How to Prepare for Your First Ever Note Investment

by | BiggerPockets.com

In its simplest form, my first note was a student loan that I took out to go to college. You could also say my first note and mortgage was the one I took out to buy an owner-occupied duplex that I still own today. But my very first note investment, where I took on the role of the bank, was a private money deal I did for a wholesaler friend.

When it came to preparing to take out my student loan, I pretty much just relied on my school counselor and the financial aid office at the college. Looking back, it was the classic “fox guarding the hen house” situation, as I just knew I wanted to go to college, and I wasn’t too concerned about the terms of my loan or what the true cost of college really was. I was just operating on faith—faith in myself to get a better job when I finished school so I could pay back the loan.

When preparing to buy my first property, it was different. I was confident. As a real estate agent, I understood the advantages and the cost of buying a property with an FHA mortgage, and I felt that I knew what I was getting into, especially since I was handy as well.

By the time I decided to use debt as an investment, I had something between blind faith and total confidence. So, where was I on this spectrum, and what did I do to prepare myself? Better yet, how can you prepare yourself to use debt as a wealth building tool?

good-real-estate-note-deal

Related: From a Tax Perspective, Is it Better to Invest in Notes or Rentals?

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Preparing to “Be the Bank”

When I decided to “be the bank” for my wholesaler friend, I felt somewhat comfortable with the process. I was aware of how hard money worked, so I mimicked many of their requirements. Since I was a partner in a title company at the time, I understood the paperwork as well as how the collateral would secure my investment.

Here are some of my typical private lending suggestions:

  1. Use a note and mortgage. Hire an attorney or title company if needed to do so.
  2. Use a deed in lieu of foreclosure in the event of non-payment (non-owner occupied, commercial only). You can also require a personal guarantee and/or confession of judgement.
  3. Know the estimated after repair value (ARV) by getting an appraisal (paid for by the borrower). Be sure to have a scope of work and possibly a draw schedule in place, as well as proof the borrower has the resources to complete the project.
  4. Be named insured on the homeowners’ policy on the property.
  5. Know the borrower. Some things to look at are creditworthiness, experience level, skill set, portfolio of past projects, etc.
  6. Check and require title insurance, as you want to ensure you’re in first position.
  7. Know the property and the area. You may end up owning it someday.

Besides meeting the lending conditions above, I also prepared myself to invest in notes through education.

I would attend workshops, and I networked with investors in the note business, as well as others who were doing private money deals, either as borrowers to grow their portfolios or as lenders to increase their yield and cash flow.

All of this helped me gain a better understanding of notes in general before finally pulling the trigger.

wholesaling-sellers

Buying Institutional Notes

Preparing to buy my first distressed institutional notes was much more difficult. Although my private note experiences helped a lot, at the time there wasn’t much info available on non-performing notes, nor were there many people to ask or groups to join, and there was a very high barrier to entry. It was tough, especially starting out with second mortgages. Things were different then as well, with much less regulations and licensing requirements.

Related: The Investor’s Guide to Performing Due Diligence on Real Estate Notes

We just started out by taking baby steps. We purchased a few high equity second mortgages with our own money and hoped things would work out—and they did.

My best advice for starting out in notes besides learning as much as you can and joining groups is to start out slow and easy until you have more experience. Maybe start out with a performing note at first. Or joint venture or partner with someone else who has more experience. You could even shadow someone else’s deal. Or maybe try participating in a note fund. My point is there are many ways to limit risk until you have more experience. It’s just taking that first step that matters most.

Now that I shared how I prepared to do my first note deals, how are you preparing to do yours? If you’re investing in notes already, what advice do you have for newer investors?

Weigh in below!

About Author

Dave Van Horn

Dave Van Horn is President at PPR The Note Co. – an operating entity that manages several funds that buy/sell/hold residential mortgages, both performing and delinquent. Dave has been in the Real Estate business for over 25 years, starting out as a Realtor and contractor and moving onto everything from fix and flips to Raising Private Money.

12 Comments

    • Dave Van Horn

      Hi Zachary,

      Sure thing, glad you enjoyed the article.

      To answer your question, we’ve probably ended up with hundreds. But, we have thousands of loans. The majority of these though come from notes we’ve purchased that are tied to unoccupied properties. It’s more commonplace with 1st mortgages, where you’re exiting through the property more often rather than exiting through the borrower. With 2nd mortgages, it’s the other way around.

      Best,
      Dave

  1. Chris Luksha

    What I love about your articles most Dave is that we can reverse engineer them. In other words we can use the advice in them to make sure when we are asking for money for friends or others, we can make sure that we prepare to help them with all these things – as security in their mind. Especially if they have never invested in real estate before this can be a huge comfort I would imagine.

    I say that fully acknowledging that I have yet to ask more than two people for money directly. I have spoken to many who have shown interest in the concept of REI but only two who have said to me “I have some money and that sounds interesting to me. how can I get involved”

    • Dave Van Horn

      Thanks Chris. I think diving deep into that topic could be a pretty interesting article in and of itself.

      In my opinion, the most effective way to raise money for REI is to either have a track record of completed projects that you did personally, had a hand in, or your partner has done. Presenting that track record to potential investors shows your model works. Combine that with a detailed explanation of the investment vehicle and it’s hard for them to say no. Retaining investors is just a matter of staying in contact and delivering on the agreed upon terms.

        • Dave Van Horn

          Hi Chris,

          Good question!

          I use an LLC to buy a note. Some note sellers actually won’t sell to you without one. It also looks better to the borrower that an LLC owns the mortgage rather than an individual. Of course it limits your liability as well.

          Hope this info helps.

          Best,
          Dave

  2. Tracy Z. Rewey

    Great Article! We work with a lot of existing notes so like to see a verifiable payment history whenever possible. Then right before closing we call and talk with the payor to be sure they like the property and are comfortable making the payments. This goes right in line with your “Know The Borrower” suggestion.

  3. Rick Gonzalez on

    Very informative and thank you! One question, if we were to purchase a distressed deal and the borrower defaults on the balloon payment and we commence foreclosure, why would the borrower file BK and subject themselves to full recourse. We’re thinking of buying one of these but wanted to confirm the unlikeliness of this happening. Thanks!

    • Dave Van Horn

      Thanks for reading Rick!

      To get the true answer to your question, you may have to discuss this more with a Foreclosure attorney in your state.

      Unfortunately, you can’t predict whether someone would file BK or why. Perhaps they think they’re going to fair better in BK court than try to settle the debt with the note owner.

      That being said, a borrower filing BK doesn’t mean you’re not going to make money on your note. Depending on the type of lien and which type of BK they file, it doesn’t necessarily determine the outcome of your deal.

      Best,
      Dave

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