Which NOTES have MORE RISK?

33 Replies

Like most investments, note investing can also be very active or very passive, depending on whether the note is performing or non-performing.

For note investors, which investments in your opinion have more risk and why:

1 - 2nd position performing notes in your own state close to home, or

2 - 1st position performing notes out of state in an area where the numbers make sense?

Originally posted by @Shiloh Lundahl :

Like most investments, note investing can also be very active or very passive, depending on whether the note is performing or non-performing.

For note investors, which investments in your opinion have more risk and why:

1 - 2nd position performing notes in your own state close to home, or

2 - 1st position performing notes out of state in an area where the numbers make sense?

 Irrelevant. Depends on equity, borrower and collateral. Tell me why a 2nd mortgage would be more risky if it's covered in equity, on a premium home worth 300k, with borrowers having good stable jobs? Versus a 1st mortgage worth 50k somewhere in the hood?

Usually subordinate debt requires a higher return than Senior debt. The same reason why equity investors have a higher required return because they are the last ones to get paid.

@Shiloh Lundahl   It also depends on if you have the cash available to deal with the first lien if they attempt to foreclose.  So here are the main questions to ask...

1)  Is there adequate collateral?

2)  Do I have enough cash to prevent loss to superior lien foreclosure?

3)  What is the situation of the borrower?

@Patrick Desjardins That's a good point.  I think as a rule of thumb, people just say 2nd position notes are riskier than 1st position notes without really looking into the equity, the borrower, and the collateral.  Thanks for your input.   

@Michael Biggs I think you are correct in that it is important to know if the collateral is adequate and also that you either have the funds to pay off the first lien to protect your position in case it becomes a non-performing not or if you have the ability to get a loan and pay off the 1st lien and take over the ownership of the property by foreclosing on the borrower.

But this answer doesn't really address the main question of the post which is "is having a 2nd performing note on a property close enough to watch over less risky or more risky than having a 1st performing note on a property that is in a different state and is more difficult to watch over yourself."

@Shiloh Lundahl   The location is not as important as the other items.  Just make sure you understand the local laws.

@Michael Biggs One of the risks of note investing is for the note to change from a performing note to a non-performing note.  So I am wondering if it is easier to manage taking the property over and turning it and re-renting it or selling it if it is local than if it is far away.

I would like to hear the opinions of some more seasoned note investors such as @Dave Van Horn , @Scott Carson , @Bob E. and others.

Which notes would you consider more risky, second position performing notes in your own area, or first position performing notes out of state?

@Shiloh Lundahl  what you are asking is skewed...but I'll give you my answer.  I live in Austin, TX which is one of the hottest real estate markets in the fastest foreclosure state in the nation.  I don't see first's or seconds period!  And I don't see much in Texas either so I had to invest outside of my home state.  I started with 2-3 states and have grown that as I've built teams in markets.  Personally, there aren't a lot of seconds out their currently to cherry pick from, but @Dave Van Horn is moving a couple this week (and one in Texas as well).  Obviously, anything in your area is going to be preferred but if you live in the AZ or CA, the notes you will see in your backyard are going to be expensive and rare to come across.  

@Scott Carson From what I can tell, you are an active Note investor more than a passive note investor correct?  Meaning you take notes that may need more effort In order to make them profitable and make them Perform at a higher interest rate.  Correct me if I’m wrong. But I’m wondering about passive  note investor. Someone who just wants to get mailbox but that may not necessarily have teams throughout the US.   For an investor such as I have described, what would you say has the higher risk? 

Originally posted by @Shiloh Lundahl :

@Michael Biggs One of the risks of note investing is for the note to change from a performing note to a non-performing note.  So I am wondering if it is easier to manage taking the property over and turning it and re-renting it or selling it if it is local than if it is far away.

 Definitely a risk in mortgage lending. There are many resources to resell your asset should you have to foreclose. Local vs. distant is not a factor. In fact if you limit yourself to local properties, you severely limit yourself on selection. To mitigate both issues, you may want to invest in a private equity fund that handles all of the management and let's you be completely passive. 

Bob

@Shiloh Lundahl  So far we have only done first lien notes or land contracts, that is our preferance because we are more secured and have more control.  It seems to me that a lot of people look at seconds like lottery tickets with the attitude that it's a cheap investment.  People with this approach are setting themselves up for a tough sled.

There are a lot of moving parts with notes.  As Scott summed up you need to look at if one in a Non judicial state, vs Judicial, time to foreclose, the quality of the note, the quality of the borrower, pay history, the condition of the property, the amount of equity if you have to foreclose, and if there are any other liens on the property and if they will be wiped out when you foreclose.  For the above reasons no two loans are the same, especially a 1st Vs. a 2nd but it is possible to weigh all the factors and make a choice between two notes.

@Shiloh Lundahl this may be a bit simplistic, but bear with me...thinking of your 10 closest friend  in high school. Imagine you gave each of them a loan of the same amount for 30 years. If your friends are anything like mine, since high school they've gone all over the place be it somewhere in my town, state, country, or the world. Would you base your risk on which of those loans was most likely to have a hiccup based on how close they still live to you or would you base it more on what you know about them? 

I think your overall question is lacking in some key factors that are more important than those you have presented. For instance, I live in NJ which many people stay away from in terms of note investing due to the long foreclosure periods. Even if I switched your question to a 1st next door to me it might be more risky than a 2nd in another state with equity. 

