If you’re interested in building wealth through real estate but want to avoid the management headaches of owning actual property then investing in real estate notes might be for you. Sometimes called mortgage notes, these financial assets can be bought when a mortgage lender sells the note attached to that loan to an investor who then takes over the loan.
This allows the lender to get cash today when they need it and offers a unique opportunity for an interested investor. The original borrower still makes their monthly mortgage payments as usual, but now the investor receives those monthly payments of principal plus interest instead of the lender. This creates a nice passive income stream for the real estate note investor.
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Understanding Mortgage Loans
When you wants to purchase real estate but can’t afford to pay for the entire property in cash up front, you’ll go to a bank or other financial institution to secure a mortgage loan. The loan requires you to pay the money back, plus interest, over the course the mortgage loan life, typically between 15 to 30 years.
If the you stop making payments and eventually default on the mortgage loan, the lender can legally take possession of your home. This situation assigns ownership of the home to the bank and places the home into foreclosure.
Most Americans are familiar with mortgage loans and have one themselves, yet fewer are familiar with what a real estate mortgage note as an investment is.
While a real estate investor can buy single-family homes or commercial properties to flip or rent out, some purchase mortgage notes as a type of investment.
In fact, Groundfloor offers mortgage notes to buy for investors.
What are Real Estate Notes?
A real estate note is a type of debt which is then sold as an investment. When a person is interested in borrowing money from a bank or credit union (known as the lender) to secure a home mortgage loan they sign an original promissory note, also referred to as a real estate note, mortgage note or just a note.
This note gives information about payments, interest rate, purchase price, monthly payment, and other information on the details of the agreement. The note is secured by the property itself – so if the homeowner fails to make the loan payments – the note holder can claim the property.
That’s the foreclosure situation we mentioned at the beginning of the article!
Why would a lender sell the note? After all, they are relinquising a nice income stream.
The lender might need the cash now and may wish to sell this note to a interested investor. Lenders sell notes to free up cash to make other investments or pay outstanding debts.
Investors buy mortgage notes in order to create passive income for themselves or to flip the mortgage notes and make a profit straight away.
How do Real Estate Notes Make Money?
Mortgage Notes make an investor money through the principal and interest payments that the borrower now pays directly to the investor. By obtaining the original note at a discount you might make a higher average return on this type of real estate investment, typically around 10%, compared to flipping or investing in rental properties.
Mortgage Note Investing
To get started buying and selling real estate notes, you’ll need to understand the types of notes and where to buy them. The lien position of the note is also important.
When someone takes out a mortgage loan to purchase property, the mortgage loan actually puts a lien against the property that remains attached to the mortgage loan until it is paid off. A lien is a claim or legal right to the property which is being used as collateral for the debt agreement. This lien outlines who is responsible for paying off the debt and determines who gets paid first if there are multiple lenders involved. A first lien holder will be the first to be paid, and then payment goes to the second lien holder, third lien holder and so on.
It’s preferable to buy a real estate note with a first lien position.
Types of Mortgage and Real Estate Notes
There are a few different types of mortgage notes that you can invest in but the two main varieties are performing mortgage notes and non-performing notes.
Performing notes – A performing mortgage note is a mortgage in which the borrower has made all payments on time and is not at risk of defaulting. This is the most common type of notes to invest in. It’s also the least risky.
Non-performing notes – A non-performing mortgage note is one in which the borrower has stopped paying their mortgage loan, also known as default. When a loan has been in default for 90 days it is classified as a non-performing mortgage note. Before making an investment in a non-performing note you must perform your due diligence and assess whether you have the risk tolerance to buy the note. You’ll want to investigate the details of the mortgage including property condition, interest rate, and total amount of debt attached to the real estate.
Buying and Selling Real Estate Notes
How to Buy Real Estate Notes
Buying a real estate note is typically easier than physically buying a property to rent out or flip in order to create cash flow. To buy a real estate note you have to find a lender who is looking to part with the note. The lender would then sell you the note in order to obtain cash and you would receive the mortgage payments in order to create a monthly cash flow for yourself.
Where to Buy a Note
There are several different places where you can purchase mortgage notes as a form of real estate investment:
Online Marketplaces – Buying notes online can be done through several marketplaces such as through Notes Direct or Paperstac. If you’re looking to get into mortgage note investing strategies but are more interested in shorter term options, Groundfloor is a platform which utilizes crowd-sourced capital to make it possible for investors to make 12-18 month investments in real estate debt. This is a plus, as note investing might require you to tie up your money until the note is paid back.
Private Sellers – In addition to buying notes online, you can discover individuals who currently own or are holding a note through sites such as Listsource. By contacting these investors directly through mail or online you may have a chance to buy a a real estate note at a discount. Sometimes in a seller financing situation, in which the buyer purchases the mortgage loan from the seller instead of a traditional bank or credit union, the seller is looking to sell the mortgage loan in order to free up cash today.
Cash today can be more valuable than cash tomorrow if used for other investments or even if the lender is in a pinch and needs to pay other liabilities, and thus why sellers look to sell these notes off as an investment.
Hedge Funds or Private Equity Firms – While Hedge Funds and Private Equity Firms themselves can buy up mortgage notes in bulk from banks directly, it can be difficult for individual investors to participate in these markets. Although it is not as accessible for individual investors to buy directly this way it has been done.
