Why You should Stop Buying Rentals And Become The Bank

79 Replies

Let's set the tone straight; most people don't get into the rental business because they like to manage problematic tenants, deal with leaky toilets or attend eviction hearings.

Most people follow traditional investment strategies, that are taught to be passive, but that in reality are far from passive for the great majority of investors.

At the very core, most people begin in therental business because they believe in the fundamentals of investing and desire to create some level of freedom and passive income to supplement their current income, and at the same time would like to have some sort of control over their investment.

There is nothing wrong with this, and i certainly wouldn’t want to discourage anyone from buying rental houses, if that’s what you really want to do. This article will simply show you a different way. A better way to create true passive income.

The whole idea of investing in an asset is to let the hard earned money you have accumulated over the years, work for you, to let it grow for retirement,on its own, without having to invest more time and energy. Isn’t that what an investment should do?

Let's take a look at the definition of passive income.

Investopedia's definition of passive income is "Earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not materially involved."

The key words are "not materially involved"

With rentals, this passive income idea becomes illusive as the mere management of it can become a big undertaking. If you hire the wrong management company, or if tenants don’t pay the rent and you have to evict and then rehab afterwards.

In addition, if you have a sizeable portfolio this becomes a real operation and could become far from a passive investment.

Managing 100 houses is a real operation that even management companies have trouble doing.

Real Estate Notes.

Investing in real estate notes gives you the freedom and flexibility to keep your current job and still enjoy an above average return without the headaches of managing tenants or dealing with management companies.

But first. What is a real estate note?

There is a lot of confusion in the market place about what real estate notes are and I’d like to demystified and simplify what a real estate note is. Because, it’s not rocket science. It truly isn’t. in fact. Real estate notes have been around since the barter system was around.

A real estate note in its simplest form is a loan. A loan that is securitized with real estate. It is a written promise to repay a specified sum of money plus interest at a specified rate and length of time to fulfill the promise.

Some of the Benefits of investing in real estate notes are:

1. A Real Estate note offers you the ability to keep your 9 to 5 and still be able to enjoy a passive return

Most of us have primary jobs that we’d like to keep. Real estate notes allows us the time to keep doing what we do best and still be able to grow our retirement basket with an above average return.

2. Avoid the typical hassles of owning rentals.

If you want to deal with tenants, evictions, leaky toilets etc, then having rentals is the way to go, but most of us aren’t particularly interested in doing that, especially when we have full time jobs and families to take care of and spend time with.

3. Monthly and Consistent income you can count on.

Most people are very responsible when it comes to paying their mortgage payment. There is a different level of commitment with owners than with renters, wouldn’t you agree?

4. Real Estate notes are backed by real estate:

Default is always a possibility. It’s one of the biggest risks that comes with investing in real estate notes. There are ways to mitigate this risk by buying notes that are in states where the foreclosure is simple and quick, like it is in Texas.

5.Real estate notes are backed by real estate.

The underlying collateral is real estate. A hard asset you can touch, see, put a value, and insure against. Tell that to your stock broker and share your experience with us.

6. Insurable against loss.

When was the last time your stock broker, insurance company or bank insured your stock against lost?

In short, this article was written to show you a different way to invest in real estate, to demystify the note business and to give a different option to a market place that has put a whole lot of energy into a singular form of investing for far too many years. It’s time for a better way.

@Patrick Faherty

Being a note buyer/Lender is a tremendous way to succeed without a lot of headaches. However, you do need a lot of money to make it work in a significant manor. Buying a single note won't change much for the average person. That is why people buy rental homes. Over time they can accumulate wealth.

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Definitely agree rentals can be a pain. Overall though, even self-managing, I can't go from extremely tax-advantaged (my effective tax rate has been negative for 13 years) to being creamed. Income taxes are our largest lifetime expense.

Nobody is treated more harshly at tax time than interest earners as far as I know. At least until my kids are out of the nest (there goes $2k per in credits if you earn too much interest) I'll stay with rentals.

