Investing in real estate vs. note investing
Mcallen, TX · Member since 2013 · 6 posts · 0 votes
Hello I am fairly new to this site and I tried to find a post on this but was not able to. My question is which is better in the longer term, buying real estate to buy and hold and cash flow or to invest in mortgage note? My goal is to have as much cash flow as I can to be able to build lots of wealth. I do not like wheeling and dealing like flipping. I much rather do my homework and find good properties that rent out good and enjoy the income.
But I have read about note buying and they make it sound like its way better than being a landlord but I just do not see what the difference is since either way you still have to make sure you pick the right property. Also (and not sure if this is possible with note investing) but in buying real estate I can leverage myself and only need 20% in most cases.
I would appreciate you guys feedback. Thank you in advance.
Josh
Joshua, it sounds like you don't want to commit a whole lot of time, and want it to be fairly passive after the initial purchase. Marc makes a great case for the passive ongoing income that performing notes offer. The capital commitment can be high. Here are some other options to consider:
* Place your funds with a hard money lending company - 8-11%
* Make direct loans to rehabbers - 12-18%
* Invest in a joint venture or syndicate with experienced investors - equity like investment with no guaranteed rate of return - target 15% and up
* Purchase high-quality rentals needing only cosmetic rehab (or even turnkey that are already rehabbed); these are probably homes you'll be all in for $110k and rent for $1,250 in good school districts; without leverage 7-9%; with leverage (15-20% + tax benefits)
* Rental property hybrid options that are intended to greatly reduce your ongoing time commitment, increase term of tenancy, and shift maintenance expenses to the tenant (lease with option to buy, sell with land contract/contract for deed) - 15% - 30%
And of course, in the note realm, since you enjoy homework, you can purchase non-performing notes that will require workout but can potentially provide very high returns of 20%+. Fairly steep learning curve, much less passive, and not the place to start.
Welcome to BP Josh. I appreciate this question. There are pluses and minuses to each. The thing about buying first position, performing real estate notes is:
You do the deal once and get paid until the term of the note expires, hopefully without any other real work! With rentals you have to keep finding new tenants to replace your old ones. With notes, most all of the headaches of home ownership like taxes, insurance, maintenance, etc-are the home owner/payer/borrowers responsibility! I personally like the idea of doing a deal one time and getting paid on it month after month for years into the future! I am sure you will get some other responses here but, I thought I would pipe up, welcome you to the board and give you my take.
Thanks Marc for the reply. Now what if I have limited funds? Like i am able to put 20% down on an investment property but would I be able to use leverage like that when purchasing a note or would I have to buy all cash up front?
thanks
Joshua, it sounds like you don't want to commit a whole lot of time, and want it to be fairly passive after the initial purchase. Marc makes a great case for the passive ongoing income that performing notes offer. The capital commitment can be high. Here are some other options to consider:
* Place your funds with a hard money lending company - 8-11%
* Make direct loans to rehabbers - 12-18%
* Invest in a joint venture or syndicate with experienced investors - equity like investment with no guaranteed rate of return - target 15% and up
* Purchase high-quality rentals needing only cosmetic rehab (or even turnkey that are already rehabbed); these are probably homes you'll be all in for $110k and rent for $1,250 in good school districts; without leverage 7-9%; with leverage (15-20% + tax benefits)
* Rental property hybrid options that are intended to greatly reduce your ongoing time commitment, increase term of tenancy, and shift maintenance expenses to the tenant (lease with option to buy, sell with land contract/contract for deed) - 15% - 30%
And of course, in the note realm, since you enjoy homework, you can purchase non-performing notes that will require workout but can potentially provide very high returns of 20%+. Fairly steep learning curve, much less passive, and not the place to start.
Thanks David
I guess what I forgot to include was that in the past I have always used property management only if it cashed flowed and that how I would enjoy a passive investment. I was just trying to see how that compared to note buying. It seems like most big investors hold on to the actual property and not just the note. I have always liked knowing that my property is being paid off and my income grows and grows.
Two different worlds. Notes can be passive if set up through a qualified plan or administered, it is also an active income business. Notes can also get into very regulated areas, the business is much like any product and turn over generates more income in making new loans or buying and refinancing them. RE has a longer term goal with tax benefits and appreciation in the market to consider. You can not pass off maintenance and repairs to "tenants" as that is an ownership responsibility, but you can if you sell on an installment agreement (but not a lease-option) in residential properties. Commercial leases can pass off maintenance and repairs as well as in-fill requirements.
I'd have to say after doing both, notes takes less time IMO compared to residential. Notes were and are my choice after years of owning, with a few exceptions. The longer you hold a note the greater the risks assumed, but also true with RE, the risks and returns are different. The plus with notes is the velocity of money creating faster returns than RE. However, notes are difficult to leverage without getting into regulatory restrictions and banking while RE is easier to leverage using the other person's money.
More like asking if one likes turkey or beef, both are meat but different animals. :)
Joshua Sanchez
When it comes to long term investing, I like both hard property and notes.
