Note investing rarely comes up when people talk about real estate. In this interview, podcast host Deidre Woollard walks through the basics with Liz Brumer-Smith, an investor who tried rentals, self-storage and fix-and-flips before she found her niche in mortgage notes. The interview was recorded in late 2020, so the market comments at the end reflect that moment.
As Liz puts it, many people think note investing is too complicated or doesn’t fit their strengths, and that’s fine. But if you are analytical, enjoy online research, and are good with small details and numbers, it can be a wonderful way to invest, and you can do it from anywhere. It can also be a chance to help people: there are creative ways to help borrowers in a tough spot move on with dignity.
What note investing is and how Liz got started
Q: What exactly is note investing?
Note investing means investing in debt that is secured by real estate. When you buy a house or an investment property, you usually get a loan from a bank. The bank is secured by the property for repayment of that debt. You make your mortgage payment each month at an agreed interest rate for 15 or 30 years, and the bank gets its money.
When you invest in that note, you step into the shoes of the bank. Instead of investing in a property, you invest in the debt secured by that property. Banks sell mortgage notes like this all the time, so you can buy the debt and act as the bank. You then collect the mortgage payments each month from the homeowner or investor. If all goes well, you simply collect for the rest of the loan’s life. If it doesn’t, you are always secured by the property.
Q: How did you get started?
I got my start in 2012, after the Great Recession. Mortgage delinquencies had surged and there was a lot of pressure on banks. Many banks were closing because so many people were defaulting.
Banks aren’t made to take back properties; they’re made to collect interest. That’s how they make money, and the more money they have, the more they can lend. The model depends on people paying their debts, and when too many default, it creates an imbalance. To avoid going under, many banks sold off assets that weren’t paying, at discounts.
That created a huge opportunity to buy nonperforming notes at steep discounts. From 2012 to 2015 we picked up mortgages for 20 to 30 cents on the dollar, sometimes up to 40 cents. Then you could try to work the note: find out why the borrower stopped paying and whether they want the home. If not, there are other routes, which I’ll come to. That’s how I started: it was the opportunity in the marketplace.
Who note investing suits
Q: Is this right for individual investors?
Note investing is not for everyone. It takes a certain skill set to succeed in it and enjoy it. Some people like getting their hands into a property, working on the design or talking with renters. Everyone has different strengths, so take that into account. Pretty much anyone can do it; it’s a question of whether it’s the right fit for you.
Notes were my first real entry into real estate. I had learned about wholesaling, fix-and-flips and rentals, and dabbled in them. Note investing appealed to me because it can be done from anywhere. I live in an RV, travel full time, work as a freelance writer and invest in notes from the road. As long as you have an internet connection and can make phone calls, you can do this business.
It is also an option if you want to widen your market. Many investors stick to their local market, and there’s nothing wrong with that. But your area may be too expensive or too competitive to find worthwhile deals. Note investing is nationwide, so there’s a lot of opportunity and inventory. There is still competition, as in every niche, but less than you’ll see in top-tier markets.
Anyone can learn this business. Being comfortable working online, using spreadsheets and running numbers, and being analytical, will help you succeed.
Q: Is it a niche beginners usually jump into?
Not usually. It’s often a strategy that more experienced investors move into. Maybe they’re tired of dealing with tenants, or they want more passive ways to invest. Most people who become note investors have some experience under their belt.
If you are brand new, you can still learn it. I started out almost brand new to this niche. Just know that there are a lot of moving parts.
Types of notes and why banks sell them
Q: Should investors specialize in residential or commercial notes, and is one harder to get into?
The two main categories are residential and commercial, and each has subcategories. In both, you can have a first-lien or a second-lien mortgage. A first-lien note has the highest level of security.
Take a simple example. You buy a rental property, put 20% down and get a bank loan for the rest. That bank is in first position, with the highest security for repayment. Fifteen years later you have equity built up, and you take out a home equity line of credit (HELOC) from another bank to buy another rental. You’re still paying the first mortgage, but now you also have a payment on the line of credit. Bank number two is in second position: it gets repaid after the first.
Say the market crashes, you have no tenant, and you stop paying. It’s unfortunate, but it happens. The first-lien holder has priority and can wipe out the second. The second-lien holder can also foreclose to get the property back, but if the first starts foreclosure first, the second can eventually be wiped out.
So first-lien positions are the most secure, in residential or commercial, and they are priced higher for that security. Many people target them. Second-lien notes are available in both categories too, and they are typically much cheaper because you take on more risk.
Then there are performing and nonperforming notes. Nonperforming means the borrower isn’t paying, and those sell at much bigger discounts than notes where the borrower has paid on time for a long period.
Between residential and commercial, residential is probably easier for someone just starting out, because it’s more affordable. Commercial real estate is more expensive: even a 10-unit apartment complex could be over a million dollars, and a note on it, paying or not, reflects that value. Unless you have more capital up front, residential is the easier starting point.
When a loan becomes nonperforming
Q: How long does a borrower have to stop paying before the note is considered nonperforming?
Start with performing loans. Banks create mortgages and sell them as part of their business model. The bank that originates a loan very rarely collects on it for its whole life. Banks sell performing loans almost immediately, sometimes after collecting for 30 to 60 days, sometimes right after the loan closes.
Nonperforming loans have stages: 30 days late, 60 days late, 90 days late. Anything past 90 days is a nonaccrual loan, one considered unlikely to be repaid or to start performing again. That’s typically when a loan is labeled truly nonperforming.
Most banks don’t sell loans until they are in late-stage nonaccrual, well past 90 days, often about six months or more without payments. It really depends on how badly the bank needs money. Banks sell these assets only when they have to, because they are taking a loss. They are willing to sell at a discount to gain liquidity.
Q: So banks see those nonaccrual loans as a lost cause and get rid of them for whatever they can?
Correct. Selling gives them more liquidity, and they have ratios they must maintain. Sometimes a bank sells nonperforming loans just to simplify its portfolio: it doesn’t want to deal with them, it doesn’t expect them to pay, and it would rather get some money for them. Other times it is forced to sell because its liquidity ratios are off, and that’s when you may see large sell-offs of mortgage loans.
Rewards and risks of performing and nonperforming notes
Q: What are the risks?
Note investing, especially nonperforming notes, is for investors with a higher risk tolerance. Performing loans can be a very consistent and reliable source of income, because you’re investing in the debt, not the real estate. You don’t deal with tenants, you rarely talk with the borrower, and you mostly collect income each month.
A loan servicing company licensed in the state where the mortgage is can collect the payments for a small monthly fee. It contacts the borrower and sends monthly notices. A performing loan is a truly hands-off investment, I think more so than most rental or other real estate income. That’s why banks do it: they want to make money as passively as possible, and you’re doing what the banks do. You don’t need to manage it, or even be in the same city as the property.
Nonperforming notes are a more active and riskier strategy, though you can eventually turn one into a passive investment. When you buy one, your job is to work with the borrower and find out what happened. Why did they stop paying? What can they pay now, if anything? Do they want to stay in the home? Is the home vacant? Or you may move forward with foreclosure or other legal action to get the property back.
There are many possible exit strategies, and that flexibility can lead to big payoffs. Some of my best investments have been nonperforming notes, and on certain deals I’ve made 200% to 300% returns. But some deals have gone very badly. That’s the trade-off: big payoffs when things go well, and many things that can cause major delays, including litigation.
You also can’t get inside the property before you buy. You’re the bank. You have an interest in the property but you don’t own it, so you can’t knock on the door and ask to look around. You are buying without seeing the inside, and sometimes that turns out well and sometimes very badly. