6 Advantages Note Investing Has Over Hard Real Estate

by | BiggerPockets.com

OK, OK. Before I start, I should say that I love real estate. Really, I do. I wouldn’t be where I am without it. Investing in hard property is why we’re all here after all, and I’m by no means saying we should drop all of our holdings and run into the note business. In fact, what I’m suggesting is far from it. Every asset class has its pluses and minuses. But there are quite a few advantages to notes that make them one of my all-time favorite investments. Though some of these advantages apply to all types of notes (whether it’s hard money, seller financed, etc.), when I say “notes” in this context, I’m mostly referring to institutional notes.

The Tired Landlord

When I first started thinking about entering the note space on a serious level, it almost seemed too good to be true. I had read a few books, attended some classes and workshops, and started to gravitate toward some other folks who were doing the business, but I still wasn’t sure it was right for me. Then again, I was pretty set in my ways.

You see, I was at this crossroads where I had to ask myself, “Should I continue on with my long-term goal toward owning 100+ units? Or do I interrupt this strategy to incorporate a new (to me) strategy that seemed like less hassle with just as many rewards?

Now, I wasn’t just trying to hit this admittedly arbitrary number of 100 units for my health. What I was really looking to do was create a more balanced life for myself while maintaining a valuable cash-flowing portfolio. After 15 years of real estate investing, I was starting to become one of those tired landlords — there had to be a better way to work smarter and not harder.

I think you might know by now which road I chose. Keep in mind; I didn’t realize all these advantages when I decided to take that initial leap. Some of these I only came to understand over time. And fortunately, because of notes, this tired landlord ain’t so tired anymore!

Advantage 1: Truly Passive Cash Flow

For me, owning hard real estate had always offered many great tax advantages (and still does), especially when including depreciation deductions that can offset positive cash flow. Although I consider my real estate to be passive from an IRS tax perspective, what many people (including myself) have failed to realize is how much active work is required for managing and maintaining property. For the owner/landlord, active work can include everything from dealing with tenants and their liability to maintenance and townships, as well as the ever-increasing property taxes. Even for those of us who own property “hands free” (through turnkey investments or outsourced property management), we still may find that managing the managers can be work.

When a note is re-performing and being repaid by the original borrower, the holder of the note will receive payments every month with little-to-no work required in order to continue receiving these payments. This makes the investment entirely passive. And there’s no toilets, tenants, or maintenance required to earn these payments. I often say, “Do you think Wells Fargo has to worry about plumbing issues?” Not when it’s only in possession of the paper (as opposed to the property).

Advantage 2: Volume and Control

I’ve always tried to keep my residential holdings simple. The majority of my properties are in the same county, are the same property type, and usually cost close to the same price. I found it easier to manage when it was cookie cutter (a limiting idea when you think about it). And then when I started to venture into commercial, that’s when I started going out of state to invest. Managing people and properties in other areas proved to be not only tiresome, but inconvenient — even with managers in place.

Owning a Note Portfolio is Easier Than Owning a Property Portfolio

A note portfolio (either performing or nonperforming) can be managed from the phone and computer without ever requiring leaving the house or office. This enables servicers to manage notes on properties all across the nation. And in those rare instances when there are issues, in the note industry we have what are known as mortgage servicers and property preservation companies to handle them. Servicers handle accounting and payment management plus any issues that arise with the resident. Property preservation companies deal with any physical issues with the property.

Related: Finding and Buying Performing and Non-Performing Notes

Advantage 3: Notes Are Profitable in Various Market Conditions

Unlike with the volatility of say, the stock market, note prices in the marketplace are directly correlated with real estate values. So in an up market, when the economy is in full swing, there are fewer foreclosures, and home prices are high and climbing:

  • There is a smaller supply of delinquent notes available in banks’ portfolios, which enable the bank to gain a higher price for its notes — especially because all notes are more likely to be fully covered by equity.
  • Although investors may have a higher acquisition cost, they now can benefit from a quicker exit. When there’s a question of time vs. money, the old adage “A fast nickel beats a slow dime” is proven true. What’s better — a 50 percent return in four months or a 150 percent return in 12 months?

