6 Advantages Note Investing Has Over Hard Real Estate
OK, OK. Before I start, I should say that I love real estate. Really, I do. I wouldn’t be where I am without it. Investing in hard property is why we’re all here after all, and I’m by no means saying we should drop all of our holdings and run into the note business. In fact, what I’m suggesting is far from it. Every asset class has its pluses and minuses. But there are quite a few advantages to notes that make them one of my all-time favorite investments. Though some of these advantages apply to all types of notes (whether it’s hard money, seller financed, etc.), when I say “notes” in this context, I’m mostly referring to institutional notes.
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The Tired Landlord
When I first started thinking about entering the note space on a serious level, it almost seemed too good to be true. I had read a few books, attended some classes and workshops, and started to gravitate toward some other folks who were doing the business, but I still wasn’t sure it was right for me. Then again, I was pretty set in my ways.
You see, I was at this crossroads where I had to ask myself, “Should I continue on with my long-term goal toward owning 100+ units? Or do I interrupt this strategy to incorporate a new (to me) strategy that seemed like less hassle with just as many rewards?
Now, I wasn’t just trying to hit this admittedly arbitrary number of 100 units for my health. What I was really looking to do was create a more balanced life for myself while maintaining a valuable cash-flowing portfolio. After 15 years of real estate investing, I was starting to become one of those tired landlords — there had to be a better way to work smarter and not harder.
I think you might know by now which road I chose. Keep in mind; I didn’t realize all these advantages when I decided to take that initial leap. Some of these I only came to understand over time. And fortunately, because of notes, this tired landlord ain’t so tired anymore!
Advantage 1: Truly Passive Cash Flow
For me, owning hard real estate had always offered many great tax advantages (and still does), especially when including depreciation deductions that can offset positive cash flow. Although I consider my real estate to be passive from an IRS tax perspective, what many people (including myself) have failed to realize is how much active work is required for managing and maintaining property. For the owner/landlord, active work can include everything from dealing with tenants and their liability to maintenance and townships, as well as the ever-increasing property taxes. Even for those of us who own property “hands free” (through turnkey investments or outsourced property management), we still may find that managing the managers can be work.
When a note is re-performing and being repaid by the original borrower, the holder of the note will receive payments every month with little-to-no work required in order to continue receiving these payments. This makes the investment entirely passive. And there’s no toilets, tenants, or maintenance required to earn these payments. I often say, “Do you think Wells Fargo has to worry about plumbing issues?” Not when it’s only in possession of the paper (as opposed to the property).
Advantage 2: Volume and Control
I’ve always tried to keep my residential holdings simple. The majority of my properties are in the same county, are the same property type, and usually cost close to the same price. I found it easier to manage when it was cookie cutter (a limiting idea when you think about it). And then when I started to venture into commercial, that’s when I started going out of state to invest. Managing people and properties in other areas proved to be not only tiresome, but inconvenient — even with managers in place.
Owning a Note Portfolio is Easier Than Owning a Property Portfolio
A note portfolio (either performing or nonperforming) can be managed from the phone and computer without ever requiring leaving the house or office. This enables servicers to manage notes on properties all across the nation. And in those rare instances when there are issues, in the note industry we have what are known as mortgage servicers and property preservation companies to handle them. Servicers handle accounting and payment management plus any issues that arise with the resident. Property preservation companies deal with any physical issues with the property.
Advantage 3: Notes Are Profitable in Various Market Conditions
Unlike with the volatility of say, the stock market, note prices in the marketplace are directly correlated with real estate values. So in an up market, when the economy is in full swing, there are fewer foreclosures, and home prices are high and climbing:
- There is a smaller supply of delinquent notes available in banks’ portfolios, which enable the bank to gain a higher price for its notes — especially because all notes are more likely to be fully covered by equity.
- Although investors may have a higher acquisition cost, they now can benefit from a quicker exit. When there’s a question of time vs. money, the old adage “A fast nickel beats a slow dime” is proven true. What’s better — a 50 percent return in four months or a 150 percent return in 12 months?
Conversely, in a down market there are more delinquent assets available (along with more junk assets), and there is less equity in the marketplace.
- Though it can take longer to exit with fewer buyers for an asset backed by a property that may be dropping in value (or have little remaining value), it's not all bad. This is a glass-half-full scenario when it comes to loss mitigation. A longer exit means a longer time to get a loan modification.
- This situation also creates more assets in the marketplace for less capital invested. For the same amount of money in an up market, a note investor could acquire a larger quantity of assets than they could in a down market. That’s what we did as a company during the downturn, and now equity is starting to come back. Our assets are only gaining in value!
