Notes vs real estate - which is better?

11 Replies

I'm looking at doing a 1031 of a property later this year into 3 new properties and have been toying with the idea of instead simply paying the taxes on the proceeds and investing in notes.  That got me to thinking about comparing the two scenarios in a simple way.  

So let's say I net $150k after taxes for notes, or $170k in 1031 (tax-sheltered) for buying three new properties to replace the one I sold.  Here's a rough approximation of how I see both going down (I'm near-completely-ignorant on notes so help me out here):

- 1031 for property

Put 56.6k down on each of three 175k houses = 3 mortgages at about 118k each. At about 4.75% for 30 years I show a PITI of about $959 (or $1262 for a 15 year note). These will rent in my area for $1300-$1500 so it will cashflow either way.

So, at the end of the mortgage term, let's say we now have three properties, each worth $225k (from their original 175k value).  The cashflow seen during the mortgage can be considered a wash, from maintenance expenses, vacancies, etc.  The end result is for 170k down, we now have three properties free and clear that are worth $675k.  That's a 390% return!

- pay taxes and buy note(s) instead

Pay the taxes and net $150k from the property sale.  Invest that into one or more notes that earn 10-12% interest annually.  Just for simplicity's sake I'll assume I got one note at $150k.  By the time that note is fully paid off (assuming it all goes according to plan) I may have collected (here's where my note experience makes the math fuzzy) a total of 325k or so from the owner.  Making for a profit of 175k on the initial 150k investment, a 116% return!

So it seems houses have won.  Or have they?

Notes seems to be a better idea as you near retirement, as they avoid tenant issues, unanticipated maintenance expenses (when your income is less since you're not working) and they also keep you from the snowballing of costs as the number of properties rises (more rental houses equals more chances for things to break).  But they also carry with them the threat of the buyer defaulting and you having to "take steps" to either get them realigned in an adjusted note or take them to court and repossess the house.

I'm 49 now, and will be 50 by the time I go to do this move, so I want to make sure I've considered everything and make a good decision that sets me up for entry 10-15 years from now for retiring.  Any help/feedback appreciated.

Hey @Paul Doherty  

Interesting exercise for sure.

A $150k note, is that a non-perfoming or performing? And is it a multi-family or SFR?

The reason I ask is because you can buy more than one NPN with that $150k, and if it's a SFR it's unlikely that someone will keep the mortgage for 30 years.

The national average is somewhere around 5-7 years, right?

So, you'd be turning that money over at least 3, maybe 5 times, in that 30-35 year span of time. 

I know it makes the calculations more difficult, but it's likely that someone with a buy and hold mentality is going to hold onto a rental for 30 years. So, you have to use the likely scenarios for the other option as well.

I think if you define those options better, you might get a better result. And that isn't to say that notes would win out after recalculating, but it might not seem like such a huge discrepancy. Not to mention if you go the NPN route there is possible Hardest Hit Funds, etc. to increase potential returns.

Anyway, as notes are my primary investment strategy I find this type of exercise super engaging. Either way, I think with managed expectations and proper due diligence, it would be hard to lose. :)

I'd guess that if you compare holding a note to term a rental would win out, you have a property at the end of the term, the note is paid off in full.

But that's not really the note business, look up the term "velocity of money" that will tell you that your discounted loan is to be paid off as soon as possible and reinvest that money again. That will burn your calculator up if you have payoffs within 60-90 days of buying your note!

Your discount is off as well and can't say as to your rate of appreciation.

I had rentals, I went to notes and got rid of most of my dirty holdings as I was losing opportunities for much, much, much better returns.

Anything in this world that makes money, any trade, job, profession, investment or anything else has a barrier to entry into that opportunity. The more money or profit that is available the higher that barrier will be. It takes land, labor, capital and entrepreneurship to take advantage of any opportunity, at least 3 of the four factor will be involved.

The barrier to entry for rentals can be rather low, the barrier to entry of note investing is pretty high, money and a greater amount of knowledge. Yes, there is luck, but just saying, note investing isn't something you just wake up and do one day because you have a pot of money.

You aren't considering the risks of your investing talents, you can lose every dime in a note if you screw up, much harder to do that with a rental. Now, if you hook up with a pro in notes, your return will be a bit less, but your risks can be significantly reduce and the barriers to entry drops.

Saying that your comparison of your alternatives don't carry the same risk and therefore are not good comparative investments, unless you get good help. There is much more to it than looking at numbers. Good luck :)

Thanks for the replies so far.  If either of you feel up to it, please modify my scenario and make it realistic WRT the way note investing actually works.  I'd like to see the comparison done realistically.

"But that's not really the note business, look up the term "velocity of money" that will tell you that your discounted loan is to be paid off as soon as possible and reinvest that money again. That will burn your calculator up if you have payoffs within 60-90 days of buying your note!"

Thanks @ Bill G.

If you could pay the note off in 60-90 days doesn't that seem to imply you could have just bought the note with cash to begin with?  How is that being accomplished that differs from doing it with cash up front?

One thing I didn't see in your analysis is reinvesting the monthly proceeds from the note, the miracle of compound interest

If you simply compound the interest you would have $775,198,17 after 15 years.  

Note this is interest income and taxable along the way and it assumes you can reinvest monthly and, realistically you would have to save up several payments to buy additional 10 or 20k notes.  But as you add more and more notes you will buy them more and more frequently.

