Note investing vs Buy and hold and how they affect net worth

Tax Liens & Mortgage Notes
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Note investing vs Buy and hold and how they affect net worth

Greg W.
Investor · IL · Member since 2017 · 2 posts · 0 votes

I am seeking perspective from the savvy note investors as well as established buy and hold (rental property) investors regarding the "best" strategy to grow net worth over time.  I am a current house flipper and looking to start converting into more passive investments and am really interested in the note investing concept.  I'm not entirely sold on the idea of note investing over buying and holding rental properties.  I understand that an advantage of note ownership is that its typically viewed as a more passive investment (no 3am toilet phone calls) and that is what attracts me to this concept.  The part that I am having trouble with is long term equity.  What I mean by this is that it seems to me that as the course of the note is paid, the equity is being reduced and more importantly, how this affects your net worth.  With rental properties (assuming your using leverage), you receive the benefits of increasing equity (forced savings via mortgage reduction), ability to lend against the asset, tax benefits, depreciation, cash flow, and possible appreciation to name a few.  With a note (while you can force appreciation by converting from non-performing to performing) you won't see any other appreciation, taxed at regular income rates, and lowered equity over the course of the payment schedule and it looks to me that you are only investing for cash flow.  Investing for cash flow in my mind is fantastic, I just want that perspective from a more seasoned person than myself as it pertains to the long term.  I do understand that there are some ways to have the equity in the note eligible for some types of lending.  This post is coming from someone who is not an expert in either field but someone who is looking to become very familiar with the core concepts of note investing before taking the plunge.  Thanks in advance for your responses.

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Don KonipolBusiness Member
Investor · The Woodlands TX / Avon, CT · Member since 2009 · 6k+ posts · 10k+ votes
8y

@Greg W., Your analysis is pretty solid.  In order to MAINTAIN equity with an amortized note, you will have to reinvest the principal part of the P & I payment you receive each month.  To INCREASE equity, you will have to reinvest both the interest and at least part of the principal payment.  What is lacking is protection from a sudden surge in inflation - or devaluation of the dollar.

What I try to do, to get the best of all worlds, is I have 50% of my portfolio in performing notes, and the other 50% in real property.  The real estate is leveraged 50%, so the total 'inflation protection' covers 100% of the total portfolio.

The notes are held in my tax deferred retirement accounts, so current income is not taxed until withdrawls begin at 70 1/2 years old.  Real property is held outside the retirement account, and while tax is paid on income/rents, depreciation will defer about 30% o the income, and the new tax law may eliminate tax on another 20%.  

So, my portfolio ends up something like this:  my notes average yield 16% (I buy some notes at discount, others I originate at 12- 18% interest), all of which is tax deferred.  Because I invest in income producing property, my net rental yield is around 8%, with yearly increases, leveraged with 4-5% loans, creating a net cash flow and debt reduction yield of about 10%.  My overall portfolio yield (exclusive of appreciation of real property of note discount at purchase) is about 14 - 15% annually.  When the capital gains are added on both notes purchased at discount and paid off at full face value, and real property appreciation, I obtain my 20% goal, on a very passive participation basis.

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  • Lisa DeCastro
    Real Estate Agent · Lakewood Ranch, FL · Member since 2014 · 3 posts · 2 votes
    8y

    Hi Greg, I can understand your point regarding the equity and purchasing a performing note, although being able to purchase directly from the banks and at a good price effects this. Purchasing a non-performing note can provide above average returns in a relatively short period of time, therefore providing the capital to purchase more non-performing notes and "churning" the funds. Much quicker than a buy and hold purchase can provide. That is the real cliff notes version of the process. 

    2Reply
  • Odie Ayaga
    Specialist · Delran, NJ · Member since 2016 · 2k+ posts · 951 votes
    8y

    Hi @Greg W. I don't think anything you said is inaccurate. As someone just getting started in notes I would recommend checking out the Note Inc podcast. Episode 001 in particular discusses in depth rentals vs notes towards the end of the show. If you want to build net worth I can't imagine you'd find anything in real estate better than rentals. However, and I'm sure you realize this, the reasons people get into other facets of real estate such as flipping and notes are for the other benefits those provide over rentals. 

    1Reply
  • Chris SeveneyBusiness Member
    Moderator
    Investor · VA · Member since 2015 · 21k+ posts · 19k+ votes
    8y
    Greg W. I ran an analysis of a performing note at 12% vs. most rentals and the returns on the note were better than a rental. Note that income from notes is no longer taxed at ordinary income based on new tax law.
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  • Johnathan Norman
    Seattle, WA · Member since 2014 · 56 posts · 45 votes
    8y

    Well from my experience the strategies that grow net worth the fastest require the most time. Non-performing notes are very much like flipping, it is certainly more passive in nature but requires more work than buying performing notes. The upside is faster capital growth. 

