Every once in a while, someone asks me about the disadvantages of investing in notes, especially as it pertains to risk compared to other asset classes, such as real estate.
While all types of investing have their own particular disadvantages or risks, your perception of and approach to those risks may change as you gain experience. For example, when I got started in real estate and purchased my first investment property, my understanding of how to mitigate the risks was minimal compared to when I purchased my 40th property.
Note investing is no exception. I’ve been in the notes business for years, and I’m humbled to say that I’m still learning. That said, here are some of the main challenges that note investors face.
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In recent years, compliance has become a big one, especially with the inception of Dodd Frank and the creation of the CFPB (Consumer Financial Protection Bureau). Not only has there been an uptick in federal oversight of financial institutions, but now the non-bank sector has become just as regulated. We also have an increase in the state licensing requirements with very little uniformity, thus creating a menagerie of various requirements.
Now, even the small mortgage investor has to be aware of compliance, as it pertains to everything from the FDCPA (Fair Debt Collections Practices Act) and auditing third party vendors to securing borrower data and confidential information. Let’s face it, I could write a book just in reference to compliance.
Another disadvantage to note investing is related to legal issues, because after all, legal is the biggest expense one encounters in the note space. After a borrower defaults on his/her loan and all other options are exhausted, the legal process would begin, and of course the foreclosure requirements, timelines, and allowable expenses will vary from state to state.
Knowing whether your loan is in a “deed of trust” state versus a “judicial” state is a good place to start as far as trying to figure out the foreclosure process, especially when it comes to things like hiring your foreclosure attorney, sending a demand letter, filing a lis pendens, bidding at the sale, and ejectment timelines after the sale.
Beyond the more obvious legal threats, let’s not forget bankruptcy, which could possibly create another entire arena of potential delays and tie ups. Other legal issues can crop up as well. For example, maybe there are back taxes, municipal liens, or homeowner association fees piling up. Maybe you need to secure the property and winterize it, cut the grass, or change the locks, etc.
Another potential challenge is in regard to collateral documents. This could be things missing in your paperwork, such as a copy of the original note, an assignment, or an allonge.
There can also be issues with the physical collateral. For example, the property condition may have declined. Or there are cases where the property may have been condemned by the city or even torn down.
Although note investing may not be as well-known as real estate investing, it is still an asset backed investment with a piece of real state acting as collateral behind the mortgage. One threat to this investment is the fair market value of the collateralized property could decline in value, leaving the investor potentially exposed in a foreclosure situation, where there may not be enough proceeds from the foreclosure sale of the property to cover the full loan amount.
With junior liens, you may even have issues when a more superior lien tries to foreclose ahead of you. This is why we suggest monitoring the status of any lien that may be ahead of you in case you want to reinstate or buy out the more superior lien in order to protect your position.
Fewer Tax Benefits
Note investing can also be a capital-intensive business without some of the benefits that are more common with owning traditional real estate, such as depreciation and appreciation. With notes, there isn’t a tax break that’s similar to depreciation — although you may get a tax break if you invested from your IRA or retirement type of account or maybe if you set up a non-profit to buy and sell notes.
As for appreciation, your payoff can only really go up if there are missed payments, late fees, or corporate advances added on to the original UPB (Unpaid Principal Balance). In other words, notes just don’t appreciate like hard real estate. There are situations where what we call “phantom appreciation” may occur. For example, let’s say a note was purchased at a discount because it was only partially covered by equity. If the real estate market were to improve, increasing the value of the collateralized property behind the note, the value of the note and mortgage would go up also.
By now, you may be thinking that there are a lot of disadvantages or potential threats to note investing in general. To be quite honest, you’re right, and I’m sure we didn’t even come close to covering them all.
So, you’re probably wondering what would possess someone to do note investing, and the short answer is that many of us have found ways to deal with or mitigate these risks or potential threats. In that way, it’s very similar to real estate investing. I have family and friends who think I’m crazy for dealing with tenants and all the issues and problems that come along with hard real estate investing.
In note investing, if you have regulatory or legal issues, you can employ legal counsel or hire a licensed servicer. Although it’s a capital-intensive business, no one says you have to use your own money. Rather, you can use OPM (other people’s money).
Also, if you’re worried about FMV (Fair Market Value), property conditions, occupancy, or liens being valid, you can mitigate most of these issues through your due diligence process.
For us, the fact that note investing is a very scalable business model, and these assets can be bought at a nice discount more than compensates for some of the risks we encounter.
So, what are some of the threats/risks that you’ve learned to mitigate in your note or real estate business?
Leave your comments below!