I've found notes to be much more scalable and less work overall. Although they don't have the same tax advantages (like depreciation) I think notes are more profitable in both time and money.
All the ideas said above were great but I noticed the idea of Collateral Assignments was left out which is where you can recapitalize on your note by borrowing against it. And you could also sell a partial as well, this way your capital isn't as tied up and you can still cash flow off the note; just like leveraging a house.
To buy a note with no money down, you could create a partial or do a collateral assignment at the time of purchase.
Also keep in mind some notes are more affordable than others (like junior liens or notes without equity) so it all depends what your business model is.
Best,
Dave
P.S.
If you don't have a ton of capital to start, you can also check out Lendingclub.com. You can invest in notes with a minimum of $25 to start.
Good points by David. lots of tricks to the note business as in any other. Just to clarify in the no money down in a note purchase. Check your state laws first before you get any ideas. Exemptions for broker requirements are usually about using your money to buy a note. If you find a 25K note and get a seller to agree to take 10K and then arrange a purchase from a dealer or anyone else say at 15K and they use that money at the settlement, you are not buying with your money, you are brokering. It's most like the old double closing A-B, B-C in RE, but B can retain part of the rights of the note holder. Many of the concepts used in notes are applicable to RE deals, vice-versa, rent the note, sell off part, retain a future interest, flip it, buy and refi, borrow against it, partner in any of these areas, use it as collateral on another purchase of RE or other assets, lots of things can be done, but you need to understand what is your interest, your money and using other funds as well as being in the business rather than buying for your own investment purposes (investment isn't earning income by trading actively as a dealer), getting creative will usually put you in a position of brokering.
And, failed to mention, the barrier to entry is much higher in notes than RE, knowledge wise, to carry it off on your own. You need to understand all the aspects of RE as your collateral and more concerning legal requirements, foreclosures and contracting, buying with or without recourse and knowing how to modify a note, underwriting as well as the simple finance side. Putting your money with a broker is usually the way to start, but you won't be getting killer deals either, but probably safer deals. Buyer/investor beware.
All good points and makes me think that just buying single family homes is the better way for me at this point in my life since i do not have that much money but am able to save up for 20% down payments one small homes. I figure i can just buy anywhere from 1-2 homes a year. Then later if i decide to sell them i can take a note on it or i can sell and move up in property type like apartments or commercial.
Thanks everyone for the responses.
Joshua, keep in mind that creative thinkers and good negotiators can arrange great deals on both the note side and RE side.
Benefits of notes: true passive investment, no tenants, no property taxes, insurance, or utilities, ease of liquidity, ability to re-structure note thereby increasing yield, scalable.
The cons of notes is the lack of ability to use leverage (it is possible, just difficult), once the note is paid off, you must find a new note to buy to replace the income, less tax benefits than holding RE, typically if you choose to sell the note, you may have to sell at a discount greater than the costs to sell RE at full retail.
In my opinion, you should do both, not one or the other.
If funds are limited, start with the RE holding, then find a note to buy. You have options to flip the note, hold, sell partial, etc. getting creative can yield nice returns.
Passive income and active business income can have different tax impacts.
For individual investors, if using his/her own money to invest notes, at what point, the interest will be considered as active business income?
Direct lending private money to rehabbers--active business income?
Buying notes without brokering it out again--passive income?
@Linda L. - as an individual (or through your LLC as well), if you are just buying and holding notes, or just making loans, you should not have to worry about this being an active business and incurring self employment taxes. And a reasonable amount of selling is fine as well, as long as it's clear through the pattern of activity that you are primarily a buy & hold investor and not an active trader of notes.
Thanks, David.
There's one benefit I can think of--with active business income, one can contribute into solo 401K, that amount can be deducted from business earning, so generating less net profit, hence less taxable income.
Or turn this solo 401K into Roth 401K, so all profit generating afterwards are tax free.
Maybe at some point, the advantage can exceed the SE taxes.
Is there a way to structure it to give us the flexibility? Or it's really determined by the activities, such as frequent traders vs. buy and hold?
Linda, yes, the amount of money made relative to other income, the time devoted to the activity, the frequency of dealings and any entity exclusively dealing in notes can all determine if you are investing or if it is a business enterprise. Buying a note and selling it in short order won't take many to put you in the business as compared to stock trading, that can be seen as a brokerage activity.
If your 401k is doing the deal it's more likely to be seen as investing, but to a point, that provides a good cover IMO. You'll need to run that past the administrator of the account. Most don't like notes as they are not as liquid and they are difficult to value, more so than traded securities. But it is done, several here on BP do as I recall. :)
I do both, like Dave Van Horn, I like the scalability of notes and they typically have less management involved. Notes have a finite income stream & payoff. Owning real estate has more tax advantages & also the possibility of appreciation, equity growth, & the income from a rental will continue as long as you own & manage it.
I too believe that a combination of the two is the most appropriate and beneficial.