    Also performing notes can significantly impact your net worth in a positive way, remember the interest is what is paid first on the loan , your equity doesn't decrease much until much until late in the loan. Moreover you can still find performing notes at a (small) discount which is nice. 

    There are few things that can beat the tax benefits of real estate however which is why i do both which is to me the "best" strategy. 

    1Reply
  • Don KonipolBusiness Member
    Investor · The Woodlands TX / Avon, CT · Member since 2009 · 6k+ posts · 10k+ votes
    8y

    @Greg W., Your analysis is pretty solid.  In order to MAINTAIN equity with an amortized note, you will have to reinvest the principal part of the P & I payment you receive each month.  To INCREASE equity, you will have to reinvest both the interest and at least part of the principal payment.  What is lacking is protection from a sudden surge in inflation - or devaluation of the dollar.

    What I try to do, to get the best of all worlds, is I have 50% of my portfolio in performing notes, and the other 50% in real property.  The real estate is leveraged 50%, so the total 'inflation protection' covers 100% of the total portfolio.

    The notes are held in my tax deferred retirement accounts, so current income is not taxed until withdrawls begin at 70 1/2 years old.  Real property is held outside the retirement account, and while tax is paid on income/rents, depreciation will defer about 30% o the income, and the new tax law may eliminate tax on another 20%.  

    So, my portfolio ends up something like this:  my notes average yield 16% (I buy some notes at discount, others I originate at 12- 18% interest), all of which is tax deferred.  Because I invest in income producing property, my net rental yield is around 8%, with yearly increases, leveraged with 4-5% loans, creating a net cash flow and debt reduction yield of about 10%.  My overall portfolio yield (exclusive of appreciation of real property of note discount at purchase) is about 14 - 15% annually.  When the capital gains are added on both notes purchased at discount and paid off at full face value, and real property appreciation, I obtain my 20% goal, on a very passive participation basis.

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  • Alex Corral
    Denver, CO · Member since 2017 · 142 posts · 104 votes
    8y
    I have been thinking about this a lot as well. I have some capitol saved up & cant make up my mind which investment is better than the other. You'd think the buy & hold would provide better returns in the future because of rents going up, & eventually payoff. BUT, a capital expenditure or some vacancies & your ROI can be wiped out. That's why I'm intrigued by the reliable returns on notes, albeit lower. Don Konipol that is an excellent strategy! Would love to learn more about how to structure.
    0Reply
  • Tracy Z. Rewey
    Investor · Orlando, FL · Member since 2013 · 837 posts · 316 votes
    8y

    @Greg W. Your analysis is right on track and  @Don Konipol provides some great insights on getting the most benefits our both strategies.  

    When we buy a note and the real estate value goes up it makes our investment safer as the payor has more equity.  This equates to more motivation for them to pay and more options for them should they get in a financial bind. As investors our ITV goes down and if they default we are protected by more equity should we need to take the property back and resale. But if the note pays as planned (which is the hope of cash flow investors) we don't reap any monetary benefit from property appreciation.  As @Johnathan Norman mentioned this is different than the NPN strategy hoping to get a preforeclosure property for a potential flip or workout.

    One thing we don't talk about much as note investors is the ongoing need to redeploy capital. For example, when you buy a note at a discount and then it pays off early there can be a huge increase in our yield. BUT now you need to reinvest that cash at the same or greater ROI. Depending on the current environment and competitiveness of the market it can sometimes be hard to find the same yield for the same risk. If we let the cash sit then the benefit of that yield bump goes down.

    Even a 30 year note usually pays off in an average of 7-10 years. So creating a pipeline for reinvesting is an important part of the long-term strategy. It is part of the reason it makes sense to refer some notes for a fee and keep others for yourself or your SD IRA as inventory needs replenished. You are always making money off your pipeline by either wholesaling the note or investing in the note.

    6Reply
  • Danny RandazzoPro Member
    Apartment Syndicator · Charleston, SC · Member since 2016 · 973 posts · 728 votes
    8y

    @Greg W. That answer to this is...it depends. It depends on your market, your buy and hold asset class and your needs/wants as an investor. It sounds like you are thinking about your options correctly. My suggestion would be buy one of each and see how both compare for you, in your market, and compared to your goals. Create your own luck. 

    0Reply
  • Mike H.
    Rental Property Investor · Manteno, IL · Member since 2009 · 2k+ posts · 2k+ votes
    8y

    I think the biggest factor to determine which route to take is how much money do you have to start with and how much do you want your investments to be worth over some set period of time (i.e. 10 years, 20 years, etc).