If every time you save up 20k you buy a 20k note at 11% with a 15 year term in 15 years you would have 46 of those notes left, each paying $227.32 for a total monthly income of $10,456.69.  Some of that would be principle and some of the notes would be near payoff but still not to bad.

This comparison is a little off I think. We would not use a COC/ROI metric to compare but we can take a little bit of a better look for illustration purposes. We generally use IRR to compare assets.

Some assumptions:
Period Net Cash RE: $210 ([$1,500 Rent x 50%] - PITI)
Annual Net Cash RE:  $2,520

Period Net Cash Note:  $1,316
Annual Net Cash Note:  $15,796

So from a periodic performance the Note does better in terms of net cash.  

What about the equitable gain of $50k the OP used?

For the ease of not comparison here is one property, then three and then the note:
(Happy that copy and paste works well BP Admin!)

********* One Property Three Property ********* Note
Sale Price $ 175,000.00 $ 525,000.00 Loan $ 150,000.00
Down $ 56,600.00 $ 169,800.00 Rate 10%
Mortgage $ 118,400.00 $ 355,200.00 Term 360
RE Sale Price $ 225,000.00 $ 675,000.00 PMT $1,316.36
RE Sale Net $ 202,500.00 $ 607,500.00 A PMT $15,796.29
Total Sum $ 221,500.00 $ 664,500.00 Total Sum $473,888.65
P IRR 0.58% 0.58% P IRR 0.83%
A IRR 6.99% 6.99% A IRR 10.00%
Net Sum $ 164,900.00 $ 494,700.00 Net Sum $323,888.65
COC 291% 291% COC 216%

* 'P' = Period  'A' = Annual

So the deceiving part here is that the COC calculation says the RE looks better. It brings back more total dollars in the investment but takes longer to do so. Thus the return is less at 6.99%.

The note with a higher periodic payment simply brings us more cash faster on a periodic basis.  Again, the RE Rental brings us more cash longer on an total investment basis.  Thinking about that, simply apply what happens in reality.  

Obviously as variable inputs change so will the results.  The key to the RE evaluation in the OP is the majority of the anticipated gain comes from the sale of the asset.  Forecasting out 30 years for RE investing is not reliable.  The property can gain and loose equity.  We also know that rents can also fluctuate.  Further there is a chance neither investment goes to term for all sorts of reasons.  In the RE Investment most of the return comes from the equitable gain.  The note does not have that concern.  The note would have a prepayment risk but up to the time of prepayment the yield is still the same.  

This is not meant to be anything more than a general look at a comparison.  It certainly does not mean that any or all RE Investments are better or worse than any or all Note Investments.  It does give you an idea of the metrics of each side by side and hopefully illustrates that you need to be careful with comparisons to ensure that what is being compared from each asset is proper.   

In general, the takeaway here is the note performs better with these inputs.  It also gives us a gauge to understand that a note must yield greater than 7% to be comparable to the potential RE Investment.  Again, all things being equal, which most of the time they are not. Either way, we still choose the note over the RE.  Less unknowns and easier to manage and manipulate to some degree.  

Happy Investing. 

Oh, malarky the table did not post.  Man that feature would be great to get fixed.  Here is a image of it.

Hi Paul,

I own rentals and I own notes. Rentals are easier to get your head around because they are more familiar of an asset class and there is a lot of information and resources available to own and manage them. BUT you have the "tenants, trash and toilets" issue to deal with constantly. 

With notes you are the bank and the homeowner deals with the physical issues of the property, much easier from my perspective. I've been liquidating my rentals over the past 2 years and redeploying my capital into notes. I've yet to have a borrower call me because his neighbor's dog has been barking all night long.  

Now, if you buy the note at a good discount and have to foreclose, you should not only get your core capital back but most likely make a decent profit on the resale, or you can do a seller finance via land contract and restart your cash flow. This assumes that the property is located in a market which has some appreciation, which many now do.

From my perspective there are a lot less "moving parts" to owning a note if you purchase correctly and have your servicing set up right, there is inherently less liability since you don't own the property and the risk that come along with property ownership. 

Assuming you buy a performing note, you have cash flow with very little management headaches that are attached to owning a property, and if you have to foreclose, your servicer can handle this for you as a single source of management. 

If you buy a non performing note and "rehab" it, then you have a much greater equity spread between the cost basis of your purchase and the value of the loan and the underlying asset (the house). 

Buying and managing mortgage notes is a specialized niche and not for everyone, but if you have a decent head for numbers and are willing to learn some new approaches to owning investment real estate, it can be a wonderful way to have cash flow without as much hassle. 

We recently published a video of our last presentation with uDirect IRA on our website at the link below. Its about 35 minutes and you may want to watch it to get some additional perspective. 

Feel free to connect with me if you want to chat. 

Bob Malecki

I agree and second what Bob says. That being said, what are your goals and timeline? 

As a younger investor, I like a mix of notes and rentals. Notes are low risk and no tenants, toilets and trash, to piggyback Bob; however if you want passive income for greater than 30 years, good luck with notes. 

Thinking of income for 30+ years, I enjoy a mixed bag of both. Just be sure you stay on top of repairs and maintenance for your rental. But a business person, or person who can utilize organizational systems can overcome that hurdle rather quickly. 


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