Buy and hold for income
Notes are a great investment for long-term cash flow. Because notes are secured by real estate you know that worst case the borrower stops paying, you foreclose on the property and can sell it, flip it or rent it. You might ask why wouldn’t you just buy rental properties? Rents are usually higher than mortgage payments so wouldn’t you get a better return? You must consider all the expenses that a property owner has; taxes, insurance, and maintenance. As a lender, you don’t have any of these expenses or the inconvenience of dealing with them. You will likely want to have a loan servicing company service the loan for you because they will be able to verify that the borrower has been making their payments and on time if you want to sell the note later. The average cost to service a note is about $208/ year or $17/ month. A property manager will typically charge 8-10% of monthly rent or flat fee around $100/ month plus expenses and a placement fee of 50-100% of the first month’s rent depending on the company and state. An obvious difference in owning rental property and owning notes is that at the end of the contract the borrower has paid off the note, compared to rental properties where you still own the house and it has hopefully appreciated. This doesn’t sound very attractive but you can usually buy notes for less than the contract value which means your yield will be higher than the interest rate on the note (also known as coupon rate). Remember you’re not just getting interest on the full contract price, not the price you paid for the not. You’re also getting principal payments on it too which can result in very high returns. For more information on how discounted notes affect your yield read our article “How to calculate the yield of a note“.
Buying Notes to Acquire the Property
Nobody likes to see people go through foreclosure, since the housing market crash in 2008-2009 likely all of us knew someone who went through foreclosure, maybe even have experienced it personally or at the very least have seen the empty houses and dead lawns in the neighborhood. The cold hard truth is that for many homeowners it is an inevitable reality regardless of who the lender is. Buying non-performing notes with the intent to acquire the property is great way to get properties at a huge discount! Banks sell these notes at bigger discounts than REO’s because they need to get these bad loans off their books and there is less competition because of uncertainty. Most flippers don’t know about note investing in the first place and if they did and bought a note to acquire a property they most likely wouldn’t know what to do with it if the borrower began making their payments again. This investment strategy can also become very difficult and complicated if a borrower goes into bankruptcy.
There are many investors out there who wholesale notes just like investors wholesale properties. You need to be careful though because often wholesalers don’t own the assets and only have them under contract, it’s easy to find yourself caught in what they call a “daisy chain” a chain of wholesalers who have the notes under contract from each other. If you buy a note from the end of a daisy chain it will be a lengthy and difficult process to get the proper documents and collateral. If you think a seller may be part of a chain just move on and like in any business always try to ensure you are dealing with reputable people. The strategy is basically the same as wholesaling real estate, find motivated sellers, buy the asset at a discounted price and sell the asset for more.
Just like you can rehab a house you can rehab a note and once you have the note performing again you can flip it to another investor or hold it long term for cash flow just like you can with a house. Rehabbing notes is great because you can get non performing notes at huge discounts and that turns into huge yields once you have them re-performing. For example, if you bought a non-performing 10 year note for $65K with a $100K unpaid balance at a 6% interest rate and got it performing again from the interest and principal payments on a 100K note your yield would be 16.53% over the 10 years. You could season the note for a year and then sell it at 80-95% of the unpaid principal balance (UPB) or hold it for cash flow. You can also encourage the borrower to refinance at a lower interest rate, you could help them by providing them a credit repair program and incentivize them with a principle discount if they refinance within a certain period. Obviously the higher the interest rate on the loan the more incentive the borrower will have to do this so if this is your strategy you will be looking for loans with high interest rates. For example, if you took this approach with a 100K note that you bought for 65 cents on the dollar and they refinanced a year later you would receive $95K, a 46% return, not including the payments you received. Always have alternative strategies though, there is no guarantee that the borrow will do what they need to do to refinance even if it makes sense.
Second Position Notes & Other Junior Liens
You can also buy second mortgages, third mortgages, and any other loan or lien on a piece of real estate. It’s very important to realize that if another loan has higher priority forecloses that your note is wiped out. If a loan in a lower priority forecloses the trustee or buyer can take control of the property subject to the higher priority loans. The government always has first priority with property taxes and violation fines so you will want to check title for government liens. For these reasons second’s and lower priority notes can be a lot riskier. You can execute all the same strategies with a second, you can buy performing and hold for cashflow, buy non-performing with the intent to take control of the property, or wholesale.
Second position with no equity
You probably think that you would never want to buy a second if there was no equity behind it but that’s not necessarily true. You certainly wouldn’t want to pay very much for it but if it’s consistently performing, payments are being made on time and the borrower has emotional equity in the property then it may be a good investment. With the higher risk you would, of course, seek a higher discount on the UPB and realize a higher yield.
Non-performing second with no equity on the first
These are very risky but but can also bring incredible returns if you invest carefully and work them out properly. If a borrower has been making the payments on the first and there was a temporary hardship that prevented them from making payments on the second but they will be able to make payments moving forward then that note might be a good investment at the right price. These situations may often involve a loan modification to spread out the payments over a longer term or possibly even a principle reduction. These are often considered junk notes so you can buy them for next to nothing and if you are really good at working them out you can make great returns. When investing these notes you are relying heavily on the borrower’s “Emotional Equity” (How emotionally attached the borrower is to their home.) You will want to research how long they have lived there, did a family member own the property before them, do they work nearby, do their children attend school in the area, are they involved in the community where they live, and are they taking good care of the property. Some people will cut loose like nothing when they are upside down, others will do anything to stay in their home, these notes require careful research on the borrowers to make good informed investment decisions.
If there’s no equity on the first and the borrower does not have the financial ability to keep the property don’t buy the junior lien. On a second with no equity the only way to profit is to get them re-performing as you would not want to take control of a property subject to another loan that would allow no equity.