An Introduction to Note Investing
From time to time I see posts on BP by members wishing to learn more about note investing. Unfortunately there seems to be a shortage of information on the subject, especially on the topic of non-performing notes. This type of knowledge can be difficult to come by so I thought I would take a crack at shedding some light on the subject with a series of blog posts. This first one is designed to provide an overview of some basics and discussion of the more common note investing strategies.
What is a Note?
A note is simply a promise to pay. For example, a personal check is a note. When real-estate is sold with financing there is a document called a promissory note which defines the terms of the loan, including the loan amount, percentage rate, payment amount, the number, frequency, and timing of payments, late payment penalties, etc. The note, by itself, is simply a promise to pay and is not secured by collateral. In a financed real-estate transaction, the note is secured through a security instrument. This is either a mortgage or deed-of-trust, depending on the state. The security instrument ties the note to the deed as a lien on the property as collateral. It also spells out the lenders recourse (foreclosure) should the borrower fail to pay, among many other details which we won't go into here.
What is Note Investing?
When one invests in a note, the note is purchased along with its security instrument. In other words, investors purchase the secured debt and become the lender, after which they are entitled to receive payments from the borrower. Generally speaking, note investors purchase notes at a discount to the remaining principal balance. Many people find it difficult to understand why someone would sell a note at a discount. We will address this in more depth shortly.
Before we get into different types of note investing strategies, it is important to cover the topic of lien position. When a debt is secured by real property, it is recorded as a lien against the deed. The rule for lien position is "first in time, first in line". This simply means that lien position is establish by the relative date and time a lien is recorded against the deed. For example, a first mortgage is in first position solely because it is recorded prior to subsequent liens like a second mortgage. There are a couple of exceptions to this. Delinquent property taxes is the most common exception. When a municipality liens a property for delinquent taxes, the lien cuts in line to the front. The other exception is HOA dues in "super-lien" states. In these states, delinquent HOA liens act like tax liens. Lien position is important in note investing primarily because in the event of foreclosure, the lien holders are paid from the proceeds of the sale based on the position of their liens. The first position lien is paid first, and if anything is left over the second position lien is paid, and so on.
Common Note Investing Strategies
There are many strategies in note investing and I am quite sure I am not familiar with all of them. I will cover the common ones which are; Performing Note Investing, Non-Performing 1st Lien Investing, Non-Performing 2nd Lien Investing.
Performing Note Investing - Buy and Hold
A performing note is simply a note on which the borrower is making regular payments, and investors purchase them to achieve a stream of recurring passive income. This is similar to purchasing a rental property but without the headaches of property management. Many of the performing notes for sale were created in owner financed real estate purchases, where the seller desires to cash out rather than continuing to receive monthly payments. These notes are generally purchased at a discount to remaining principal balance, providing the investor with a higher effective yield than the interest rate of the note. Double-digit yields on these investments are quite common. Why would someone sell at a discount? The simple answer is sometimes life circumstances dictate that money now is more important than money over time.
Performing Note Investing - Buy Long Sell Short
If I told you I would give you $100 now or $100 in 10 years, which would you choose? The answer is obvious and we know this intuitively. The fact is that money today is quite literally worth more than money in the future. This is because money today can be invested for a return over time, while future money cannot. There is a standard financial formula (Present Value) for calculating exactly what a future payment is worth. If you look at a series of loan payments over a number of years and apply the present value calculation to each payment, using the interest rate of the loan as the discount rate, you will see that each payment is worth progressively less. For example, a 100K loan at 10% over 30 years has a monthly payment of $877.57. The first payment has a present value of $877.57, while the last payment in year 30 has a present value of just $43.87! The buy long sell short strategy takes advantage of this degradation of value over time, and uses a technique known as selling a partial. In this technique, the investor purchases a performing loan (at a discount) and sells some number of the high value payments from the front of the loan and retains the relatively low value back portion of the loan. Investors who purchase well can retain this back portion at low or no cost, or even make a profit selling the front portion. With the font portion sold, the investor has recovered most or all of their original investment and retained a valuable asset which will provide an income stream in the future. If the loan is refinanced or paid off in the sale of the property prior to maturity, the investor gains a cash bonus in the principal which is due them on the back portion.
Non-Performing First Lien Investing
In this strategy, the investor purchases a loan in which the borrower has stopped making payments. The banks have many of these on their books right now, and have chosen to sell some of them to investors to get them off of their books rather than take the time and incur the expense of foreclosure. Because these notes are non-performing, they sell at a steep discount to principal balance. Investors who purchase these have several exit strategies to consider:
- Workout - A loan purchased at a discount can be modified to forgive arrears and reduce the principal balance, thus lowering payments. Many borrowers with severely underwater homes have stopped paying simply because they don't see a point in paying on a loan balance which is double or more the current value of their property. Others have suffered employment setbacks and have found themselves so far behind on payments that they can no longer bring the loan current, so they give up on it. Whatever the reason, a workout can solve a painful financial problem for homeowners and provide the investor with a re-performing loan acquired at a very nice discount.
- Deed-In-Lieu - When a workout is not possible or feasible, taking possession of the property via deed-in-lieu can sometimes be a workable approach. With this approach, the borrower signs the deed over to the lien holder as consideration for the debt. The thing to keep in mind with a deed-in-lieu exit is that any junior liens will remain on the deed.
- Short Sale - Just like a bank, the note holder can approve a short sale by the borrower. As with deed-in-lieu, junior liens can make this approach unfeasible because clear title must be conveyed in a sale.
- Foreclosure - This approach can be the only option in some cases. The downside is that it takes time and incurs holding cost and legal expense. The benefit is that junior liens are removed, leaving clear title.
Non-Performing 2nd Lien Investing
Because the lien position is junior to the first lien, non-performing 2nd liens can be purchased at extreme discounts. It is common for these types of notes to be partially or completely underwater with regard to property value. Workout is the primary exit strategy, as foreclosure and deed-in-lieu from 2nd position will leave the 1st lien in place. Because of this, non-performing 2nd lien investors tend to look for for notes with a performing 1st lien, and scrutinize the quality of the borrower rather than focusing on the value of the collateral property. For a deeper dive on this note investment strategy, I recommend listening to Bigger Pockets Podcast - Show 28 where Dave Van Horn shares his expertise on the subject.
Wrapping It Up
I hope this provided some insight into this somewhat esoteric area of investing. As with standard real estate investing, it is far easier to find a bad deal in notes than good ones. While the rewards can be very good, the risks can be considerable, especially with non-performing notes. These can only be mitigated with a solid working knowledge and a fair amount of work. There are many aspects to consider when looking at potential note investments. Check out part 2 of the series where I cover information required to evaluate a potential note purchase.