The Note Business: What is it and how do I make money

As real estate investors we pretty much understand what real estate is and what renting is, but many don’t quite understand what is meant by the Note Business.

What is a Note

A Note is a promise to pay overtime by a borrower. The Note is going to include the amount that is owed or the principal, the time frame of the note and the interest to be paid.

If you were to seller finance a property and create a note, you would then be owed a stream of payments based on the amount owed, the time frame to pay the note and the interest owed. In this scenario, the stream of payments would include the principal amount, the amount you financed, but also an interest payment every month.

Just like banks who finance houses, your note or Promissory Note for long would create and define the debt owed and it would further be secured by real estate through a Deed of Trust in Missouri or a Mortgage in Kansas. This Deed of Trust or Mortgage puts the public on notice that you are owed a debt secured ty a particular piece of property and defines what would happen if the borrower failed to pay that debt.

What is Discounting a Note

To understand discounting a note let’s put some numbers in an example. Let’s say you seller financed a property and the borrower signed a promissory note with the following terms: Principal is $100,000, Interest is 8% and a Time Frame is 30 years or 360 Payments.

The face value of this note is $100,000 and the holder or owner of the note is owed 360 payments that each include some amount of principal and some amount of interest based on an amortization schedule

If a discount note investor were to buy this note, they would not pay the full face value of the $100,000 but would rather want to buy it at a discount, so that instead of earning 8% interest over the 360 payments, they earn a higher rate of return. So rather than paying $100,000 for the note, the discount note investor might pay $80,000 for that note, thus increasing the rate of return much higher than 8%.

Profiting Over the Long Term

When we look at making a profit on a discounted note we need to add a few more numbers to our example. Let’s say we have a $100,0000 Note that earns 8% interest over 30 years or 360 payments. If we plug these numbers into an amortization schedule, a software that tells us how much each monthly payment should be and how much of it is principal and how much is interest we find that the monthly payment should be $733.77.

If we take that monthly payment of $733.77 and multiply it by the 360 payments, we find that the owner of that note would receive $263,880 over the full life of the note.

So if you were the landlord and had $120,000 house that you rented out for $800 a month, you would get a little more in monthly rent payments over that same 30 year time frame, but out of that you would have to deduct taxes, insurance, maintenance, and vacancy, that could quite possibly eat up ½ of your monthly rent payment leaving you earning maybe only $400 a month. Not to mention the headaches of managing tenants and toilets.

If you were to seller finance that same house and get $20,000 as a down payment and create a $100,000 note you would then earn the $263,880. And if you were to sell that note to a discounted note investor, you would get $80,000 NOW, in this example, and the note investor would then earn the $263,880.

Quite often the Discounted Note Investor seeks out notes created by sellers who would much rather have their money now, the $80,000, rather than waiting 30 years to earn the full $263,880, and that is how the Discounted Note investor makes huge profits, by being willing to wait to earn his profit over time.

Risk in the Discounted Note Business

If you take a look at our example we have been talking about, the balance of the note is $100,000 and it is secured by a house that is worth $120,000. If you were the investor who purchased this house at a discount, say $50,000 and put $20,000 in renovations, you have $70,000 in the house when you sell it, and end up with $20,000 down and a note for $100,000 that will pay you $263,880 in payments over 30 years. You are sitting quite well, with the possibility of getting all your payments or the $120,000 house back if the borrower stops making payments.

Now the Discounted Note Investor can step in and pay you a discounted price of $80,000 in this example. The Discounted Note Investor is stepping into a similarly low-risk scenario with only $80,000 invested and being owed the $263,880 that they will either get in payments or if the borrower does not pay, getting a $120,000 back through foreclosure.

And you the Investor who created the note? Well, you earned the $20,000 and made an additional $10,000 when the Discounted Note Investor bought your note.

There are several ways to make money with the note.

1. Buy the house, sell the house and create the note, with very low risk if you do your homework on the borrower and make sure they have the ability to pay.

2. Sell that note to a Discounted Note Investor to get your cash now and go on with other investments.

3. Buy that note as a Discounted Note Investor and collect your profits over time, here you want to do your homework not only on the borrower but also the note itself and the house securing the debt.

All three ways of investing are fairly low risk because there is still the security of the house that the owner of the note can get back if the borrower does not pay, Then the house can be resold for cash and/or a new note created.
Two Types of Notes in the Note Business

In the above examples, we were talking about a performing note, a note where the borrower is paying as agreed. When the borrower stops paying as agreed the note becomes a non-performing note. There has always been performing and non-performing notes in the note industry that comes from homeowners who sold their homes seller financed or by banks funding the purchase of homes.

The Non-Performing Note Business

With the mortgage crisis in 2008, 2009, 2010 the big banks learned something that has changed the way the industry deals with non-performing notes. Pre 2008 if a borrower was in default either the bank foreclosed or possibly an investor or real estate agent would work really hard to negotiate a sale for less than what was owed, this is called a short sale.

During the mortgage crisis, due to the sheer number of loans in default, the big banks learned something. They learned it was less costly to sell that defaulted loan in a package with other defaulted loans at a fairly steep discount than it was to keep it in house and devote their own time money and effort to collecting the money or foreclosing and selling the house.
They started selling these large packages of non-performing notes to hedge fund investors, who would break these up into smaller packages and sell them to smaller hedge funds who eventually would sell them in ones and twos to the average discounted note investor.

Now you may ask, what would a discounted note investor want with a note that was not being paid?

First, there was the discount. By the time a Non-Performing note made it to the average discounted note investor, they were able to purchase this note for about ½ the value of the home that was backing the loan.

Second, because the note was purchased at such a steep discount, the discount note investor could reach out to the borrower and modify the loan in all kinds of ways from lowering the principal balance, reducing the interest, to extending the time frame, all in an effort to get the borrower paying again.

Third, when the homeowner could not or would not start paying the modified amounts or in some cases had already abandoned the home, the discount note investor could often negotiate to get the borrower to give the house back to wipe out the debt or they could foreclose and acquire the house.

Full Circle

And this brings us full circle, the investor who forecloses or gets the home back from the borrowers non-payment, can now sell the house at a discount to other investors to make a profit. Or they can rent it out. Or they can retail it out to an all cash or all financed buyer. Or they can create a new note, to earn profit now on the down payment, profit over time through monthly payments, and if they want their money now, they can sell that note to a discounted note investor.

There are just so many new profit avenues in the Note Business. In real estate investor terms you can create a note, or flip or wholesale performing notes and you can buy and rehab non-performing notes.

The article was written based on a series of Videos from NoteSchool on YouTube. If you would like to learn more about the Note Business and how you can use it in your current or future real estate business, join MAREI in welcoming Joe Varnadore from NoteSchool at the meeting on the 8th where he will explain how rules and regulations have changed the real estate marketing.

He will show us the strategies that successful investors are using to optimize their results by combining real estate investing with the note business.

Learn more about Note Investing at the MAREI Meeting on Tuesday, May 8th and be sure to reserve your seat early for the 1-day workshop on Saturday, May 12th. Early Bird Pricing runs through the 8th of May and MAREI Members will find discount codes in several emails the last week of April.