What are the downsides of mortgage note investing?

Tax Liens & Mortgage Notes
6yFollow

What are the downsides of mortgage note investing?

Nicholas Z.
New to Real Estate · Mountain View, CA · Member since 2020 · 57 posts · 31 votes

I've been researching mortgage note investing, and from everything I've read, it seems like a great way to invest in real estate. However, I've not seen much about how mortgage note investing can go bad. According to what I've read so far, assuming you've purchased a first-lien mortgage, the possible outcomes are:

1. The borrower continues to pay, so you get regular monthly income.

2. The borrower refinances, so you get paid a large lump sum and exit the mortgage.

3. The borrower pays off the mortgage, you get a large lump sum and exit the mortgage.

4. The borrower stops paying, at which point you can:

   a. Sell the mortgage note

   b. Reach out to the borrower to try to get them to pay again

    c. Foreclose on the property

This seems about as close to a no-lose situation as there can be...and that gives me pause. I don't believe in no-lose situations. There's always some way for things to go wrong and you lose your money.

So the question is: what are the downsides of mortgage note investing? How might I actually lose all or most of my money doing this?

1Reply
69 views

Most Popular Reply

Jamie Bateman
Investor · Baltimore County, MD · Member since 2014 · 466 posts · 439 votes
6y
A few others to add: 1) there are no tax advantages to note investing, 2) a note decreases in value as the principal balance is paid down, 3) the borrower can stop paying and it is possible you cannot foreclose because there is not a clear chain of assignments/title, 4) see my blog post here on BP comparing notes to rentals: https://www.biggerpockets.com/...
4Reply
See this reply in the discussion

25 Replies

Jump to latestLatest
  • Chris SeveneyBusiness Member
    Moderator
    Investor · VA · Member since 2015 · 21k+ posts · 19k+ votes
    6y

    @Nicholas Z.

    Downsides:

    1. Borrower stops paying, files Bk, stops paying, file foreclosure, file another bankruptcy... they can really drag it on and when you buy or sell a non performer it trades at a significant discount.

    2. You are guesssing on the property value as you do not get to see the inside. I had a property that should of been worth $75-$100k but guy was lazy and had a blocked pipe that led to 4 ‘ of water in basement and house was filled with mold.

    3. Borrower sues you and you are forced to defend a lawsuit whether it’s frivolous or not

    These are just several, but if people tell you buying non performing notes is passive, it is far from it. It is not passive and takes a while to scale.

    7e investments53 Reviews
    WebsiteView Page
    3Reply
  • Cody Cox
    Note Investor · Wilsonville, OR · Member since 2010 · 149 posts · 113 votes
    6y

    You foreclose after 12 months of court proceedings. Finally, get title to the property (assuming there is no redemption period), only to find there are squatters in the house. Additional court time and costs to get them removed. Then paying the sheriff to forcibly remove them. Meanwhile, property taxes continue to be added, utilities continue to be added, and code enforcement adds fines. 

    2Reply
  • Jamie Bateman
    Investor · Baltimore County, MD · Member since 2014 · 466 posts · 439 votes
    6y
    A few others to add: 1) there are no tax advantages to note investing, 2) a note decreases in value as the principal balance is paid down, 3) the borrower can stop paying and it is possible you cannot foreclose because there is not a clear chain of assignments/title, 4) see my blog post here on BP comparing notes to rentals: https://www.biggerpockets.com/...
    4Reply
  • Jamie Bateman
    Investor · Baltimore County, MD · Member since 2014 · 466 posts · 439 votes
    6y

    @Cody CoxPurely hypothetical, @Cody Cox?

    1Reply
  • Nicholas Z.
    OP
    New to Real Estate · Mountain View, CA · Member since 2020 · 57 posts · 31 votes
    6y

    So it sounds like the downsides are all related to when the borrower stops paying and that foreclosure is not straightforward, fast, or cheap.

    Any downsides to performing notes (other than becoming non-performing)?

    @Chris Seveney under what circumstances would a borrower sue a note holder?


    @Cody Cox that sounds unpleasant. Reminds me of trying to evict in MA. 

    @Jamie Bateman thanks for the link, that was very helpful. I’d definitely prefer to own rentals, but looking at all aspects of real estate to figure out how best to leverage my money. 

    0Reply
  • Bob Malecki
    Investor · Kingston, WA · Member since 2008 · 1k+ posts · 1k+ votes
    6y

    @Nicholas Z. well no tax sheltering as the interest income is ordinary income. Also if the equity spread between the UPB and the value of the home shrinks due to major recession, you would be forced to hang on to the note else sell it at a possible substantial discount if you needed to liquidate and cash out. Other than than the myriad of land mines with foreclosure, a performing note with a stable borrower is nice cash flow and fairly low risk.

