Which is the Riskier Investment: Performing or Non-Performing Notes?

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I bought my first discounted note in May of 1976 and have done almost everything that can be legally done with them ever since. I’ve brokered ’em to clients, bought, sold, foreclosed, and hypothecated ’em. I’ve traded them into other things—and not just real estate. And that’s not all. They’re wonderful, as long as you understand which way is north on that map.

Ah, and there’s the rub.

Compared to buying residential income properties around the country, the acquisition of discounted notes, whether performing or not, is far more involved, with far more “under the radar” pitfalls, period, over ‘n out. However, with a real working knowledge, either your own or with a professional at your side, even non-performing notes can be an incredibly useful arrow to add to your quiver.

What’s a Note?!

Simple—it’s an IOU, a promise to pay the lender back on the terms stated. It sometimes is amortized completely or may have a shorter term with a balloon payment. It’s always, at least in my world, secured by a piece of improved, though rarely unimproved, property. There’s some kind of deed, a trust deed in many states, which evidences the fact of a specific property acting as collateral on that loan. If you’re the guy making the monthly payments and don’t pony up long enough? You eventually lose the property.

What is a Discounted Note?

Nothing sophisticated here. A discounted note just means that whatever the loan balance the day you buy the note, your purchase price will be less. To what degree is always the million-dollar question, right? The bigger the perceived risk, the higher the discount. Or the lower the note’s interest rate when the discounted note market demands much higher, the higher the discount. And yeah, if the note’s interest is high and all other factors being more or less equal, the discount will be less. See what I mean? Definitely not rocket science.

“Non-Performing Notes” Means What You Think it Means

The property owner, the guy contractually obligated to make the loan payments, ain’t doin’ it. Sometimes it’s not lack of payments. It can be one or more of many “breaches” of the note contract. But usually it’s unmade payments that describe what’s commonly called a non-performing note. Now that we have the easy stuff down, let’s move things up a notch or three.

Related: The Elephant in the Room: Where Are All the Real Estate Notes!?

What’s the Overall Bigger Risk—a Performing or Non-Performing Note?

I’ve won a ton of drinks and free food with that question. It’s a superb example of always do the complete analysis when comparing two or more potential investments with a finite wallet. Take a look at one of each kind of note, then decide for yourself. But realize down to your bone marrow that it’s a different answer in different cases. It’s been my experience in 42 years of note doings that the non-performing note purchases nearly always carry less risk. This assumes a professional is involved one way or the other.

Note #1: Performing

Loan balance is $50,000, with an 8% interest rate. Payments are $403.57/mo. Never had a late payment. House is worth $80,000, as is at the time you purchased the note. The note can be had for $41,500. Your cash on cash return would be 11.67% (year’s payments divided by purchase price). If the payor lost their job and missed a bunch of payments, you’d need to commence foreclosure. That’s an expense that varies, but should be in the $2-4,000 range, out the door, all finished, you own the home. Let’s do the simple math.

Caveat: If a broker gets you a note and takes a fee or commission for it, that’s perfectly OK. But never allow anyone to do the analysis on the note without counting in any of that fee/commission that came out of your Levis. For example: You pay $25,000 for a note and a $1,500 fee to your pro. As far as you’re concerned, the yield will be figured using $26,500 as the original capital investment.

(Both the following notes are in first position.)

If a performing note pays ’til the end, you’re happy. If it pays of early, you’re happier. Let’s say this one paid as agreed for several years, then defaulted. Here’s a common scenario, following successful foreclosure.

1. The home needs $5,000 of lipstick to get the highest price, and sell quickly.
2. It sells for $90,000.
3. After commission and closing costs, your net proceeds are around $82,800, though we’ll round down to $82,000.
4. Your original $41,500 has grown to $46,500 due to $5,000 of lipstick.
5. $82,000 – $46,500 = $35,500 profit, NOT counting all the payments you did receive.

Your yield clearly depends upon how long you had the note from day one to day last. If your total time owning the note/house was 5 years, and out of 60 scheduled payments you got say, 48-50 or so, your overall yield would be somewhere around 17-22%/year. Not bad.

Note #2: Non-Performing

The home securing this note is literally across the street from the performing note above. Its balance is the same, and home value also. All things are the same sans payments made. The homeowner/payor hasn’t made a payment in six months, and the note holder is ready to cut his losses, not interested in foreclosing. You can buy that note today for $25,000. I know, ’cause I’ve seen me do it so many times.

This means that from day one, he could realistically be collecting his net proceeds from escrow in 60-120 days. But let’s say Murphy makes this note a special project, and it takes a year, just for chuckles. So what? That means he’s netted $73,000 in a year with a total capital investment of $34,000 (purchase price + foreclosure costs + lipstick). Let’s now figure out not only his actual yield, but talk about his relative risk, compared to the guy who bought the performing note securing the exact home across the street.

Related: The Beginner’s Guide to Building Wealth With Private Notes

We have $34,000 invested, divided by $73,000 net proceeds to total (drumroll please) 114.7% annual return. Normally, he’ll have gotten in and out in less than a year, but you can easily see the point. In regular folk speak, he more than doubled his money in a year. Now, show of hands, who wants to sign up to do that a couple times a year into infinity? Again, duh, right?

Let’s Talk Relative Risk

This ain’t rocket science, people. Same loan balance, same home and home value. We consider the risk in discounted notes and land contracts to be found when foreclosure becomes reality. The loan-to-value ratio on both these note balances at time of acquisition was identical—62.5%. In the note biz, we call that a safe position. However, the total capital invested/value ratio is quite a different story. Our first guy sports a $46,500/$80,000 = 58.125% “capital-to-value” ratio, whereas our non-performing investor has a $34,000/$80,000 = 42.5% ratio. Which one seems riskier to you? Go ahead, take your time, no rush.

But let’s go ahead and pile on anyway by counting how much better the return was not only in dollars made, but in time spent. The non-performing investor not only made more money; he made it roughly five times faster! A double winner. Since home values, loan balances/terms/neighborhood were identical, the real difference was the safety of the original investment capital. In other words—and ironically to most—the non-performing note carried with it less risk than the performing note did. Not only less risk, but more built-in profit to boot.

But what happens if we have another economic calamity before the home can be sold?! Oh. My. You’ll then find yourself “stuck” with a just rehabbed, free ‘n clear home all ready to rent. Poor baby. As a fallback position you could do a lot worse. Ask yourself what happens like clockwork when the economic down cycle rights itself. Price begin to climb. That $80,000 home in 2011 is now worth how much? Ah, now you’re smiling.

Takeaway

Though not universally true, I’ve found this example to be, more or less, the rule. The key, as it always is, is that we do the analysis to the last digit. When I do these analyses on non-performing notes, at the end the decision to buy or pass virtually always makes itself.

Any questions on investing in performing vs. non-performing notes?

Comment below!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.