An Alternative Investing Tip For 2021
Dear Rich Lifer,
In this highly volatile stock market, many investors are worried they could lose a large chunk of their retirement savings if they’re not careful.
Some are even ditching stocks entirely and stashing their wealth in savings accounts earning two percent interest.
Banks on the other hand, love this and are happy to lend out your money to make a handsome profit. But something not many investors realize is they can be the bank in this situation.
Because financial institutions would rather have you invest in stocks and bonds, they don’t often advertise the fact you can buy alternative investments from them, like real estate notes.
You’re probably wondering how exactly you become the bank? Before we get to that, let’s first talk about what a real estate note is and the difference between a mortgage.
What is a Note?
A note is simply a promise to pay. When real estate is sold with financing, there is a document called a promissory note which defines the terms of the loan, including the loan amount, percentage rate, payment amount, and the number and timing of payments.
The note by itself is simply an IOU that contains the promise to repay the loan. The note is then secured through a security instrument called a mortgage, or deed of trust, depending on where you live.
The security instrument ties the note to the deed as the lien on the property, and as collateral. When you buy a note and mortgage, you’re buying the debt that remains to be paid on the note, secured by the property. You’re not buying the property.
Lien-Lord > Landlord
Becoming a lien-lord is a lot easier than becoming a landlord. When someone buys a property, their name goes on the title and they are now responsible for maintaining the property, paying taxes, holding insurance, paying for any repairs.
As a lender, you have vested interest in the property, but you’re not responsible for any of the upkeep or hassle. You simply collect a principal and interest payment each month until the note is satisfied.
If something goes wrong with the property, like the basement gets flooded or windows need to be replaced, the owner takes care of it — not the bank.
Types of Mortgage Notes
Something else to know is there are different types of mortgage notes you can invest in. The two main types of notes are: performing notes and non-performing notes.
For today, we won’t bog you down with all the details but here’s a quick overview of these two types of notes and their advantages.
When a borrower is making regular payments this is called a performing note. These types of notes are attractive to investors looking for a steady stream of recurring passive income. They’re similar to purchasing a rental property but without the headaches of becoming a landlord.
Many performing notes for sale are created through owner financed purchases, where the seller wants to cash out instead of continuing to receive monthly payments.
You can buy these notes at a discount to the remaining principal balance, which offers you a higher-effective yield than the interest rate of the note itself.
Why would someone sell at a discount?
Simply because they need the money now, not later. This strategy is called buy and hold.
Another common strategy in note investing is buy long sell short. The idea follows a similar logic in that it takes advantage of the money-today is worth more than money-in-the-future principle.
The formula for calculating this is called Present Value. If you take a series of loan payments over a period of time and apply the present value calculation to each payment, using the interest rate of the loan as the discount rate, you will see each payment is worth progressively less.
For example, a $150,000 loan at 7% interest over 30 years has a monthly payment of $997.95. The first payment has a present value of $997.95, while the last payment in year 30 has a present value of just $131.10!
The buy long sell short strategy leverages the degradation of the present value through a technique known as selling a partial.
When you sell a partial, you purchase a performing loan at a discount and sell a number of high value payments from the front of the loan. You keep the relatively low value payments at the back of the loan.
If you do it right, you can retain the back portion of the loan at no or very little cost. And since you’re selling the high value front portion of the loan, you recover most of your original investment which can then be reinvested in another deal.
Do this repeatedly and you’ll have several recurring streams of income. If the loan is refinanced or paid off early, you’ll receive a cash bonus in the principal which is due on the back portion.
The other type of note is a non-performing note which is when the borrower has stopped making payments. Banks will sell these to get them off their books rather than take the time and incur the expense of foreclosure.
Because banks have to report the non-performing debt and it can affect their ability to loan additional money, there’s incentive to part with these notes at a steep discount.
Non-performing notes can sell for 25 cents to 60 cents on the dollar. And unlike credit card debt that is unsecured, real estate notes are secured by the property.
One caveat, however, is your debt security depends on the position of the lien. The rule for lien position is “first in time, first in line”. Which means lien position is established by the relative date and time a lien is recorded against the deed.
For example, a first mortgage is in first position because it is recorded prior to subsequent liens like a second mortgage. If you’re investing in a second position note, these get paid only after the first position lien is covered.
But why buy a note if the borrower is not paying?
Non-performing notes are attractive to investors for two reasons: first, because of the steep discount; and second, because of their flexibility in engaging borrowers with multiple exit strategies.
As the lender, you can negotiate with the borrower on a new payment plan, called a loan modification. You can have the borrower sell the property at a short sale, have the borrower return the deed, called a deed-in-lieu. And last but not least, foreclose on the property.
The Risk of Investing in Notes
Like any investment, note investing has its share of risk. Because notes are secured debt, your risk is lowered.
However, tenants will stop paying their rent and your passive investment can quickly turn into an active investment.
Also, a good rule of thumb to follow is if you wouldn’t own the property that the mortgage note secures, don’t buy it.
A major concern when buying non-performing notes is not being able to see the interior of the property before buying the note.
You can alleviate some of this risk by assuming the property is in horrible condition. If you end up with the title of the property, you’ll have a nice surprise if it’s in better condition than you anticipated.
Another way to lower your risk is by negotiating the largest discount possible when purchasing the note. This way you have less skin in the game.
Investing in real estate notes offers many benefits versus traditional buy and flip strategies and rental properties. You get less headaches not having to deal with tenants and enjoy higher than average rates of return versus low yield bonds and most stock dividends.
To a richer life,
The Rich Life Roadmap Team