{"id":52794,"date":"2014-01-09T12:23:01","date_gmt":"2014-01-09T19:23:01","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=52794"},"modified":"2021-03-16T10:14:51","modified_gmt":"2021-03-16T16:14:51","slug":"2014-01-09-starting-notes-real-estate","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/2014-01-09-starting-notes-real-estate","title":{"rendered":"Real Estate Notes: Key Concepts to Consider"},"content":{"rendered":"

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. \u00a0There was a time that I knew virtually nothing about real estate, and I probably thought a note <\/a>was a musical symbol.<\/p>\n

When venturing into a new area of investing, it\u2019s a good idea to learn the terminology, regardless of what you\u2019re 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\u2019s the same way with Notes. There\u2019s a language to every business, ever profession, and the language in Notes is definitely different than that of Real Estate. But, it\u2019s a good place to start.<\/p>\n

What is a Real Estate Note?<\/b><\/h2>\n

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).<\/p>\n

Most of the time, when we correspond with investors and someone mentions a note; we are all referring to a secured note that\u2019s backed by real estate. Now keep in mind, there all kinds of notes. Secured notes<\/b> are backed by an asset like real estate or an automobile, but unsecured notes<\/b> 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.<\/p>\n

When we reference a mortgage, we usually mean a mortgage or deed of trust, depending on what’s common in that particular state. \u00a0If 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.<\/p>\n

So, what’s the difference between a performing real estate note and a nonperforming real estate note?<\/b><\/h2>\n

Some of these definitions can vary depending on who you are asking. \u00a0For example, if I asked an investor, \u201cwhat’s a nonperforming note<\/b>?\u201d\u2014he 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.\u00a0 In fact, when buying loans in bulk, whether the loan is current or 30 days late, they’re typically priced in the same bucket. \u00a0As 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.<\/p>\n

A performing note<\/b> is a note and mortgage that’s paying\u2014that\u2019s pretty obvious. \u00a0But 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. \u00a0Up until that time, it’s considered a re-performing loan. \u00a0You can see how it can become semantics once you start discussing these types of \u201cscratch and dent\u201d <\/i>loans.<\/p>\n

So, what’s the difference between first and second notes, and why would someone invest in seconds?<\/b><\/h2>\n

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.<\/p>\n

The first mortgage can\u2019t 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\u2019t secure any of the junior lien\u2019s 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\u2019t 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.<\/p>\n

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. \u00a0Although, you can mitigate this risk by knowing the geography and having a good handle on fair market value. \u00a0Commercial deals could also be perceived in a similar way\u2014a lot of money is in one deal.<\/p>\n

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. \u00a0When acquiring firsts, the buyer may be fixated on taxes, escrows, insurance, and homeowner’s associations. \u00a0In seconds\u2019 world, for the most part, the senior liens worry about those things. \u00a0Besides buying seconds at lower price points and spreading the risk around, there’s often less competition<\/a> in this space. This can be a good thing sometimes for the note investors.<\/p>\n

This last question I actually get pretty often\u2026<\/p>\n

What’s the difference between equity, partial equity, and no equity deals, especially with seconds notes?<\/b><\/h2>\n

Well, let’s look at an example:<\/p>\n

Equity Deal\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Partial Equity Deal\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 No Equity Deal<\/b><\/p>\n

$100K FMV\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $100K FMV\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0$100K FMV<\/p>\n

$50K 1st Mortgage\u00a0\u00a0\u00a0\u00a0 \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 \u00a0\u00a0\u00a0 $75K 1st Mortgage\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 \u00a0\u00a0\u00a0$110K 1st Mortgage<\/p>\n

$20K 2nd Mortgage\u00a0\u00a0\u00a0 \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $50K 2nd Mortgage \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0$30K 2nd Mortgage<\/p>\n

As you may be able to tell, notes with equity are more valuable, because there\u2019s less risk<\/em>.<\/p>\n

Just so you know, we first started buying strictly equity deals, and that was easy because we were in an up market<\/i>. \u00a0Today, less and less equity deals and more no equity deals are in pools.\u00a0 It’s very common to pay a premium to get equity deals.<\/p>\n

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.\u00a0 Other factors could be how much volume you’re buying, whether it\u2019s 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\u2019re ready to purchase.<\/p>\n

The biggest \u201cAh-ha\u201d moment for us as a company, is that we sincerely thought you had to buy equity loans to make money\u2014we 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\u2019s emotional attachment to the home can influence the outcome of a deal.<\/p>\n

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 \u201clearn by doing\u201d business<\/em>. 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.<\/p>\n

If you\u2019ve 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\u2019ve been in Notes for awhile, feel free to chime in as well. Let\u2019s talk notes!<\/p>\n","protected":false},"excerpt":{"rendered":"

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