchased my 40th property.

Note investing is no exception. I’ve been in the notes business for years, and I’m humbled to say that I’m still learning. That said, here are some of the main challenges that note investors face.

Compliance Regulations

In recent years, compliance has become a big one, especially with the inception of Dodd Frank and the creation of the CFPB (Consumer Financial Protection Bureau). Not only has there been an uptick in federal oversight of financial institutions, but now the non-bank sector has become just as regulated. We also have an increase in the state licensing requirements with very little uniformity, thus creating a menagerie of various requirements.

Now, even the small mortgage investor has to be aware of compliance, as it pertains to everything from the FDCPA (Fair Debt Collections Practices Act) and auditing third party vendors to securing borrower data and confidential information. Let's face it, I could write a book just in reference to compliance.

tax-implication-notes

Related: The 8 Non-Negotiable Habits of a Successful Note Investor

Legal Issues

Another disadvantage to note investing is related to legal issues, because after all, legal is the biggest expense one encounters in the note space. After a borrower defaults on his/her loan and all other options are exhausted, the legal process would begin, and of course the foreclosure requirements, timelines, and allowable expenses will vary from state to state.

Knowing whether your loan is in a "deed of trust" state versus a "judicial" state is a good place to start as far as trying to figure out the foreclosure process, especially when it comes to things like hiring your foreclosure attorney, sending a demand letter, filing a lis pendens, bidding at the sale, and ejectment timelines after the sale.

Beyond the more obvious legal threats, let’s not forget bankruptcy, which could possibly create another entire arena of potential delays and tie ups. Other legal issues can crop up as well. For example, maybe there are back taxes, municipal liens, or homeowner association fees piling up. Maybe you need to secure the property and winterize it, cut the grass, or change the locks, etc.

Collateral Issues

Another potential challenge is in regard to collateral documents. This could be things missing in your paperwork, such as a copy of the original note, an assignment, or an allonge.

There can also be issues with the physical collateral. For example, the property condition may have declined. Or there are cases where the property may have been condemned by the city or even torn down.

Market Conditions

Although note investing may not be as well-known as real estate investing, it is still an asset backed investment with a piece of real state acting as collateral behind the mortgage. One threat to this investment is the fair market value of the collateralized property could decline in value, leaving the investor potentially exposed in a foreclosure situation, where there may not be enough proceeds from the foreclosure sale of the property to cover the full loan amount.

Capital Intensive

With junior liens, you may even have issues when a more superior lien tries to foreclose ahead of you. This is why we suggest monitoring the status of any lien that may be ahead of you in case you want to reinstate or buy out the more superior lien in order to protect your position.

Fewer Tax Benefits

Note investing can also be a capital-intensive business without some of the benefits that are more common with owning traditional real estate, such as depreciation and appreciation. With notes, there isn't a tax break that's similar to depreciation — although you may get a tax break if you invested from your IRA or retirement type of account or maybe if you set up a non-profit to buy and sell notes.

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No Appreciation

As for appreciation, your payoff can only really go up if there are missed payments, late fees, or corporate advances added on to the original UPB (Unpaid Principal Balance). In other words, notes just don't appreciate like hard real estate. There are situations where what we call "phantom appreciation" may occur. For example, let's say a note was purchased at a discount because it was only partially covered by equity. If the real estate market were to improve, increasing the value of the collateralized property behind the note, the value of the note and mortgage would go up also.

Related: The Investor’s Guide to Performing Due Diligence on Real Estate Notes

By now, you may be thinking that there are a lot of disadvantages or potential threats to note investing in general. To be quite honest, you’re right, and I’m sure we didn’t even come close to covering them all.

So, you’re probably wondering what would possess someone to do note investing, and the short answer is that many of us have found ways to deal with or mitigate these risks or potential threats. In that way, it’s very similar to real estate investing. I have family and friends who think I’m crazy for dealing with tenants and all the issues and problems that come along with hard real estate investing.

In note investing, if you have regulatory or legal issues, you can employ legal counsel or hire a licensed servicer. Although it’s a capital-intensive business, no one says you have to use your own money. Rather, you can use OPM (other people’s money).

Also, if you're worried about FMV (Fair Market Value), property conditions, occupancy, or liens being valid, you can mitigate most of these issues through your due diligence process.

For us, the fact that note investing is a very scalable business model, and these assets can be bought at a nice discount more than compensates for some of the risks we encounter.

So, what are some of the threats/risks that you’ve learned to mitigate in your note or real estate business?

Leave your comments below!