    Bob

    4Reply
  • Nicholas Z.
    OP
    New to Real Estate · Mountain View, CA · Member since 2020 · 57 posts · 31 votes
    6y

    Thanks @Bob Malecki, that’s helpful. 

    0Reply
  • Andy Mirza
    Lender · Ladera Ranch, CA · Member since 2014 · 1k+ posts · 1k+ votes
    6y

    @Nicholas Z. Chris, Justin, and the others have hit the major points of the downsides. I'll give a couple of examples:

    1. Borrower actions are outside of your control and can greatly affect the value of your note - we bought a NPN a few years ago, borrower filed BK 13 to stop the sale & filed a civil lawsuit. She dropped the lawsuit when the plan was confirmed. She's on her fourth plan modification, which has allowed her to skip about 15 payments to the trustee and extended the plan by two years. (That's right, CH 13 plans can go longer than 5 years. This one now has 7 years.)

    She is consistently just under 60 days late on her direct P&I payments to us, which prevents us from filing our MFR. It's been three years and we haven't received a single payment on the arrears from the trustee. We're stuck with a loan that would only trade at a significant discount. We have to be patient and wait for the reward at the end. If we had to liquidate, we wouldn't make as much, if anything.

    By the way, we've been sued three times by borrowers who were trying to delay legitimate foreclosures. It's an added expense and takes more time.

    2. Title issues will affect your note's value and ability to re-sell - We bought another NPN a few years ago. Borrower filed BK 13 twice to stop the trustee sales. The second time he got on track and has been making making ontime payments for about three years. We tried to sell the loan a year ago but found out that there were two minor title issues: legal description was wrong in the original note & several assignments referenced the wrong instrument number (off by one digit).

    We shouldn't have missed those but neither should the 5 big banks that had the loan before us. We tried to fix the issues but got stalled. Even though these issues wouldn't impede a foreclosure if you needed one, we found that re-performing buyers didn't want to touch this loan or wanted too much of a discount.

    So, we're just holding on until the borrower exits BK and we'll try to help him refinance. Again, if we needed to sell for some reason, we'd make a lot less.  
     

    2Reply
  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    6y

    One thing I think is important.. is to realize there is more than one kind of mortgage debt.. its not all owner occ debt. which everyone posting above is talking about and the most risky if not done right.

    Commercial debt is a different animal while you have different borrowers the red tape and how you treat a borrower is far different and more investor friendly than owner occ debt.. you still have risk to BK  and waste of the property. But the Dodd Frank risks are hugely mitigated.

    Podcast Guest on Show #222
    JLH Capital Partners51 Review
    WebsiteView Page
    2Reply
  • Nicholas Z.
    OP
    New to Real Estate · Mountain View, CA · Member since 2020 · 57 posts · 31 votes
    6y

    @Andy Mirza wow, those are some stories! I guess the lesson here is that non-performing notes have a lot of potential downside and are probably best left to people with some experience dealing with them. It sounds like the foreclosure process is never easy.

    @Jay Hinrichs thanks for the tip about commercial notes. I'd imagine those would be more difficult to analyze for value? Any advice on where one could go to purchase commercial notes?

    0Reply
  • Andy Mirza
    Lender · Ladera Ranch, CA · Member since 2014 · 1k+ posts · 1k+ votes
    6y

    @Nicholas Z. The lessons are:

    1. NPNs are more work than a lot of people think

    2. There's a huge element outside of your control that affects the timeline to liquidation

    This makes it difficult and riskier to do "one offs" unlike traditional real estate.

    3. Mitigate the risk by spreading capital among several notes; they're not all nightmare cases, some are easy, but they balance out in the end

    4. Be careful of leverage. Hard Money Loans don't work here like they do in fix and flips because of #2.

    5. Anyone can do it, just be aware of the risks. (Or, if you're inclined to invest in this asset class, partner up with someone with experience of invest passively in a fund.)

    1Reply
  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    6y
    Originally posted by @Nicholas Z.:

    @Andy Mirza wow, those are some stories! I guess the lesson here is that non-performing notes have a lot of potential downside and are probably best left to people with some experience dealing with them. It sounds like the foreclosure process is never easy.

    @Jay Hinrichs thanks for the tip about commercial notes. I'd imagine those would be more difficult to analyze for value? Any advice on where one could go to purchase commercial notes?

    Hard money lenders orignate these daily.. and are always looking for investors.. 

    Podcast Guest on Show #222
    JLH Capital Partners51 Review
    WebsiteView Page
    0Reply
  • Nicholas Z.
    OP
    New to Real Estate · Mountain View, CA · Member since 2020 · 57 posts · 31 votes
    6y

    Thanks @Andy Mirza for summing that up for me. I'm currently investigating investing with one of PPR Note's funds to get started.

