The Elephant in the Room: Where Are All the Real Estate Notes!?
When BiggerPockets first reached out to me about two years ago to write a book on note investing, the note market wasn’t like it is today. In fact, the economy wasn’t like it is today. We weren’t quite in an upmarket yet, though signs of an upswing were rapidly approaching (growing construction starts, less foreclosures, etc.). And at the time, my company (then in its eighth year) was still going strong as a note seller. Selling notes, along with loss mitigation, was the core of our business (mainly second liens, but also some firsts as well).
I had also been blogging for more than three years about real estate, and in my posts I had been consistently recommending one of my favorite niches to everyone—notes!
Now, let’s fast forward to today. Our business has grown, and we now favor first liens to second liens. I’ve tried to expand my blogging to cover more than just notes by including all types of real estate investing. Oh, and the book is completed—and we’re officially a month away from launching! I suppose we can also probably all agree, a lot in the world has changed since even 2016! We’re in a different place than we were two years ago—in more ways than one. But we’re also in a different market than the one we once knew. And this revelation, like most things, is something that only dawned on me quite recently.
Around the beginning of the year, a forum post in the Tax Liens, Notes, Paper & Cashflow Discussion Forum caught my eye. The majority of responses, including my own, probably sum up the answer to the question posed by this article.
But let’s expand on that. The original poster was someone relatively new to the institutional note industry. His general feeling, in his words, was that it seemed like there was less inventory and more people chasing it. Now, this was something I kept hearing over and over again from note buyers and investors, and I wanted to give my take.
In this current market, is their room for new investors to get started in the note space?
I think that’s the real question people are after here. Looking back at the forum, my answer was this:
"My company and I entered the space in an upmarket as well; the only difference being it was really just a matter of months before one of the biggest economic crashes ever. Fortunately, we were able to build and eventually thrive as a second-lien business in a down market because of that. The irony is, we've now grown enough in the time since the pendulum has swung the other way: we've bought more first- and second-lien product this year than the past few years combined. The rub to the retail institutional note buyer is, we've also sold less than ever. What you're describing when you talk about what you see right now is really just a factor of the marketplace."
What do I mean by that? In some ways, it’s a simple supply-and-demand equation. With employment at an all time low, and the lack of underwriting for junior liens, it’s only natural to see a dip in supply of that particular type of product. But surely there is still product out there, right? Right. And the closer you get to the top of the chain of product, you see the same large funds, banks, and servicers. So why don’t more assets trickle down? The answer again, lies in the characteristics of an upmarket. With notes being in direct correlation with property values, notes are worth more and more as the real estate market continues to rise. So of course these outfits are going to hold onto their product if it increases the value of their portfolio. But there’s more to it than just money. So going back to my question in this post:
“…on the institutional side, there’s not much advantage to sell to the retail buyer for a variety of reasons. For example, many institutional funds can make more money either holding notes that are appreciating in value or selling notes in bulk to another bank where they can get things like NSO credits. It’s not only about the money, but also the risk with compliance being what it is.”
Imagine you were a bank—what would you do? Would you sell to a guy off the street who you didn’t know from Adam? Or would you choose to hold assets that are gaining value and only sell in bulk to other reputable funds, non-profits, and banks that can purchase product in bulk from you? And these larger outfits that have the ability to purchase in bulk, they could obtain what are known as NSO (Neighborhood Stabilization Outcome) Credits, which could allow them to continue to qualify to purchase directly from government entities.
I know, I know, you’re not the bank. And hey, I’m not either! But it’s important to put these things into perspective. People often ask me, “Why aren’t you selling as many notes today?” And like I said in my forum post, my new favorite reply is, “Where were you five years ago? We sold everything we had!” If you’re going to buy in 2018 like you would in 2013, you’re going to struggle to get the same type of product with higher prices, higher demand, and lower supply. Of course, there will always be some sort of institutional product out there—it’s just a matter of how much and when. But you can’t just sit on your hands while you wait. There’s only one thing you can do in times like these, and that’s adapt.
Listen to the Market
To the point in my forum post, notes will never go away. In times like these, it goes to show how much the institutional note market is capital intensive and all about relationships. There’s still product out there to find—whether it’s different from the product you’re accustomed to buying (or even if it requires you to buy it in new ways). For example, partnering with others to take down larger trades in order to cherry pick the assets you’re looking for while selling off the rest.
Keep in mind the note business isn’t just limited to the institutional space. What I tried to express in my book, above all else, is that the note space is versatile, vast, and full of possibilities. As with any investment, you can’t tell the market what you want it to do for you. You have to listen to the market and adapt to it. And the good news is you have options.
Here’s an Example
Now what I’m going to tell you next is a short little story that is one of my favorites about doing just that. I often tell investors this story when I speak. I tell it in the book (albeit in a different way), and I’m going to tell it again here by quoting my post. Obviously I love this story! And I think by the end of it you’ll see why:
"I've told this story before, and I'll probably tell it again. But around the time of the crash, I had a friend who didn't know what to do. He was struggling financially. His then-current buy-and-hold business model was no longer working. He just couldn't get much financing. So instead of remaining despondent, he decided to take a banker to lunch. What he was really doing wasn't, "Hey, I have _____, will you lend me money on it?" Instead, he took the approach of asking, "What is it you're looking for? What is your bank—or other banks you know of—lending on?" The banker responded: student housing and commercial multifamily. So my friend goes, "Okay," and he began to adapt. He started by pounding the pavement for apartment and student-housing deals, reaching out to his network, and building his team. Pretty soon, he was raising private money for student-housing rentals and finding the remainder of traditional financing he needed pretty easily. That was 10 years ago. He now owns over $100 million in student- and commercial real estate, and makes a pretty penny in his salary raising capital as well."
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Let's take a lesson from my friend and go from there. With market time being quicker than ever, we're switching back to a seller's market. The good news for us note investors who've been working for years in the business is that our portfolio valuation has never been higher! Even in my own personal portfolio, the notes I own are worth more than ever. I'm getting cashed out more often (with more people refinancing as they gain equity in their homes). But the flip side is—I still have to look for places to put my capital with fewer notes in the marketplace.
So what do I do? As I see the interest rates going up on my properties, I’m starting to do something I was never a fan of in a down market: I’m paying some mortgages down. Sometimes the best mortgage notes are the ones you already have. This is why I also just did 4 modifications from adjustable to fixed.
I try not to limit myself to any one part of the industry. And I don’t want you to either! Hopefully my upcoming book (and series of articles) will help illuminate new ways to look at your real estate and note investing strategies to create profitability from a new angle. So whether it’s using unsecured notes to buy properties, taking over a note (via subject-to), or partnering notes with commercial real estate, the sky’s the limit!
Don’t Follow the Herd, Lead It
Way back when, when we were starting our note business and the market crashed, we were in quite the predicament. My partners and I could’ve tried to continue on like nothing had changed, but we chose to really dive head first into distressed, upside-down second mortgages. And people thought we were nuts! But hey, I’m glad we didn’t listen to them. We’re still here, and we’re bigger than ever after years of forging our own path. And with the creative strategies in my writing to come, I want to help you do the same.
So if you can’t find a performing note, create one with seller financing or hard money lending. If you can’t find a NPN? Work in P2P Lending. Or better yet, don’t listen to me. Do whatever the market is telling you.
What do you think?
Share your own opinions in the comments below!