Rentals or fix-and-flips are the real estate investing vehicles we usually talk about to build wealth and achieve financial independence. But another, equally powerful real estate technique should be on your radar if it’s not already.
The technique is called private note investing.
In general, a private note just means you’re the lender instead of the owner of a real estate property. And in case you didn’t notice, the names on many of the biggest and most expensive buildings in small towns and big cities around the world are lending institutions (i.e. banks)!
It’s no accident. Those big, institutional note investors paid for those fancy buildings with profits. And as a smaller, private note investor you can build your own net worth and financial independence in a similar way.
Like other parts of real estate investing, there are many different niches and approaches to private note investing. I’ll share some of the top ones in the rest of this article using real world examples. I’ll also share some of the challenges and reality checks that come with private note investing.
But let me begin with why you should consider investing in private notes in the first place.
How to Purchase Real Estate With No (or Low) Money!
One of the biggest struggles that many new investors have is in coming up with the money to purchase their first real estate properties. Well, BiggerPockets can help with that too. The Book on Investing in Real Estate with No (and Low) Money Down can give you the tools you need to get started in real estate, even if you don’t have tons of cash lying around.
Why Private Notes?
I’ve been investing in real estate for 15 years. Like most of us, I started with flipping houses and buying rental properties. Rentals, in particular, are still a core part of my approach to real estate investing today.
But much of my success in both rentals and flips came from using money or equity from others in the form of private notes. I supplied a good deal, and they supplied most of the money.
It didn’t take long for me to realize that these private lenders were making good returns. And on top of that, I was doing all the work and taking most of the risk as the property owner!
After this realization, I didn’t give up the other real estate strategies. But I did start building a private note portfolio in parallel. Here are a few reasons I did.
1. Steady, Consistent Interest Income
In a world of 1% bank CDs (certificate of deposits), 2% stock dividends, and 3% bonds, high yielding private notes are a luxury. This is especially wonderful when you need to live off your investment income.
But interest income is also a great wealth builder if you reinvest the earnings wisely (and tax efficiently). More on that soon.
2. More Passive
Private notes are a more passive investment than rentals or flips. Notice I didn’t say completely passive. There is no such thing.
And this passive quality makes private notes ideal for a self-directed IRA or 401k, where you want to be more hands off.
But retirement accounts are also the ideal holding entity for private notes for another reason. When you earn interest personally, it’s taxed at your ordinary income tax rate. But inside of a retirement account, there is no tax on the interest until it’s taken out (or in the case of a ROTH IRA, it’s never taxed).
So, if your goal is to use private notes to build wealth, a retirement account is the perfect vehicle to let them grow and compound tax-free for years.
3. Greater Control
I started investing in private notes because I liked the control. Notes, like rentals, allow you to personally impact your investment success. You decide the borrower, the interest rate, and the note collateral (i.e. a property) that’s acceptable to you.
As a beginner, this may be a daunting reality. How do you know who makes a good borrower, what a good interest rate is, or what type of property makes good collateral?
This is why I think private notes are not a beginner strategy. You need some experience in the trenches of the real estate game so that you understand the investors you’ll be lending to.
But even if you have experience, getting educated on the fundamentals of notes and receiving help from competent professionals is still a prerequisite. Especially early on, the experience of others can compensate for your lack of knowledge.
So, for all those reasons and more, private note investing was worth my time. And perhaps it’s worth your time, too.
Now, let’s look at the primary types of private note investing.
The Two Primary Types of Private Note Investing
As I said earlier, private note investing means you’re in the role of the lender. And within that role, there are two major types I see investors use:
- Private money lending
- Discounted notes
With private money lending, you are in the business of loaning money to other investors.
And the discounted note business involves creating and/or buying notes at a discount to their face value.
In both cases, you could own the entire note yourself. Or you could own part of multiple notes through a fund (i.e. a group of investors). There is also a relatively new approach to lending called real estate crowdfunding. It has made it possible to invest in pieces of many larger loans (like $2,000 to $5,000 chunks) through online platforms.
Both private lending and discounted notes have their pluses and minuses. I’ll go over each and give examples below.
Private Money Lending
Private money lenders often fund some or all of the purchase when investors buy properties to flip or to hold. For example, when investors buy rentals using Brandon Turner’s now-famous BRRRR (buy-rehab-rent-refinance-repeat) technique, the upfront money often comes from a private money lender (or a hard money lender, which is a business that loans out money on behalf of private money lenders).