Thanks for sharing, Fred! Could be a nice blog post!

I love notes and hold many of them in my portfolio.  Like rental real estate, notes have their strengths and their weaknesses.  Consider the following:

  • Inflation - In an inflationary environment, real estate values will rise with inflation while the value of notes will decline (because the value of the dollar that is loaned is declining). 
  • Taxes - Income received from rental real estate is significantly sheltered from taxation by property depreciation.  Interest received from loan repayment has no such built-in tax advantages.  Because of this and other factors, notes are a very nice asset to hold in self directed retirement accounts where the income is tax advantaged.
  • Appreciation - Loans simply don't appreciate in value.  Real estate may not either, depending on the market, but the opportunity for appreciation is there if the real estate is in the right market.
  • Leverage - As a general rule, you can't get financing to buy a loan.  You have to buy loans with cash.  We all know that it is quite common to buy real estate with financing. 

So while notes don't have the same maintenance and other difficulties that come with real estate, they don't have many of the benefits either.  My view is that is good to have both notes and real estate.  I like to hold notes in self directed retirement accounts so that the returns are protected from taxation.  I like holding real estate outside of retirement accounts where I can take advantage of financing and built in tax advantages.

@Sean Dolan there is no real sweet spot for notes, I have purchased 7 this year with less than 60k.  None of these were performing at the time so the price is different. @Mike Hartzog is correct when saying you should own both. Fred makes some good points about notes also but there is plenty of work to be done and can and will have hassles, just different hassles. 

@Patrick Shawn Faherty   rates of return depend on what you pay for the note, how long you hold the note etc... you make your $$ when you buy... There is no minimum "buy-in" unless you are buying into a fund and at that point you need to be an accredited investor most likely.

FCI, PPR,  and others. I haven't bought any notes from any exchange, I used my contacts who get assets direct.  I partner with other to get the most value for my $$

This is a great thread and thumbs up to the OP.  I started private lending four years ago and have found it an excellent source of income.

@Patrick Shawn Faherty   it's  subjective.  what  one  may think is a sweet note another  investor would never buy it..  It comes down to risk tolerance,  expectations  and current cash  you have..   Our investors  expect a return  of  anywhere from  10% to 13%  for first  lien performing  notes  and  those go anywhere from $40,000  to $90,000 

Eh, let's readdress some ideas in here:

@Fred Ramos
"A real estate note in its simplest form is a loan. A loan that is securitized with real estate."
- a real estate loan is not "securitized" but rather "secured".  Those don't mean the same thing.

Items 3,4 & 5 :
- First and foremost, most of the notes being purchased by street level investors are distressed loans.  Thus they carry a higher risk of default than that of a prime loan.  Wanting to pay and being able to pay are two different ideas.  
- Buying loans in non-judicial states is not a mitigation of loss or risk.  Just because you can foreclose on an asset in a shorter amount of time does not necessarily mean you will mitigate any loss incurred by way of purchase, advances and disposition.  In addition, this is a commonly misunderstood target of newbie note investors.  Texas loans are "better" because they are quicker.  Quicker doesn't mean better.  Pricing for loans in states with longer foreclosure timelines are in line with the amount of time that it takes to disposition that note.  In other words, pricing is relative for all assets.  You can lose 100% of your investment in Texas just like you can in New York.  

Item 6:
- Nobody around these boards are buying loans insured against loss.  Certain loans may contain private mortgage insurance policies but those will not commonly trade to a street level investor.  In addition, those do not insure against full loss only a portion thereof after the investor properly dispositions the asset and files a claim that gets approved.   The point is, we should not imply there is insurance protection against defaulting loans since for the majority of the market there is none.  

@Mike Hartzog
Inflation - In an inflationary market real estate values rise.  Usually because credit markets expand and interest rates lower.  This increases the value of the property.  As such, the "value" of the loan rises due to balance increases and the market rate return is pushed lower.  We are experiencing this now.  