Conversely, in a down market there are more delinquent assets available (along with more junk assets), and there is less equity in the marketplace.

  • Though it can take longer to exit with fewer buyers for an asset backed by a property that may be dropping in value (or have little remaining value), it’s not all bad. This is a glass-half-full scenario when it comes to loss mitigation. A longer exit means a longer time to get a loan modification.
  • This situation also creates more assets in the marketplace for less capital invested. For the same amount of money in an up market, a note investor could acquire a larger quantity of assets than they could in a down market. That’s what we did as a company during the downturn, and now equity is starting to come back. Our assets are only gaining in value!

Advantage 4: Collateral

Unlike owning stocks that offer no real collateral, real estate is one of the safest investments since it’s actual physical property. It wasn’t until I learned about notes that I discovered there was an investment option that offered a very similar style of security. Since a performing note is secured by real physical property, there are multiple means of protecting a note investment, including…

  • Owning a secured lien that is tied to property, especially if the property has equity, involves little or moderate risk because a note owner has a right to foreclose on the property and to recoup some, or all, of the initial investment. The investor who owns the note has a claim on the property, just as the bank would if they were to own the note.
  • Unlike in an eviction, in a default of a property with equity, the note owner could recover missed payments, late fees, attorney fees, and corporate advances in the future.
  • Even junior liens with no equity (or low equity) can still be viable investments because the borrower usually has a vested interest in the property, and traditional equity may not always be the sole factor when it comes to remaining in the home.

Advantage 5: Versatility

Now this one is my favorite. What many real estate investors may not know is that nearly all the forms of profitability that property ownership offers can be found with note investing.

What You Can Do with a Note

Not only can purchasing notes be a unique way to obtain property (especially when buying vacant first mortgages), notes can also be flipped, rehabbed, and borrowed against or leveraged like real estate.

• Flipping or wholesaling a note

Whether a note is performing or nonperforming, it can potentially be sold to an investor in any condition, at any time. Generally, a note is not required to be held for a certain amount of time before it can be sold again.

For example, in an upmarket, someone could purchase a performing note and hold onto it for a few months as they collect payments. Later they could sell it for close to (if not the same amount) as the purchase price. More importantly, the note doesn’t need to be performing to be sold.

 • Recapitalize by selling what is known as a partial

This practice refers to selling a partial amount of payments to an investor for a designated term at a designated price. This option can be a great way to quickly recover a portion of the initial investment while maintaining ownership of the note. It is beneficial for the partial-note buyer as well because it requires a smaller amount of money to invest for a shorter period of time.

• Rehabilitating a note

Like rehabilitating a house, notes can be rehabbed or retouched by reworking the original note. If a borrower were to miss one or more payments because of an unforeseen circumstance, the note owner (or their servicer) has the ability to rework the terms of the loan to fit the borrower’s new needs. This allows the borrower to stay in the home while the investor maintains a steady stream of cashflow.

• Borrowing against the note

The most versatile strategy of all involves an investor’s best friend: leverage. Since the note generates monthly income for the investor, it can be considered a cash-flowing asset. As an asset, this note can then be used as collateral for a loan with a private-money investor; this is known as a collateral assignment of note and mortgage.

Just as a motor vehicle is collateral for an auto loan, a performing note can be collateral for a private-investor loan. In fact, the private-investor loan allows the investor to recapitalize in a tax-free manner. Since this is a loan, the new private money creates an opportunity for a revenue stream that is exponential because the loan can be used to purchase more notes.

Related: 7 Common Challenges Real Estate Note Investors Face

Advantage 6: Socially Conscious Investing

One thing that always attracted me to real estate was the fact that everyone needs a place to live. Through my rentals or flips, in some ways, I was responsible for helping families find homes. With notes, investors can do something just as valuable – and that’s helping borrowers stay in their homes without incurring any additional debt that could cause further repercussions down the road. Unlike stocks, which are essentially a zero-sum game with investors playing either side of the investment (always leaving one party at a loss), notes can actually be advantageous for the investor and for every party involved.