    If you're starting with 100k and getting 10 to 12% return, you're making 10k to 12k a year? What does that look like in 20 years in terms of the value of the notes and income they're generating? 

    But if you use it buy real estate instead, and say you leverage it with the BRRR strategy and come out of pocket 7 to 10k per house, what does that look like in 20 years in terms of value and income.

    Assuming a bread and butter deal here I'm seeing here in illinois, you'd be buying a house worth 150k and all in at 100k to 110k. You could use the BRRR method to add 10 to 12 homes.

    So now you'd own about 1.5 to 1.8 million in real estate. You'd owe 1.1 to 1.2 million. And you'd be getting 1,500 to 2k a month in net rental income - in the beginning. That income would slowly go higher over time as rents go up. 

    In 20 years, when the houses were paid off and likely be worth about double the 150k per house (historical averages here in midwest), you'd have about 3 to 3.5 million in real estate and you'd be making 10k to 12k a month in rental income.

    I'm not saying you can't do that with notes - based on what some friends of mine were doing a few years ago. If you buy non performing notes and can get them paying again and can find them at discount, who knows.  But those same friends stopped buying notes completely and switched over to rentals about 3 years ago because, to them, the numbers weren't even close.

    What I would say is that the rentals are going to be way more work than notes.

    So which one would produce the most net worth? Its going to be real estate - hands down - provided you buy right and use the BRRR method to stretch your capital and take advantage of OPM.

    2Reply
  • Bill R.
    Henderson, NV · Member since 2014 · 111 posts · 163 votes
    8y
    Originally posted by :

    Even a 30 year note usually pays off in an average of 7-10 years. So creating a pipeline for reinvesting is an important part of the long-term strategy. It is part of the reason it makes sense to refer some notes for a fee and keep others for yourself or your SD IRA as inventory needs replenished. You are always making money off your pipeline by either wholesaling the note or investing in the note.

    In the bond world, I've seen a lot of people get stuck in a similar scenario.  They buy a 20 or 30 year bond at X% interest and think that they're getting that income for the next 20 or 30 years.  But most bonds have a call provision which allows the issuer to call the bond early (they pay off what they owe).  Of course, when do bond issuers pay off their bonds early?  When they can refinance at a significantly lower rate.  So, maybe you had a bond paying 12% interest when inflation was high but now rates for a similarly rated bond are 6% so they exercise the call option and pay off the bond holders who now have to go out and reinvest that money at prevailing rates (e.g. 6%).  

    It's not a reason to not invest in notes, just an area that doesn't receive as much attention as it should in terms of planning cash flow.  

    0Reply
  • Patrick Desjardins
    Real Estate Investor · Amherst, VA · Member since 2015 · 386 posts · 400 votes
    8y

    Don's model is basically what I'm trying to do as well. I personally heard this strategy from Gordon Moss but I'm sure it's been around for a long time.

    They both complement each other. Notes are higher cash flow / less demanding, but are finite (at some point they run out) and their value diminishes over time. Real estate's cash flow is typically lower and more demanding, but in theory it should last forever and accrue in value. And even in areas with stagnating prices, rent rates have still gone up.

    You can also get some of the rentals at a discount through the note, so even if you're not an expert landlord you get the houses cheap enough that you can't really mess up.

    3Reply
  • Don KonipolBusiness Member
    Investor · The Woodlands TX / Avon, CT · Member since 2009 · 6k+ posts · 10k+ votes
    8y
    Originally posted by @Patrick Desjardins:

    Don's model is basically what I'm trying to do as well. I personally heard this strategy from Gordon Moss but I'm sure it's been around for a long time.

    Just to be sure to give credit where it's due, this strategy was first told to me in 1979, by Jimmy Napier, author of the BEST book on note investing ever written 'Invest in Debt'.

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  • Khanh Tran
    Pearland, TX · Member since 2017 · 42 posts · 0 votes
    8y
    Originally posted by @Chris Seveney:

    Greg W.

    I ran an analysis of a performing note at 12% vs. most rentals and the returns on the note were better than a rental.

    Note that income from notes is no longer taxed at ordinary income based on new tax law.

     So what is the income tax rate for income from notes?

    0Reply
  • Chris SeveneyBusiness Member
    Moderator
    Investor · VA · Member since 2015 · 21k+ posts · 19k+ votes
    8y

    @Khanh Tran - With the new tax laws these are passive income so they will be taxed at 21% is my understanding. I need to confirm with my CPA but that is what I have been told (note: I own them through an LLC).