Rates are 3.5% to 4%.  Property values have increased because lower rates are prevalent allowing for more borrowers to buy more property which increases the price.  As such, the balances of those loans are higher which means buying a loan, even at a discount of 25%, implies paying more for a loan than in the previous market.  Since capital market returns are pushed lower, pensions and insurance investors will accept 4% returns, this additionally drives the already inflated price of the loan upward since the discount for yield or return is lower in the market due to investor competition seeking a lower return.  

The idea that you are buying "more loans cheaper" is riskier because more loans cheaper also means higher probability of negative equity when inflation starts to deflate.  See 2006-2008.

What actually happens is you buy more loan for lower return with an innately higher risk of loss due to the higher probability of a slide in equity.  

@Sean Dolan
The price points for loans varies widely due to many factors.  None of which were really defined in the answers given to you.  Loans trade for a premium (100% balance plus), par (100% balance) and discounts (less than 100% of balance).  How much of a premium or discount in a loan's sale price will depend on the investor buying and the holder selling along with the characteristics of the loan including the borrower, paperwork and collateral.  

As I stated above, most private street level investors are purchasing distressed loans.  So the balances are discounted.  Those discounts can rage from 0% to 95%.  Recovery of capital can range from a nice return to a loss of capital.  The amount of discount is a function of the defects within the loan within the borrower, paperwork or collateral and are influenced by the amount of time and effort it takes to disposition the asset.  

There is a market at work when it comes to loans.  The secondary mortgage market.  Private street level investors are but a mere fraction of that market.  As such, their influence or ability to be market makers is greatly suppressed.  This is important to understand because in general when capital market returns trend downward we tend to see risk spike upward.  This is currently happening and has been happening for several years.  Investors will seek riskier assets, they will define those additional layers of risk as minimal to justify a greater than market return.  

The 10 Year Treasury yields 1.5%.  The 1 Year Treasury yields 0.60%.  That is a "risk free rate of return".  When investors start talking about returns in the double digits, as opposed to simply double or triple the return in a risk free investment then, naturally, the risk is elevating.  When Icarus flew too close to the sun, he lost his wings.  

In regards to the suggest of own both performing and non-performing loans, I find that most newbie investors are romanticized by non-performing loans and the illusions of grandeur.  What is ever lacking is a proper evaluation of the real risk to capital and the amount of capital needed to actually disposition the asset.  In distressed performing loans the market will deliver somewhere between 8% to 12% yield.  In non-performing loans the market will deliver 20% returns.  Real returns are influenced by servicing and administration.  Realizing the payment of a discounted loan sooner rather than later increases your return.  However, the market doesn't allow for investors to seek those higher returns on a silver platter.  Bidding a loan with higher than general market prices will typically result in a non-sale.  Adversely, if you are winning bids along the lines of 40% returns, in example, you should pause and ask yourself if you are taking on excessive risks.  

Cavet Emptor.  

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@Dion DePaoli - I agree with your comments regarding decreasing/increasing interest rates impacting the value of existing loans.  The same dynamic happens in the bond market.  It is true that lower rates with drive up housing prices as they have over the past few years.  This affect, however, is limited to the housing market and is not inflation.  The inflation rate for the US economy overall has been hovering around 1%, which is shy of the Fed's 2% target.  What I am talking about is broad inflation like we saw in the 1970s and early 1980s.  In that type of environment, hard assets like real estate can help preserve wealth. 

@Mike Hartzog

In an inflationary market a property worth $100k becomes $110k.  The $20k you had for down payment goes from being 20% to 18%.  The smaller $90k house becomes $100k.  So if 20% is required to buy, the product is of lesser value than it was prior.  (Such as a smaller house)  The price of the asset increases and the value for which your down payment dollar will get you decreases.  That is not limited to the housing market, it is inflation for any market.

The main point to my call out was that while the real property value increases the value of the note does not decrease.  It goes up.  I saw another thread where somebody tried to make the same claim and is not accurate.  In an existing note, if the value of the home increases, the borrower has more equity and a note seller will demand a higher price due to increased equity.  In addition, new credit extended is at the higher purchase price do to the increase in value.  Not to mention, an older note would typically have a higher rate and therefore a sale price in a market going from 8% to 4% warrants a higher price.

