Investing in performing underwater notes

[Mike Day]

I am considering investing in some notes for the first time and want to know what people think about this idea. Is it a valid strategy to invest in performing first position underwater notes (where the borrower owes more than the home is worth)? It appears that being underwater is not actually a popular reason to stop paying, and not that many people did it even during the great financial crisis. Barring some kind of new crisis, it seems like the risk is probably only a few percentage points higher than loans that do have equity, yet these notes have much higher yields. Especially if you can get a good payment history on these notes, they seem only slightly more risky. Am I missing something? Because I'm thinking of making this a niche.

[Chris Seveney]

Quote from @Mike Day:

I am considering investing in some notes for the first time and want to know what people think about this idea. Is it a valid strategy to invest in performing first position underwater notes (where the borrower owes more than the home is worth)? It appears that being underwater is not actually a popular reason to stop paying, and not that many people did it even during the great financial crisis. Barring some kind of new crisis, it seems like the risk is probably only a few percentage points higher than loans that do have equity, yet these notes have much higher yields. Especially if you can get a good payment history on these notes, they seem only slightly more risky. Am I missing something? Because I'm thinking of making this a niche.

You're asking the right questions, and on paper, the math can look very appealing with underwater notes — but in practice, there’s a lot more nuance.

First, remember that you really have no idea what the property is truly worth unless you can get inside. These properties often come with added risk: delinquent taxes, lapsed insurance, unknown property condition, and possible code violations or liens. The borrowers also have less incentive to maintain the property, which can deteriorate faster than you expect.

We've done hundreds of notes, and while it’s true that being underwater alone isn’t always the trigger for default, we’ve consistently seen better overall returns — and smoother exits — on loans where the borrower has some equity or a strong incentive to stay. When they have something to lose, they tend to stay engaged.

Foreclosure timelines and legal costs also vary wildly by state, so what looks like a high yield can get wiped out quickly if you’re not factoring in delays, legal hurdles, or damage upon taking the property back.

It’s not that you can’t make money with underwater notes — you can — but if you're thinking of making it a niche, just go in with eyes wide open and build a strategy around low acquisition cost, strong servicing, and legal efficiency.