Advantage 4: Collateral
Unlike owning stocks that offer no real collateral, real estate is one of the safest investments since it’s actual physical property. It wasn’t until I learned about notes that I discovered there was an investment option that offered a very similar style of security. Since a performing note is secured by real physical property, there are multiple means of protecting a note investment, including…
- Owning a secured lien that is tied to property, especially if the property has equity, involves little or moderate risk because a note owner has a right to foreclose on the property and to recoup some, or all, of the initial investment. The investor who owns the note has a claim on the property, just as the bank would if they were to own the note.
- Unlike in an eviction, in a default of a property with equity, the note owner could recover missed payments, late fees, attorney fees, and corporate advances in the future.
- Even junior liens with no equity (or low equity) can still be viable investments because the borrower usually has a vested interest in the property, and traditional equity may not always be the sole factor when it comes to remaining in the home.
Advantage 5: Versatility
Now this one is my favorite. What many real estate investors may not know is that nearly all the forms of profitability that property ownership offers can be found with note investing.
What You Can Do with a Note
Not only can purchasing notes be a unique way to obtain property (especially when buying vacant first mortgages), notes can also be flipped, rehabbed, and borrowed against or leveraged like real estate.
• Flipping or wholesaling a note
Whether a note is performing or nonperforming, it can potentially be sold to an investor in any condition, at any time. Generally, a note is not required to be held for a certain amount of time before it can be sold again.
For example, in an upmarket, someone could purchase a performing note and hold onto it for a few months as they collect payments. Later they could sell it for close to (if not the same amount) as the purchase price. More importantly, the note doesn’t need to be performing to be sold.
• Recapitalize by selling what is known as a partial
This practice refers to selling a partial amount of payments to an investor for a designated term at a designated price. This option can be a great way to quickly recover a portion of the initial investment while maintaining ownership of the note. It is beneficial for the partial-note buyer as well because it requires a smaller amount of money to invest for a shorter period of time.
• Rehabilitating a note
Like rehabilitating a house, notes can be rehabbed or retouched by reworking the original note. If a borrower were to miss one or more payments because of an unforeseen circumstance, the note owner (or their servicer) has the ability to rework the terms of the loan to fit the borrower's new needs. This allows the borrower to stay in the home while the investor maintains a steady stream of cashflow.
• Borrowing against the note
The most versatile strategy of all involves an investor’s best friend: leverage. Since the note generates monthly income for the investor, it can be considered a cash-flowing asset. As an asset, this note can then be used as collateral for a loan with a private-money investor; this is known as a collateral assignment of note and mortgage.
Just as a motor vehicle is collateral for an auto loan, a performing note can be collateral for a private-investor loan. In fact, the private-investor loan allows the investor to recapitalize in a tax-free manner. Since this is a loan, the new private money creates an opportunity for a revenue stream that is exponential because the loan can be used to purchase more notes.
Advantage 6: Socially Conscious Investing
One thing that always attracted me to real estate was the fact that everyone needs a place to live. Through my rentals or flips, in some ways, I was responsible for helping families find homes. With notes, investors can do something just as valuable – and that’s helping borrowers stay in their homes without incurring any additional debt that could cause further repercussions down the road. Unlike stocks, which are essentially a zero-sum game with investors playing either side of the investment (always leaving one party at a loss), notes can actually be advantageous for the investor and for every party involved.
How Note Investing Can Be Beneficial
- Borrowers benefit from working with note buyers to create a viable solution, whether it’s to stay in their property or move on, and/or buy time without incurring debt that can be detrimental to their financial life.
- Banks benefit from others investing in notes as well because they are able to remove assets that are considered “toxic” from their books. Therefore, they are given a greater lending power to do what they do best: lend money.
- Housing makes up a large percentage of the economy, and reforming distressed debt in that area is beneficial to the entire economic system. When a person is not paying their mortgage, they’re also not paying their taxes or insurance escrowed in their mortgage. By turning these delinquent mortgages into performing ones, note investors not only help an individual through their financial struggles, but they also help improve the community at large.
So with all these advantages, who wouldn’t want to add note investing to their portfolio? Of course, these benefits don’t necessarily mean note investing is always easy. But hey, neither is real estate. I’ve always subscribed to the idea of “there’s no such thing as a bad investment.” And I have found the most success comes from being diversified in multiple investment avenues, creating a synergy between asset classes — all in hopes to experience the advantages of as much as possible. Hopefully with this article and my new book, you can start to do the same.
Have you invested in notes?
How has your experience been? Share below!