Since 2007, Dave Van Horn has served as president and CEO of PPR Note Co., a $150MM+ company managing funds that buy, sell, and hold residential mortgages nat...
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    Jignesh Shah Real Estate Investor from Herndon, VA
    Replied over 4 years ago
    Great piece Dave, couldn’t be better in terms of clearly laying out risks of note investing in RE…perhaps you should write that book, I would buy it! For a newbie investor like myself, could you recommend where one could get more information on the local note investing market & perhaps suggest some basic steps to do proper DD on the collateral behind the notes? Btw, did you see John Oliver’s last show this past Sunday? Great take on private debt buying, though with this kind of spotlight from popular shows this is going to be causing more headaches for investors (or prospective investors such as me) such as us!
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Thanks Jignesh! I actually have written a book about it! And it covers a lot of what you have questions about. I’ll PM you a free copy! And yes, I did see the recent John Oliver episode. Funny as always, with an interesting take on debt (sticking mostly to medical debt, which is a whole other animal). My only qualm was he didn’t cover the positives as much as the negatives of the industry. Approaching the ten year mark of being in the debt industry, I can definitely say there’s plenty of both! Best, Dave
    Michael Sadler from Edmonton, AB
    Replied over 4 years ago
    Great post thanks! Don’t forget that there’s lots of fraud when trying to put together a note buying deal online.
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Thanks for the comment Michael! And you’re right, the online market place is just as risky for note buying as it is for most other industries. In fact, the best price I ever got on a note was on an asset I never received! I should also say, there are plenty of reputable funds and exchanges out there, so due diligence and research are key. Best, Dave
    Shawn Hughes from GOODYEAR, Arizona
    Replied over 4 years ago
    Dave thank you for the insight on the pitfalls of note investing. As a newbie looking to get into not investing these articles are great reads and as Jignesh said would make a great book.
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Thanks for commenting Shawn! Already PM’ed you a copy of my new book! Best, Dave
    Patrick Desjardins Real Estate Investor from Amherst, Virginia
    Replied over 4 years ago
    In my humble opinion the biggest issue with NPNs, especially if your strategy is to hold them for cash flow, is the large expenses upfront vs the long term profits. Some months are rough in the beginning when legal expenses are much higher than your cash flow. You need solid reserves and you have to manage it really well.
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Hey Patrick, You’re absolutely right here, notes are capital intensive and with NPN’s legal is your biggest expense upfront. This is why many can only go so far in the NPN business with their own personal capital. After that, there are really only two options. Either recapitalize quickly (either by selling a partial, completing a collateral assignment, or selling the note) or find a money partner(s). And like you said, management is key. Thanks for chiming in. Best, Dave
    ZJ Thorne
    Replied over 4 years ago
    Do you switch strategies in markets where bankruptcies are likely to increase?
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Hi ZJ, We do switch markets but it’s not to avoid BK assets. In fact assets in BK trade for cheaper, and we already know the outcome of them so they don’t bother us. That being said markets full of BKs are ones we pay attention to because that means there is likely a high amount of job loss in the area which can affect exit strategies. Best, Dave
    John D. from Fremont, California
    Replied over 4 years ago
    Great article Dave. Can you PM me the book as well if you don’t mind. I’ve listed to your podcast on BP and also read a few articles. Looking forward to finally taking the plunge!
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Sure thing John!
    Michael Weckel Project Manager from Little Elm, Texas
    Replied over 4 years ago
    Dave, A very well written article and as a newbie note investor, it gave me a few things to think about. I would also like to take a look at your book, could you please pm it to me as well? Thanks for the insight and help to other investors.
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Absolutely Michael! And thanks for chiming in, appreciate the kind words. Best, Dave
    Jeff Heflin Flipper from Dickson, Tennessee
    Replied over 4 years ago
    Dave – Thank you for another excellent article! I have been considering adding note investing to my portfolio, but I’m still learning. I’ve found your past articles to be an excellent source of information as well. If you wouldn’t mind, I’d love to take a look at your book as well. I’ve got a background in credit analysis & risk management, so this seems like a good fit. Again, thanks for sharing your knowledge!
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Thanks for the kind words, Jeff! Glad to hear you enjoy the writing. It sounds like your background could make for a perfect fit to invest in notes. Will forward along the book ASAP. Best, Dave
    Lori Vines Involved In Real Estate from Austin, Texas
    Replied over 4 years ago
    Excellent post Dave Books for us all? 🙂 just read a few note buying books and would love to add yours to that list!
