Note Investing is simply investing in loans or Notes secured by real estate. A note is a debt security instrument obligating repayment of a loan at a set interest rate in a defined time period.
Depending on the state where the property is located, the borrower either signed a mortgage or a deed of trust when she took out the loan to purchase the home.
Traditional bank mortgage loans are no longer an option for many homeowners, not because the loans are particularly risky, but due in large part to legislation following the housing crisis, the banks fee structure is not set up to handle these lower priced homes. As hard as it may be to imagine in major metropolitan areas such as Seattle, in many other parts of the country there are many perfectly nice homes valued at less than $100,000.00. Additionally, banks still have a great deal of bad real estate loans on their balance sheets, particularly following the economic crisis. Most banks are unwilling to make real estate loans, particularly on lower priced homes, or unless they conform to a very strict set of criteria. Many homeowners and real estate investors find they have limited financing options available to them.
Many note investors feel that notes are better than most traditional investments because of the underlying collateral and the generally higher returns. The two closest investments to notes are probably tax liens and real property. With tax liens, you are in a safer lien position since property taxes are paid ahead of mortgages in the event of a default or foreclosure situation. When investing in a tax lien, you invest your funds, and then you wait to be cashed out. It’s extremely rare that you would take back the property. In the meantime, there is no cash flow or income while you are waiting to be cashed out.
With Note investing, you can achieve monthly cash flow and also have the potential to earn higher returns – without the degree of risk associated with the stock market, or the headaches of being a landlord or a rehabber. When you buy real estate as an investment, as opposed to notes, it’s simply not as passive because typically you (or your property manager) must deal with tenants, maintenance, contractors, townships, liability, etc.
The biggest differences between buying real estate and buying notes are depreciation and appreciation. From a tax perspective, there are no depreciation advantages with notes. As for appreciation, the face of the note is the face of the note, but sometimes when purchased at a discount, there can be a “phantom appreciation” because note values directly correlate to property values. When real estate values go up, the value of the notes go up. Another plus with purchasing a note is that you don’t need any credit, nor do you need to “qualify” as you would have to do for a mortgage to purchase real property.
Many new note buyers are fearful of foreclosure, if the borrower should stop paying. If a tenant of a rental property doesn’t pay rent, you must take the tenant to court by filing for eviction. Not only do you lose rent, but you must go through the eviction process, pay court costs, fix up the property again and then re-rent the unit. Usually, these expenses are incurred without recourse since many tenants do not have assets. If, on the other hand, you hold a mortgage note, you may be able collect the missed payments, late fees, corporate advances and any attorney fees, if the homeowner should fall behind in her payments. By attaching these items onto the loan balance, per your loan documents, you should be able to recover these fees at some point, provided there is enough equity. There’s also a significant difference between a homeowner’s mentality and a tenant’s mindset, and how they will care for the property. The homeowner usually has more invested into the property due to pride of ownership.