Motgage Note Brokers – These are individuals or firms who have an inventory of notes and deal in buying and selling them. As with all brokers, understand the commission and fees the broker charges.
Crowdfunding or Funds – If you would prefer to buy a group of notes, pre-packaged and vetted, then you might be interested in a real estate debt platform like Groundfloor. This company originates the loans to borrowers and investors may then buy shares in a package of real estate notes. This is kind of like buying shares of many stocks through a mutual fund.
Similar to flipping actual real estate, you can also make money buying real estate notes at a discount and then reselling or flipping them, for a profit.
Flipping notes is simply buying a real estate note and then later selling it. There are a variety of ways to make money with this strategy including buying a note at a discount and then reselling it. Or you might buy a note and then sell only a portion of the note.
Here’s another way to flip notes and make a profit. Contract with a lender to find a note buyer for either a performing or non-performing loan, for a small fee, typically between 3-6% of the contract price.
Risks of Note Investing
The main risk of investing in notes comes if the borrower defaults on their mortgage loan and is unable to pay the monthly principal and interest payments. If this happens then you will no longer receive monthly cash flow and will have to work with the borrower to help them get back to paying or to determine their other options such as foreclosure.
Although foreclosure could be considered an opportunity to purchase the property at a discount. Although most mortgage note investors prefer to trade in notes and not actual real estate. This is one reason to perform your due diligence before buying a note. Having to foreclose on a buyer involves a lot of work, legal fees, and time. And throughout the process, there isn’t the cash flow from the mortgage note payments.
In order to mitigate the risk as a note holder, it’s important to research the investment and examine the borrower’s past financial dealings inclulding credit score, payment history, the lien position of the loan. Determine from the seller whether the borrower has had difficulties making payments.
It’s better to walk a way from a risky situation than lose time and money chasing a non-paying borrower or worse, forclosing on them.
Pros and Cons of Investing in Notes
There are several pros to investing in mortgage notes. The most prominent ones are creating an income stream. And note investing is easier than buying and managing real estate.
Income stream – By investing in a mortgage note from the original lender you then receive the monthly principal and interest payments that are made by the borrower. This results in guaranteed passive income for the duration of the loan balance.
Ease of investment – Buying a note is an easier real estate investment than buying and managing real property. There is a lot of time and money that can go into purchasing a property for sale or rent. You have to factor in costs for fixing it up and then either listing it to sell or finding a renter. If you rent out the proerty you’ll need handle all the management tasks. Renting property out has its own risks and you can lose money quickly if unable to find renters. There’s also expensive maintenance comes up unexpectedly or even price depreciation.
If you invest in a fund, then you’ll spread the risk around and minimize the danger that your only note goes into default.
One disadvantage of investing in mortgage notes is the risk that the borrower will default. If you buy non performing mortgage notes, then it’s more likely that the borrower will be unable to keep up with their monthly payment and thus, default on the mortgage loan. If this is happens, then you will need to work with the borrower directly to help get them back to payment status so that you can receive the cash flow. Or, you might need to foreclose on the property, and then you’ll own the real estate, not just the note. And that comes with a whole host of other problems.
Mortgage Notes can be great real estate investments as long as you perform your due diligence. Through mortgage loan payments you can receive a steady cash flow through the principal and interest payments that the borrower makes. You’ll want to make sure that the note is a performing mortgage note unless you can handle the risk of investing strategies in non-performing mortgage notes.
Before investing, understand the overall condition of the property and know if there are any liens or unpaid taxes. It’s also important to understand the borrower’s payment history and their credit score. This will help you evaluate whether the investment is a solid one.
In order to make money on mortgage notes you must make sure that the note you purchased is in good standing order. If the note is in default you will have to work with the borrower to get them back on track with making payments. As the note holder you make money when the borrower pays their mortgage loan payment. The principal and interest go straight to you as the investor, instead of to the lender as they had gone to previously.
Investors buy notes so that they can create a consistent cash flow for themselves for the long term, in a way that is typically much easier than managing a rental property or spending the time and money to flip a home.
You can flip a mortgage note in several ways. The more traditional way is to purchase a note from a seller and then sell it to a note buyer for a fee.
You can also buy the note at a discount, then resell it for face value.
Another method is to get the note holder to pay a referral fee to the investor when they find a buyer with an acceptable offer. This can be a preferred way to go as their is no pressure on the investor to find a buyer and recoup their money and gives the investor time to find a buyer which is less stressful.
Investing in mortgage notes can be a great way to get into or continue with real estate investing. Note investing is currently less popular than buying and selling physical properties but is gaining in popularity thanks to the ease and flexibility it can provide.
By understanding this type of real estate investment you can open the doors of possibility for creating cash flow for the long term without the stress of finding renters or managing a property. Additionally, by flipping notes you can also create a opportunity in which you receive a payment up front just like you would if you were to flip a property. Again this method takes less time and effort than it would to physically do repairs and renovations on a property to sell or manage with renters.
Overall investing in mortgage notes can be a lucrative investment as long as you do your homework and understand the details of the note you’re buying.
Ultimately, you may want to consider investing in a fund or crowdfunding platform, so that you are investing in a diversified group of notes and not just a few.
Disclosure: Please note that this article may contain affiliate links which means that – at zero cost to you – I might earn a commission if you sign up or buy through the affiliate link. That said, I never recommend anything I don’t personally believe is valuable.
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