The rates that private money lenders charge aren’t cheap. I’ve seen them range from 7% to 15% or more, and there are usually upfront fees and points in addition to the interest.
Related: How to Define Systems & Build a Team When Investing in Real Estate Notes
But many investment property owners still use these loans because traditional lenders are not as flexible or fast with investment purchases. And the availability of the money allows investors to buy profitable deals that they might have lost otherwise. They then refinance or sell the property within a short period of time to avoid paying the higher rates for too long.
As a private money lender, you can make loans directly to borrowers.
For example, you could network on BiggerPockets or at local meetups and find a fix-and-flip investor who you trust and who demonstrates competence. You could then arrange to loan this investor money for their next project.
You could also find a local, experienced broker who finds, screens, and services loans for you. In this way, you borrow their expertise and logistical skills in exchange for a fee that comes out of the interest and points charged to the borrower.
You could also invest in group funds and crowdfunding platforms that have made it possible to diversify your money across multiple loans. You usually need to be an accredited investor to use either of these options. But if you are, it could be a viable way to diversify your risk and to use professionals to help screen deals up front.
Now, let’s look at a specific example of using private money loans to build wealth over a longer period of time.
Example of Growing Wealth With Private Money Loans
Mike is 35 years old, and he has already been investing in real estate for five years. He owns five rentals, and he’s completed several fix-and-flip deals. He had challenges and made mistakes early on, but his “battle scars” taught him lessons that made him a better investor in the end.
Now Mike has turned his attention to his 401k retirement account from an old employer. He has a balance of $300,000 invested in stock index funds. The stock prices have gone up significantly, and he wants to diversify some of that into real estate private notes.
So, he rolls over a $150,000 chunk of the 401k funds to a self-directed traditional IRA account. This is not a taxable event because the money goes directly from one custodian to another.
With the new self-directed custodian, he can invest in alternative assets like real estate notes. And as the beneficiary of the account, he gets to choose and have control over where to invest his money.
Finding Borrowers for Private Money Loans
For many reasons, Mike does not want to advertise that he has money to loan. Instead, his strategy is to meet investors and find the ones he likes and trusts. Then he will approach the subject of private money lending if it makes sense.
So, Mike begins networking heavily on BiggerPockets and at local real estate investor meetings. It takes a while, but he gets to know a couple of fix-and-flip and rental investors that he feels good about. He likes their character and honesty. And he also likes their competence and ability to execute successfully on their investment projects.
During a conversation with one of these investors named Regina, the topic of private money comes up. She tells Mike that she finds more deals than she has money to fund herself. She would like to use a private money lender to do a few extra deals per year.
Mike tells Regina that he has some self-directed IRA money and would be interested in making loans. So, they discuss details and agree to work together on the right deal.
The First Private Money Loan
Within a month, Mike makes his first private loan.
The property is a fixer-upper single-family house that Regina plans to flip within six months. Her purchase price is $75,000, and she plans to invest another $75,000 in repairs to make it a beautiful home that can sell for $225,000.
The house has been a long-time rental, and it needs major updating. It needs a new HVAC system and a new roof. Plus Regina plans to overhaul the layout, kitchen, baths, landscaping, and cosmetics.
Here are the terms that Mike and Regina agree to:
- Note and mortgage paperwork will be prepared by Mike’s attorney
- Title insurance required
- Hazard and liability insurance for vacant property required
- $140,000 total loan
- $65,000 at closing (Regina makes a $10,000 down payment)
- 3 repair draws of $25,000 (total of $75,000), third party inspector required & fee paid by Regina
- Interest and fees:
- 2 points (a point is an upfront fee for 1% of the loan, so 2 points = $2,800 in this case)
- $200 processing fee to cover the IRA custodian transaction fees
- 10% interest
- Interest only monthly payments
- 9-month term
- No prepayment penalty
- 2% fee for extending loan an extra 3 months
Regina is happy because Mike’s IRA funds the loan 10 days from the date of her request. This allows her to make a strong offer to the seller and get her low price.
Mike is happy because he has a competent borrower, solid collateral, and profitable terms.
Regina fixes the property and has it sold in 6 months. So, after getting paid off, Mike’s results for the first loan look like this:
|Results of First Private Money Loan|
|Interest Earned (6 months):||$7,000|
Regina is happy because she made a profit of over $40,000 after all her costs. Mike is happy because he got an above average return on a property and a deal type that he understands. They are both ready to do another deal together as soon as possible.