How Note Investing Can Be Beneficial

  • Borrowers benefit from working with note buyers to create a viable solution, whether it’s to stay in their property or move on, and/or buy time without incurring debt that can be detrimental to their financial life.
  • Banks benefit from others investing in notes as well because they are able to remove assets that are considered “toxic” from their books. Therefore, they are given a greater lending power to do what they do best: lend money.
  • Housing makes up a large percentage of the economy, and reforming distressed debt in that area is beneficial to the entire economic system. When a person is not paying their mortgage, they’re also not paying their taxes or insurance escrowed in their mortgage. By turning these delinquent mortgages into performing ones, note investors not only help an individual through their financial struggles, but they also help improve the community at large.

So with all these advantages, who wouldn’t want to add note investing to their portfolio? Of course, these benefits don’t necessarily mean note investing is always easy. But hey, neither is real estate. I’ve always subscribed to the idea of “there’s no such thing as a bad investment.” And I have found the most success comes from being diversified in multiple investment avenues, creating a synergy between asset classes — all in hopes to experience the advantages of as much as possible. Hopefully with this article and my new book, you can start to do the same.

Do you want to invest but don’t want to deal with tenants, toilets, and termites? Do you want to make a long-lasting passive income stream—from paper? If you answered YES to any of these questions, this book is for you! Pre-order today!

Have you invested in notes?

How has your experience been? Share 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.

14 Comments

  1. Cindy Larsen

    Dave,

    As always, thanks for another interest8ng and well written article.

    i am interested in investing in notes from my Roth IRA. i am only interested in 1st lier notes. Does your book tell me where to buy them, and how to evaluate them?

    • Dave Van Horn

      Good question Jerry!

      Usually not larger banks or lending institutions, but I do know of folks who’ve had luck buying from smaller community banks. An individual can also buy from servicers, note funds, and loan exchanges, as well as other individual note sellers.

      Best,
      Dave

  2. Anne Wallace

    Dear Dave
    I enjoyed your article. It makes me wonder about the range of returns for various levels of risk in notes on the income side. And also the potential total returns for the various types ( risk levels) of notes. Thanks again for the information.
    Anne

  3. Marcio Wilges

    I personally think that it’s important to diversify and a lot of people will really prefer something physical over something that’s intangible. Where a contract is still considered “tangible” there’s no actual value to a stock or share like that unless the company says there is isn’t it? This is why the world would crumble if there isn’t gold or silver or some other precious metal to back all of these financial tools. We all need to believe that there is an actual value to everything if the economy goes South…

    • Dave Van Horn

      Marcio, I think the same could be said of something physical like hard real estate. When arguing that ownership is a fallacy, I often say “try not paying your taxes and you’ll see who really owns your property!” 🙂

  4. All good points. There are 2 risks worth mentioning. First, with fixed-rate notes, as interest rate yields increase, the market value of the note decreases. The longer the note and/or the more rapid the rate increase, the greater the problem. Second, I’d also be wary about notes in second or lower position unless the senior liens are manageable and there is a mountain of equity cushion above the second. I have represented many whose second lien positions evaporated because they couldn’t cure the first, and foreclosure sales are often not for FMV. I’d say as long as you know the risks and go into it with your eyes wide open, this can work.

    Finding and buying can be a challenge. I’ve seen some bank note inventories that were not priced attractively(including market rate notes offered at substantially over face value). Crowdfunding sites offering secured loans at high rates tell me there ought to be a market. I’ve also known hard money lenders who do quite well financially in real estate even though they only hold notes.

  5. Dave Van Horn

    Hi Susan,

    Not exactly but our note fund is similar in some ways. I’m assuming your real estate security fund is a publicly traded company that invests in hard real estate, whereas our fund is a non publicly traded company that currently only invests in mortgages. Both also pay passive returns.

    Best,
    Dave

Leave A Reply

Pair a profile with your post!

Create a Free Account

Or,


Log In Here