    Thanks @Jay Hinrichs. I may just look into that.

    1Reply
  • Jeff S.
    Lender · Los Angeles, CA · Member since 2009 · 1k+ posts · 2k+ votes
    6y

    Your original post did not mention non-performing notes, @Nicholas Z., though it seems the majority of responses were from NPN investors. These represent the soft underbelly of note investing (and hundreds of percent ROI in many cases, for a lot of hard work).

    All notes involve some amount of risk that can scare the daylights out of you with the endless horror stories. Have you read any of the landlord related stories here?

    “I guess the lesson here is that non-performing notes have a lot of potential downside and are probably best left to people with some experience dealing with them.”

    No one was born with the experience, Nicholas. You can learn it too. While NPN's can be great, you are not limited to these.

    Many hard money lenders sell their newly originated first position notes, written against local properties you can and should walk thru, to borrowers you can and should meet. This is one way into the business. Another is to find local borrowers yourself and have a licensed CA real estate broker originate a first position loan on a property you’ve seen and vetted. Though we are licensed now and can originate loans ourselves, this is what we do and always against local flips by experienced rehabbers we’ve gotten to know, like, and trust.

    In our view, the business purpose side of the performing note business is much cleaner and easier for a lender than buying consumer purpose NPNs. Of course, the returns are generally a lot lower, but they are also more predictable.

    It’s a remarkably easy business to learn, and though we too have stories, this side of it is also relatively safe and time efficient, if that’s important to you. Taxes suck, as they do with most note investments, but these can be mitigated when you invest through a retirement plan.

    There’s no best way to invest in notes (or anything else), Nicholas. Everyone does what they are comfortable with. It’s good you asked but don’t let the horror stories scare you away.

    2Reply
  • Nicholas Z.
    OP
    New to Real Estate · Mountain View, CA · Member since 2020 · 57 posts · 31 votes
    6y

    Thanks for the response @Jeff S.. That’s very helpful. I’m just wanting to make sure I’m going through the appropriate beginner steps and not taking on more than I can handle right now. 

    0Reply
  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    6y
    Originally posted by @Jeff S.:

    Your original post did not mention non-performing notes, @Nicholas Z., though it seems the majority of responses were from NPN investors. These represent the soft underbelly of note investing (and hundreds of percent ROI in many cases, for a lot of hard work).

    All notes involve some amount of risk that can scare the daylights out of you with the endless horror stories. Have you read any of the landlord related stories here?

    “I guess the lesson here is that non-performing notes have a lot of potential downside and are probably best left to people with some experience dealing with them.”

    No one was born with the experience, Nicholas. You can learn it too. While NPN's can be great, you are not limited to these.

    Many hard money lenders sell their newly originated first position notes, written against local properties you can and should walk thru, to borrowers you can and should meet. This is one way into the business. Another is to find local borrowers yourself and have a licensed CA real estate broker originate a first position loan on a property you’ve seen and vetted. Though we are licensed now and can originate loans ourselves, this is what we do and always against local flips by experienced rehabbers we’ve gotten to know, like, and trust.

    In our view, the business purpose side of the performing note business is much cleaner and easier for a lender than buying consumer purpose NPNs. Of course, the returns are generally a lot lower, but they are also more predictable.

    It’s a remarkably easy business to learn, and though we too have stories, this side of it is also relatively safe and time efficient, if that’s important to you. Taxes suck, as they do with most note investments, but these can be mitigated when you invest through a retirement plan.

    There’s no best way to invest in notes (or anything else), Nicholas. Everyone does what they are comfortable with. It’s good you asked but don’t let the horror stories scare you away.

    Jeff,  Question  does CA have a carve out for the small investor IE they can do no more than say 1 to 3 loans a year and no more than say 3 to 5 in their portfolio as long as they dont hold themselves out as a lender etc.

    some states have those rules.. other wise I agree a perfect start for most is to align with a good HML that takes on individual clients. IN CA you can fractionalize a Trust Deed.. so it allows someone to get in the game with a low dollar amount.. I know when I had my shop in Oakland 95% of my loans were fractionalized.. and this is pre computer servicing platforms we had to split payments by hand each month .. Had one employee thats all she did :)

    Podcast Guest on Show #222
    JLH Capital Partners51 Review
    WebsiteView Page
    0Reply
  • Jeff S.
    Lender · Los Angeles, CA · Member since 2009 · 1k+ posts · 2k+ votes
    6y
    Originally posted by @Jay Hinrichs:

    some states have those rules.. other wise I agree a perfect start for most is to align with a good HML that takes on individual clients. IN CA you can fractionalize a Trust Deed.. so it allows someone to get in the game with a low dollar amount.. I know when I had my shop in Oakland 95% of my loans were fractionalized.. and this is pre computer servicing platforms we had to split payments by hand each month .. Had one employee thats all she did :)

    Years ago, I asked our attorney that same question. I believe he said the limit was 7 or 8 loans, which I recall was a lot, but I can’t be certain anymore. I am certain there is no limit on how many loans you can hold in CA. It’s almost irrelevant, since you’d have to be out of your mind to originate a loan yourself in this state and anywhere else. Why anyone would risk life-changing amounts of money without the protection of an attorney or licensed broker has always been beyond me. The cost is nominal, and the borrower pays anyway.