In deflationary markets the note investor is susceptible to extension risk.  The risk that a return today at 4% is less than a return tomorrow at 8%.  Since credit then becomes more expensive, less expensive credit to the debtor is more valuable and is held longer.  So it will take the note investor a longer time to recover and reposition their capital at the higher prevailing rates.

To that extent, in a deflating market the note holder looking to sell is up against the same extension risk issue in the secondary market.  Since new credit is garnering a high return, a lower yielding loan from the prior market condition will warrant a larger discount - therefore costing the selling note holder to lose money on the way down.

Lastly, as you know, holding a note is not the same as holding real property.  So a note owner should be considerate of how market inflation and deflation affects their assets, they do not directly benefit from the real property as an inflation hedge.  

@Mike Hartzog @Dion DePaoli Great information guys, a lot of it is going over my head though. ;) Let's say I have $50K that I don't necessarily need to make any return on for 15 years, and I want the least disruption of my current business (least hassle/involvment, but if the return on my time is over say $500/hour, I'd be fine jumping in to resolve any issue) How would you go about investing this? 

@Sean Dolan

To recap, you have, in example, $50k in capital and a 15 year investment horizon.  The risk you are willing to take sounds minimal as you do not want to disrupt other things in your life.  

A good performing loan can certainly help you gain returns that have the potential to exceed typical stock and bond investments. As I mentioned, the market for those types of investments for street level investors is usually going to be loans which will yield somewhere in the 8% to12% range. Where 8% will be less risky than 12%. Many REI and Note investors will seek a 10% yield with the least amount of risk they can find.

Depending on how much you really want to be involved you can look to investment funds who pursue the asset class or you can look into notes on your own.  It is hard for us to quantify $500 an hour for you as some more experienced folks might solve an issue faster than you.  There are certainly loans which have investment horizons less than and beyond 15 years.  In that idea, you sort of have to contemplate do you want to make one investment or pursue shorter investment terms and reinvest from time to time.  So, for instance make/buy 3 - 60 month loans or one 15 year loan. 

Once that idea is resolved, I suppose you can address what to do with reinvestment of return.  Since the investment horizon is out far, does that mean you also wish for the return on the $50k to be reinvested?  

One year of payments might not be a suitable investment size to flirt with the asset class.  So that might require a lesser interest bearing account to accumulate enough to reinvest.  Obviously, you can simply take the return distribution and buy yourself nice things.

For simple math we can apply the Rule of 72.  If you earn 7.2% interest you will double your money every 10 years.  In tandem, if you earn 10% interest you will double your money in 7.2 years.  The rule breaks down the farther you get away from the core numbers.  It is meant to be a simple mental exercise in evaluation of return, that is all.  

So to answer your question, you have more to consider and define.

@Dion DePaoli  By definition, in an inflationary environment money loses its value.  When this happens, it takes more money to purchase hard goods than it did before.  Therefore, the true value of cash I have in accounts as well as money that I am owed (loans) goes down.  It's a very clear relationship. 

Yes, when the value of collateral appreciates, the equity position of existing debt secured by that collateral improves.  This could have a small impact on the price a given loan would sell for in the secondary market.

So what do you think the Fed will do in the event inflation increases significantly above their 2%target?  Who knows, but my guess would be that part of the strategy would include raising of  interest rates, like they did in the early 80's.  The federal funds effective rate was over 18% at times in that time period. What happens to the value of your 8% rate loan when new debt can be issued in the high double digits?  Take a guess... You definitely would want to be a borrower at 8% rather than a lender in that kind of environment.

@Mike Hartzog

Last Friday the Fed guidance was, and I quote:  "..70% chance rates will be between 0% and 4.5%"

LOL - so take that how you will and contemplate what happens to the outlier 30% over a nice holiday libation.