Further, are you defining risk as likelihood of default or potential lower ROI? A likelihood of default isn't in and of itself a great risk depending on the circumstances . For instance, there could be a great chance for an amenable loan modification or a deed in lieu that could occur even in a long foreclosure state that would alleviate the inherent risk of a long, drawn out foreclosure.

you can both do first position short term in your neighborhood.. lending to flippers.. of course flipper could go under.. but if you do them right.. good return mitigated risk. most cities of your size have some long term established HML who allow folks to invest in their deals.

To me the foreclosure rules are a key component .. when your buying notes that you did not originate.

@Odie Ayaga  that was a great example. That does make a lot of sense with regard to lending money to friends. It’s more about the friends’ character than about their location. I agree. 

The reason that I made this post in the first place was I have created some second position performing notes on some of my rentals that I have rented out as lease options. When I have talked to some people about these notes, I have heard from several people that they don’t invest in second position notes because they’re too risky. What I understood from what they were saying was that if the first position note stopped getting paid and they foreclosed, then they would lose their entire investment being in second position. My thought, which comes from some things that I heard in the podcast with David Van Horn, was that second position notes tend to give higher interest-rate‘s with lower capital invested. And if the first note stopped performing then the holder of the second position could pay off the first and foreclose and take ownership of the property in order to protect their investment Just as the first position good for close and take possession of the property.

My point was that, in my opinion, it is easier to manage the foreclosure and the sale or the leasing of the property again if it is closer than trying to build a team in a different state to manage all of that for you.  That is why I wanted to see - if a note goes bad and you have to foreclose on it, it is easier to do it when it is in your own state than to build a team in a different state and do it.

the notes you created have little value on the street.. there not even real notes if you just leased the property to someone.. if you owner financed it on a wrap and then took a second behind the wrap.. these you just need to hold and prey you get paid.

@Jay Hinrichs I appreciate your opinion, so I will give you some more details of what I am thinking of doing and would love to hear some of your thoughts on it. 

 This year we have purchased 16 buy and hold properties that we are doing lease options with. About half of these properties we were able to do with a 75% loan from the bank and we were able to get the majority of our money out. However, they were a few that we are less than the 75% loan and we have more equity just sitting in the property. Someone had mentioned to me to create some second position performing notes on these properties to get out about $93,000 among 4 properties. I thought that that was a good idea and I could pay off some of the debt that I have in my name that I have been using to fund my real estate. This would have a positive effect on my personal credit and I would rather pay an investor than a bank for the 93k that I have in the properties.

So I created 4 second position performing notes, they perform at between 11 and 12% APR. These are notes on my own rentals. However, I am the one that pays the notes from the cash flow that I receive from the rentals. So basically these are personal loans that are backed by the equity in my rentals. As I talk with investors, however, many are looking for higher returns on passive notes. I see these as very low risk investment at 11 - 12% because I am the borrower and my credit history is stellar. But other people have thought that they are risky because they are second position notes.

I would love to hear any thoughts or advice that you may have for my situation. Thank you.

@Shiloh Lundahl   I will let the note experts chime in here but I suspect most note buyers are not going to do cash out refi's to you.. and if they do they will want a massive discount.

but throw them up on FCI exchange there are all sorts of newbs that don't know any better and might bite.

@Jay Hinrichs Thanks for your response Jay. I will try that. I am not looking to discount them. I currently have the notes and get the 11% APR for them right now. I just wanted to reposition some cash right now. So I will continue to look for somebody who wants to be a purely passive investor who just wants to get 11 to 12% APR on their money for a 4 to 5 year period of time.

@Shiloh Lundahl   good luck that's far under the going rate of return most would want for a newly originated first on an investment property were the owner was yanking all his or her cash out :)  maybe you can get one of the note experts to Opine.

@Jay Hinrichs , thanks Jay, since I don’t need to sell them, I will just let people know that I have them and I’ll wait for someone who just wants to be a passive investor earning 11-12%. I know it may not be very attractive for an experienced note investor or active real estate investor but I think it may be attractive to someone who just wants mailbox money. So I will just keep looking.

@Shiloh Lundahl I am not one of the experts @Jay Hinrichs is talking about though you should be somewhat honored that he made his way to this conversation as he's about as knowledgable as anyone you could find in anything you could find that has to do with real estate so I'd start by going back and re-reading everything he said.

That said, part of what I think he's getting at is the more "homegrown" your note is the greater the discount you'd probably have to take to sell it. The less you get a servicer involved, or an RMLO involved, etc the more at risk you put yourself and the value of your note.

Getting back to what you mentioned, If you originated a 2nd position note and the first goes into default this does not give you an opportunity to work with the first to pay them off and whatever you might hope to happen from there. In general, if they are PAYING the first, but not you as the second that could give you some options to foreclose SUBJECT TO the first meaning if you were successful in your proceedings you would become property owner with the 1st position lien still in place.

If the borrower stopped paying the first (or very likely you AND the first) and the first foreclosed, you could entirely be wiped out depending on how much equity there is in the property. For instance, if you have a $20K second position, on a property with a $100K first position for a property value of $90K the first could foreclose and lose $10K, but you would be wiped out entirely. @Dave Van Horn could probably warn you to the dangers you're wading into better than  I could since he's been swimming in the waters of 2nds far longer than I have

@Odie Ayaga   what he is trying to do is

he owns the property.. he is originating his own note with him as trustor and beneficiary.. then he wants to sell it to yank his remaining equity out of the property.

Most folks I know in the bizz would look at this scenario and pass on its face regardless of the return.

@Jay Hinrichs that was sort of the idea of what I thought was going on. I don't know what the market for seller financed notes looks like perhaps you can provide some clarity. Does this seem like a particularly problematic seller financed note relative to what might be out there? He didn't mention an RMLO so I'm assuming there isn't one involved at this point

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