Private Lending Wealth Building Over Time
Not every deal for Mike will go like the first one. Some will be better, and some will be worse. And his overall returns likely won’t be so high.
First of all, Mike’s has $150,000 in the self-directed IRA, but only $140,000 was invested. So, $10,000 sat idle at the custodian making no return. This will likely be the norm because it will be difficult to always invest the total amount of money in the account. There will also be times between loans when the money is not invested. So, during that time, there will be no return.
Next, Mike will likely incur collection, legal, and foreclosure costs at some point. It’s almost inevitable when you lend money over the long run. And the fees to solve those issues will eat into overall returns.
Lastly, over time Mike may decide to use brokers and loan servicers to help find deals, handle some of the work, and monitor loans. And their fee will take some of the returns.
So, to simplify calculations and provide an example of how Mike could use private lending to build wealth, let’s assume Mike’s average return on all of his money is 10% per year.
At age 60 after 25 years of consistently lending, Mike’s original nest egg of $150,000 would grow into just over $1,625,000!
[If you want to use a financial calculator to do those types of calculations, I use the free fncalculator.com app for Android and iPhone/iPad.]
And let’s assume his $150,000 investment in index funds also grew but at an annual rate of 8%. Those funds would be worth just over $1,027,000 in 25 years.
Altogether, his retirement funds at age 60 would be worth over $2,652,000. But most importantly, he could turn those funds into income to pay for his living expenses in retirement.
Even if he could only generate 6% income yields from more passive investments, that would still be $159,000 per year (.06 x $2,625,000).
And knowing people like Mike, I’m sure he has also done well on his non-retirement account investments in real estate. So, his total income in retirement will likely be much higher.
Now let’s look at the other type of private note investing—discounted notes.
Discounted note borrowers could be investors or owner-occupants. The common theme is that you as the private note investor own the note at a discount. And that discount gives you extra risk protection and an increase in returns.
How can you find a note at a discount? I’ll give you a short example using my primary approach to the discount note business.
Let’s say I buy a single family house at a discount for $50,000 using my own cash. It needs work, and I invest an additional $20,000 into making it a nice place to live. After the work, the house is worth $100,000, and I have $70,000 invested.
But instead of flipping the house and cashing it out, I find someone who wants to buy it with owner financing. After screening them heavily with a third party mortgage originator (more on this and Dodd-Frank regulations later) and testing them out as a renter for a year, I then sell them the house for $100,000.
Related: Diversifying into Real Estate Notes? Better Choose a Strategy! Here’s How.
The new buyer puts $10,000 down, and I carry back seller financing (i.e. a private note) for $90,000 at 7% interest for 20 years. This note is also secured by a first mortgage or trust deed to give me security in case I need to foreclose.
My net investment is $60,000 ($70,000 minus the $10,000 down payment), and I own a private note with a face value of $90,000. The discount increases my return and gives me a larger margin of safety in case something goes wrong and the borrower stops paying.
Although I created the note in this example, there is also a HUGE business buying seller financing notes like I created. Either individually or through note group funds, you could buy those $90,000 notes from people like me (at a discount, of course).
Example of Growing Wealth With Discounted Notes
In the discounted note example above, I financed $90,000 at 7% interest. With a 20-year amortization, that means the payment to me as the note investor would be $697.77 per month.
But remember that your actual return on this note is much better than 7% because you own it at a discount. Your net investment after receiving the $10,000 down payment is only $60,000.
So, using a trusty financial calculator again, your return on the $60,000 over 20 years is more like 12.9%!
And if the buyer pays you off early, like in 5 or 10 years, your return will be even better because you’ll get a big chunk of the discount you built up front.
Our prior example with Mike and his $150,000 in a self-directed IRA could easily apply to this type of investing. Instead of or in addition to private money lending, Mike could choose to buy a couple of houses at a discount and then sell them with owner financing like I explained above.
And the safety and returns over time could be just as good as private money lending or better.
In fact, what I like about either creating or buying discounted notes is that the notes are more consistent. In 2008 and 2009, I created discounted seller financing notes. Today, almost 10 years later, most of the buyers are still happily paying me. And I’m happy to still be receiving their payments!
With these types of notes, you do most of the hard work up front. And then you continue to reap the rewards for many years to come.
But like any business, there are also challenges to discounted notes and private lending. I’ll discuss a few of the more important ones in the next section.