    I do agree that fractionalized loans are among the best kept secrets in both lending and borrowing. These are an easy way to spread relatively small amounts of money across several deals instead of possibly risking it all in one. CA’s SB-978 prevents you from investing more than 10% of your net worth in any one brokered loan, so this sort of forces the issue for most in CA anyway.

    1Reply
  • Mike Colucci
    Member since 2020 · 39 posts · 5 votes
    6y

    Hi everyone, I'm a new investor from South Florida. I've spent the last few hours on various blogs including this one reading about investing in mortgage notes as form of passive investing compared to non-traded RIETs. It seems the safest way to invest in mortgage notes is to invest in performing notes. Assuming the purchased note is deemed a good investment, how does one scale this business? If your doing multi-family rentals the technique is to wait the seasoning period, refinance with a cash out option and go purchase another property. What is the technique for purchasing more performing notes to say increase ones net yearly income to $100,000 or more?

    0Reply
  • Jamie Bateman
    Investor · Baltimore County, MD · Member since 2014 · 466 posts · 439 votes
    6y

    @Mike Colucci A couple of common ways are to sell partials (or hyphothecate) -- I just wrote a blog post on this topic here on BP -- and to manage a note fund. I also lend my own money to our note business to buy more notes. 

    0Reply
  • Mike Colucci
    Member since 2020 · 39 posts · 5 votes
    6y

    @Jamie Bateman Thanks for your reply. I didn't think anyone would respond for a couple of days. I read your blog post, but I'm still a bit confused as to how it works. If I purchased a performing note for $100,000 and lets say I'm getting $700 a month in payments just to use an even number. I need $50,000 out of it to put towards another note, so I partially sell 5 years of payments to a partial buyer. That means the partial buyer gets the $700 a month from the original note and has control of it for the 5 years, and I take my $50,000 and buy another note with it? Since I only have $50,000, I can't buy another $100,000 note or can I?

    0Reply
  • Jamie Bateman
    Investor · Baltimore County, MD · Member since 2014 · 466 posts · 439 votes
    6y
    No, but you can buy a $50k performing note. Or if you own two $100k performers, you can sell a $50k partial on each to buy another $100k note. There is a lot of flexibility in how you can structure partials.
    0Reply
  • Jo-Ann LapinPro Member
    Loan Officer · Tustin, CA · Member since 2015 · 3k+ posts · 713 votes
    6y

    Trust deed investing changed radically about 10 years ago. Hard money loans / private money loans became more mainstream with the credit crunch  shortage in 2008. The industry became more opportunistic for the real estate investor / small business owner. Bigger private/ hard money capital came into the space. Still today there is a flood of money in this space and it has driven yields down along with the low rate environment. The quality of the trust deed investment has also became of a higher standard. Many that lent to owner occupied properties no longer do so. There are still quality factional and whole notes out there . Every investment that pays a higher yield is not without risk however in my humble opinion trust deed investing has become less riskier .

    [email protected]
    0Reply
  • Mike Colucci
    Member since 2020 · 39 posts · 5 votes
    6y
    Thanks guys. I appreciate everyone's feedback, but I think I'm going to go back to my original plan of purchasing a small multi-family property and scaling up from there. My gut is telling me that's the way to go.
    0Reply
  • Bob Malecki
    Investor · Kingston, WA · Member since 2008 · 1k+ posts · 1k+ votes
    6y

    @Mike Colucci Unless you find a greatly discounted deal, you may want to wait on that for 6-9 months for the market to correct, we are somewhere at the top and your equity may evaporate if you buy now, depending on the market you plan to acquire the property. 

    0Reply
  • Mike Colucci
    Member since 2020 · 39 posts · 5 votes
    6y
    Hi Bob, for me there are still a lot of unknowns as first time investor. I still have a lot of things to get in order before I can even think about purchasing anything. 6- 9 months is probably still too short of a time frame for me. Probably going to be more like a year. There is still so much I need to learn first.
    0Reply
Join the conversationCreate a free account to reply, vote on answers and follow this thread.
Log InJoin for Free