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Haha sure why not! I’ll send it along, you’ll have to let me know how it compares to others on the list! Best, Dave
    Jack Morad Investor from Great Neck, NY
    Replied over 4 years ago
    Thanks for sharing your knowledge in this article… Could I also ask for a copy of your book ? Thanks Jack
    Jack Morad Investor from Great Neck, NY
    Replied over 4 years ago
    Thanks for sharing your knowledge ! Could I also ask for a copy of the book ? Thanks Jack
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Hi Jack, Sure! I’ll PM you a copy now. Thanks for reading. – Dave
    Christina Fulle
    Replied over 4 years ago
    Good article, Dave! I also loved hearing your interview on the NoteMBA podcast! Great content to use toward developing our note portfolio. I would love to read your book, Dave!
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Actually, couldn’t find your profile. Here’s a link to the e-book. http://www.pprnoteacademy.com/intro/ Best, Dave
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Thanks Christina! Glad to hear you enjoyed the podcast (I have another one on BP as well that you might be interested in checking out). Keep an eye on your inbox, I’ll be sending over a copy asap. Best, Dave
    Jay Johnson Specialist from Nashville, TN
    Replied over 4 years ago
    Dave Van Horn: Thank you for taking the time to educate us about Real Estate Notes. Please send me a copy of your book. -J Johnson
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Will do Jay! Best, Dave
    Mindy Zimmerman Investor from Maryville, Illinois
    Replied over 4 years ago
    Another great post, Dave. Thank you so much for sharing your knowledge and book! Peter at PPR sent me the Investor’s Guide to Performing Notes after I asked him a couple questions and I really liked the info you provided in that one. Can’t wait to read this Intro book, too. I was able to download it from the link.
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied over 4 years ago
    Thanks Mindy! Glad to hear you enjoyed the Guide, hope you like the book as well. Please let me or Peter know if you have any questions after reading. Best, Dave
    Sean Sullivan Investor from Pensacola, Florida
    Replied over 4 years ago
    Hey Dave, great podcast interview and blog post. Could I get a copy of the book as well?
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied about 4 years ago
    Absolutely! Just sent it through Private Message. Best, Dave
    James Mc Ree Rental Property Investor from West Chester, PA
    Replied over 4 years ago
    May I have a copy of your book too? thanks, Jim.
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied about 4 years ago
    Sure thing James! Sending it over as we speak. Best, Dave
    Jorge Mendez from Rutherford, New Jersey
    Replied over 3 years ago
    Great post, how update is this info. Still learning about notes as an investment, any guidance on how to start or help JV a deal would be much appreciated
    Joe Yobaccio Specialist from Pasadea, CA
    Replied about 3 years ago
    Dave, how do you now make sure you don’t wire funds and end up with no asset? Do you use escrow. even if you use an attorney, once the money leaves you, even an attorney cant get it back easily if at all.
    Jeremy B.
    Replied over 2 years ago
    Thanks for the info! Huge difference in Performing vs NPN’s and the logic behind each investment; different legal caveats specific to each. . Notes are a great investment if have a solid understanding of how the debt industry works. I look forward to reading your book! -Jeremy
    Frank Kielpikowski from Crown Point, Indiana
    Replied over 2 years ago
    Thanks for the info, Dave, I’m VERY interested in this topic, and would there be any way to get your book as well? I’d love to start making some monthly cash flow and hopefully you’re the “man with the plan”! haha
    Valenda D.
    Replied about 1 year ago
    I'm a former buy & hold invester (NJ co-op, San Diego condo and Sarasita-area SFH ) ready to invest in owner-occupied, SFH, first pisition, NPN. I currently live in Long Beach, CA and have been learning a great deal about notes from BP posts. 3 years ago I attended a presentation by Jasmine Willois, founder oil f Theoh te Ass iui stance Hello from Long Beach
    Valenda D.
    Replied about 1 year ago
    O-o-ops! I accidentally posted that incomplete post. ... Here is the rest of it: ...Jasmine Willois, Founder of The Note Assistance Program. Has anyone tajen her Note Lab or bought the entire program? Iui f so, please share your experience. Also, what is the best business structure entity for the note business I will be starting-LLC, Business Trust or ROTH Solo 401K? I will be handling the business by myself. My seed money is a $20K lump sum of non-earned income, $7K of which I've earmarked for the Note Assustance Program- I need the step-by-step "handholding" and one-on-one access. It's 1/2 price with a partner, which I very well may have by January 2020. Thereafter, I'll have about $1K to invest from a monthly Social Security payment either induvidually or in JV through my local REI networking group. A reference for a local real estate attorney and an accohntant experienced in notes investing would be helpful. I'd like to talk with them BEFORE I set up my business. I've read the book from the Notable Capital Fund. 'The Banker's Code' is next on my reading list. I also read the 'Distressed Notes.com' site and listen to the Naked Notes and the 'Note Queen' podcasts. Are there any other suggedtions on books, blogs or sites to read about note investing that would be helpful? Thank you.