A real estate note is simply an IOU secured by property. Before you buy one, you need to analyze what I call the three P’s of note investing: the paper, the property and the payor. This lesson explains what a private note is, why notes sell at a discount, and the questions to ask about each of the three P’s.
What a private real estate note is
In a conventional real estate transaction, a buyer makes a down payment, gets a loan, and signs a note promising to pay a certain amount each month to the lender until the loan, plus interest, is paid.
In a private real estate transaction, the buyer makes a down payment but does not get a loan. Instead, the buyer signs a note promising to pay a certain amount each month to the seller until the price of the real estate, plus interest, is paid. The seller becomes the bank. One is a loan; the other is an installment sale.
If the buyer defaults on a private real estate note, the seller’s collateral is the property. The seller can modify the terms of the note, pay the buyer to move, or foreclose.
Why notes sell at a discount
At the time of writing (2020), over $17 billion in first lien private real estate notes were created each year: about 100,000 notes, or almost 300 a day. That number could double if second liens were included.
Few people know that real estate notes can be bought and sold. Fewer still know what makes investing in notes so profitable: notes are sold at a discount from the balance. That discount gives the investor a higher yield than the interest rate on the note.
For example, you find a note with a $50,000 balance at 6% interest and 120 monthly payments of $555.10. If you bought it for $50,000, your yield would be 6%. Not bad. But what if the note owner needs cash right now and will accept $40,000? Put that in a financial calculator and you find that your yield is 11.18%.
The paper: questions about the documents
The “paper” means the documents: the note, the mortgage (or trust deed or contract for deed), the property settlement statement, the payment history and so on. If you are new to notes, or not familiar with the laws of the state where the note was originated, have a real estate attorney in that state review the documents.
Ask these questions about the paper (assuming it is a first lien):
- Is the note performing, non-performing or re-performing?
- If non-performing, what is the status of foreclosure, if any?
- Is the note secured by a mortgage, trust deed or contract for deed?
- What was the original balance, and what is the current balance?
- What is the interest rate?
- What is the payment amount, and are payments due monthly or on another schedule?
- When was the first payment, and when is the next payment due?
- How many payments have been made, and how many remain?
- Is the note fully amortized, and when is the final payment due?
- Is there a balloon payment? If so, when is it due and how much is it?
Ask the seller for copies of the payment history. If the note is serviced, the servicing company will provide it. If the seller collects the payments, ask for copies of the deposit slips or bank statements.
The property: questions about the collateral
Get a current appraisal of the property paid for by the note seller. If necessary, offer to reimburse the seller for half the cost if you buy the note. If that doesn’t work, offer to pay the full amount, but only after you buy the note. Do not spend any money before you buy the note.
The best appraisal is a complete one, inside and out. Second-best is a drive-by appraisal. Third-best is a real estate broker’s opinion of value.
Ask these questions about the property:
- What kind of property is it (single-family house, duplex and so on)?
- What is the address?
- Does the payor live there? If not, is it rented, how much is the rent, and how long has the tenant been there?
- What was the sale price, and when was it sold?
- How much cash did the buyer put down?
The payor: questions about the borrower
Do not contact the payor. Get this information from the note holder:
- Has the payor ever been late? If so, how many times?
- Is the payor current? If not, how far behind?
- What has the note holder done to bring the payor current?
- What is the payor’s employment?
- What are the payor’s name(s), address and (if known) Social Security number?
Closing the note purchase
Buying a note can be as simple as the seller writing on the back of the note that it is assigned to you and signing it. But it is best to use a title company or attorney in the state where the property is located to make sure the documents are prepared properly. Have the note assignment recorded to protect your interests.
Prepare a letter from the note seller to the payor telling them to send their payments to you from now on. Have the seller sign it, then send it to the payor by a service with proof of delivery.
Follow the three P’s and you will be well on your way to evaluating notes like a professional.
