The Future of Note Investing

10 Replies

Hey, with all this talk of rising rates and inflation, would one gather it would not be the best time to get into note investing since the money you’ll receive won’t be worth as much OR that since rates are rising, you could justify evicting a tenant on a non-performing note and sell the asset(obviously this view is a little coarse but nonetheless a fact if someone’s already defaulted on a lower rate)?

I think you have framed the discussion well in that inflation will affect the outlook for a performing note investor differently than an NPL investor. Personally, I am locking in long-term, low-rate debt on assets so that my cost of capital is still low (as a borrower) to help fund my note business. And hopefully inflation will lead to a supply increase, which could bring down prices on notes. Right now pricing is sky high, in general. 

What will inflation look like and how long will it take to see the effects? I think these questions need to be answered first before you adjust your note business.

The worst case scenario is the onset of high inflation in a short amount of time and would require the most adjustment to one's business model.

Yes, inflation will make some loans unattractive i.e. loan mods with very low interest rates.

If you bought a performing note on yield, then you should be ok as long as your return is still attractive in the inflationary environment.

If you buy underwater NPNs then inflation will help you as the value of the real estate will go up and you can collect more than you  anticipated.

"evicting a tenant on a non-performing note" doesn't make sense to me. You should have a borrower on a NPN and your recourse is foreclosure, not eviction. A very important distinction to understand.

As andy mentioned - inflation typically leads to higher home prices (along with lack of inventory), so price appreciation on homes reduces risk on a NPL while a drop in home prices can have a significant impact on returns. 

On a performing note inflation is offset by increased interest rates. When rates go up the risk free rate of return (type of treasury bill or bond backed by US Govt) will rise would want your risk adjusted rate of return to increase based on the same risk premium.

To put in English, if the risk free rate of return went from 1.5% to 4% and you had a 8% return (8-1.5 is 6.5% risk premium). Based on the risk free rate of return your new target may be 10.5% (6.5%+4%).

But if you have a solid performer and happy with the returns you can internally adjust / lower your risk since you know the investment well

Originally posted by @Chris Seveney :

@Jamie Bateman

The problem in the note space right now is the amount of illegal drugs that have entered the space.

So many note sellers are so high on crack or some other drug with the prices they are asking they need rehab

If the stock market corrects 20% does that affect the notes you currently hold?

@Mike Hern

Mortgage no investing is not correlated to the stock market. Performing notes typically go delinquent for two reasons, a change in income status by the borrower from either a death in the family, loss of job or divorce. The other is a significant drop in property values and the borrower must relocate and has no equity

Originally posted by @Chris Seveney :

@Mike Hern

Mortgage no investing is not correlated to the stock market. Performing notes typically go delinquent for two reasons, a change in income status by the borrower from either a death in the family, loss of job or divorce. The other is a significant drop in property values and the borrower must relocate and has no equity

I think you left out mortgage moratoriums but I get your drift. Thanks.

@Mike Hern I agree with Chris. The stock and real estate markets may have some affect on each other but, in general, there's no relationship that affects both of them at the same time for the same reason. Just because the stock market dropped 20% doesn't automatically mean there will be a drop in real estate. There are so many different variables in play that would make each scenario turn out differently.

Everybody needs a place to live but not everybody needs to hold on to stocks. In fact, most people would make the choice to sell stock so that they could pay their mortgage if they had to.

@Christopher Nicholas

Here’s how I diversify my real estate portfolio to protect against inflation and still yield an excellent return

I have half my assets invested in real property (or equivalent participation’s in syndications) where the property is 50% leveraged. So this means I have control of real property valued at the total value of my portfolio (since I have half in notes and half in real property) thereby theoretically protecting the value of my total portfolio from inflation. The real property average gross returns are 8%, the debt is at 5%, so my cash on cash return is 11%.

The notes I own or control make up the other half of my portfolio, with the average return 12%. But this is only the nominal return, since many of the notes are purchased at a discount, and come due in the near future, I am looking at a probable 17% annualized return.

This means my annualized returns, assuming (1) notes held are paid timely and (2) revenues and expenses on real properties stay stable is 14% annualized. Not accounted for is any increase in value of the real properties; or should a deflationary environment (like 2008) unexpectedly occur a decrease in real property values.

Obviously, no "hedge" is perfect under all economic scenarios, and many scenarios, or consequences exist where I could still lose money. However, with no leverage on my notes, all with UPB of 60% or less of real value, and only 50% LTV on real estate, I feel I'm in pretty good shape. Additionally, as a conservative approach, I maintain a balance of 10% of my total net investments in cash.

Let me know what you think of my approach, and if you have a different take I’d be interesting in what you do and why.