Challenges and Reality Checks With Private Note Investing
As a BiggerPockets reader, you’re not the type of person who believes everything is easy. I gave you a lot of benefits of private note investing above, but you and I both understand that any worthwhile technique has its shortcomings.
The shortcomings of private note investing for me fall in two big areas:
I’ll talk about each of those here.
Regulation of Private Note Investing
The long-term trend for private note investors is to be regulated in the same way as big institutional lenders like banks. More than anything, this increases your costs and hassles in order to stay compliant.
For example, The Dodd-Frank Act was signed into law in 2010 in response to the turmoil and in many cases mischief that occurred in the lending markets leading up to the 2008 Great Recession. The wide net cast by the law caught seller financing and other small lending operations in the same rules.
And there are an array of other state and federal laws that you must pay attention to, both with private lending and discounted notes.
So, the first lesson is that you must get educated on regulations and receive professional advice before jumping head first into private note investing.
The BiggerPockets forums are a great place to start. Follow and ask questions to experienced note investors like Jay Hinrichs, Dave Van Horn, Jeff Brown, and Bill Gulley. You can also read this post by Brian Gibbons with a nice summary of the Dodd-Frank regulation’s impact on seller financing.
Also, plan to get local legal counsel from an attorney who understands private notes and real estate investing. You may be able to find this person through local real estate meetups.
The second lesson of private note regulations is to learn the legal exemptions.
For example, the regulations that resulted from the Dodd-Frank act apply to owner occupant borrowers. So, if you’re making loans to investor borrowers, those particular rules don’t apply. There will be other federal and state rules that still apply, but it would less cumbersome.
Also looking at the Dodd-Frank act, investors who only seller finance three or fewer properties per year have fewer regulations than others.
So, by knowing the rules and the exemptions of lending laws, you can build your private note investing in a way that stays compliant and safe.
Risk in Private Note Investing
All investments have risk. You’ve heard that before, haven’t you?
But what are the big risks of private note investing? Here are a few that you should watch out for.
Your borrower could stop paying you or default on your private note in another way. If the borrower is uncooperative, you would then have to hire an attorney to foreclose. And a bankruptcy could delay even that process.
So, you need to be prepared for major delays and costs in the event of a default.
This is the reason experienced note investors emphasize a margin of safety. A margin of safety between your investment and the value of your collateral protects your principal. I like to be at 65% or less loan-to-value.
Defaults are also the reason you should maintain cash reserves. If you loan every bit of your money, you could put yourself in a very unfavorable position.
The borrower of your private note determines much of your success. A bad borrower with little character or desire to follow through when things get tough will make your lending experience miserable.
On the other hand, a good borrower with character will follow through and do right by you even when a deal or an economy go downhill.
Finding good borrowers starts with getting to know people. You can and should also use proxies for character like credit and background checks. Then if possible require skin in the game (i.e. their own money in a deal) and a personal guarantee.
The property is your ultimate collateral and the safety net for many of the other risks mentioned here. So, problems with the property, the title, and with the local market bring major risk.
So, first of all, make sure you always hire an attorney to research and guarantee title with a title insurance policy. Title problems would prevent you from selling the property in the event you had to repossess the house.
Second, make sure the property itself is inspected thoroughly by knowledgeable inspectors and contractors before you fund the deal.
Third, hire an appraiser to help you understand the market value of the property. And I also suggest studying and learning the neighborhood trends yourself. The local market fundamentals are so important that you can’t just depend on third parties.
And related to properties and risk, here’s my number one rule for private notes.
If this is not a property you would be excited to buy for the same price as your loan amount, don’t do the deal.
You may be a lender, but there’s always a chance you will become the property owner after a foreclosure. So, think like one!
There are so many profitable niches within real estate investing. I hope this article has shown you why private notes are an important one that you should consider for wealth building and long-term income.
If private note investing appeals to you, it may be something you do on the side in order to complement and synergize with your other investment strategies like rentals and fix-and-flips. That’s what it’s been for me.
Or you may decide private notes have enough promise to be your primary investing strategy. There are investors who have successfully done that as well.
But whatever you choose, be sure to treat private note investing like a business. Get educated, network with successful investors, and hire professionals to help. Let this article only be the beginning.
Best of luck!
What do you think about private note investing? Is this something that you’d like to try? If you’re already investing in private notes, what has your experience been like? How have you chosen to invest in this niche?
I’d love to hear from you in the comments.