    Previously with it being through the LLC is was taxed as earned income.

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  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    8y
    Originally posted by @Tracy Z. Rewey:

    @Greg W. Your analysis is right on track and  @Don Konipol provides some great insights on getting the most benefits our both strategies.  

    When we buy a note and the real estate value goes up it makes our investment safer as the payor has more equity.  This equates to more motivation for them to pay and more options for them should they get in a financial bind. As investors our ITV goes down and if they default we are protected by more equity should we need to take the property back and resale. But if the note pays as planned (which is the hope of cash flow investors) we don't reap any monetary benefit from property appreciation.  As @Johnathan Norman mentioned this is different than the NPN strategy hoping to get a preforeclosure property for a potential flip or workout.

    One thing we don't talk about much as note investors is the ongoing need to redeploy capital. For example, when you buy a note at a discount and then it pays off early there can be a huge increase in our yield. BUT now you need to reinvest that cash at the same or greater ROI. Depending on the current environment and competitiveness of the market it can sometimes be hard to find the same yield for the same risk. If we let the cash sit then the benefit of that yield bump goes down.

    Even a 30 year note usually pays off in an average of 7-10 years. So creating a pipeline for reinvesting is an important part of the long-term strategy. It is part of the reason it makes sense to refer some notes for a fee and keep others for yourself or your SD IRA as inventory needs replenished. You are always making money off your pipeline by either wholesaling the note or investing in the note.

     For those very reasons is why I like performing notes and for the investor to hook up with a company that is in the business of originating good solid performing notes like @Don Konipol and or some other affiliated companies.. we never run out of notes so when one pays off you roll into a like kind note in a matter of days.. So those are great points when out there chasing NPN or super high discount yield notes.. they are not just that easy to get takes a lot of money to even find them in direct marketing etc.. wereas when the investor hooks up with the right company that's all done for them and 100% the return goes to them minus a tiny amount for servicing but they spend Zero money on finding the dog gone things .. which as you state is a real challenge in todays highly competitive world of trying to find discounted owner carry back owner occ notes..

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  • Michael Williams
    Real Estate Agent · Los Angeles · Member since 2018 · 8 posts · 6 votes
    7y

    @Don Konipol fantastic insight, in your opinion would it be better to start your portfolio in multifamily and start deploying capital to notes? or the other way around?

    0Reply
  • Chris SeveneyBusiness Member
    Moderator
    Investor · VA · Member since 2015 · 21k+ posts · 19k+ votes
    7y

    @Michael Williams - There is no right answer to this, it depends on your situation. I work for a multifamily developer and buy notes for my own portfolio. Each has its benefits and disadvantages and people can debate one is better than the other. What it comes down to is

    1. What did you pay? 

    2. How are you managing it?

    I believe #2 is significantly more important than #1. I am a firm believer you make your most profit when the asset is well managed. In today's economy, the pricing is set by the market with some variation and some discounts/deals. This discount may allow for some room for error, but if the asset is continually mismanaged it will not be profitable and your resale value will be significantly less. This goes for both a note and a multifamily property.

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  • Josh Thomas
    Rental Property Investor · Fort Lauderdale, FL · Member since 2015 · 65 posts · 15 votes
    7y
    Originally posted by @Chris Seveney:

    Greg W.

    I ran an analysis of a performing note at 12% vs. most rentals and the returns on the note were better than a rental.

    Note that income from notes is no longer taxed at ordinary income based on new tax law.

     Hi @Chris Seveney can you elaborate how you interpret note interest is taxed?

    Based on this link it seems the IRS still qualifies it under ordinary income.  
    https://www.irs.gov/taxtopics/tc403 

    0Reply
  • Alex Booth
    Member since 2018 · 38 posts · 15 votes
    2y
    Quote from @Chris Seveney:
    Greg W. I ran an analysis of a performing note at 12% vs. most rentals and the returns on the note were better than a rental. Note that income from notes is no longer taxed at ordinary income based on new tax law.
    What new law affected this? I was always under the assumption that the interest portion of each note was classified as regular income. 
    0Reply
  • Chris SeveneyBusiness Member
    Moderator
    Investor · VA · Member since 2015 · 21k+ posts · 19k+ votes
    2y
    Quote from @Alex Booth:
    Quote from @Chris Seveney:
    Greg W. I ran an analysis of a performing note at 12% vs. most rentals and the returns on the note were better than a rental. Note that income from notes is no longer taxed at ordinary income based on new tax law.
    What new law affected this? I was always under the assumption that the interest portion of each note was classified as regular income. 

     No idea. that was six years ago and as of today I agree with you the interest portion is classified as ordinary income.

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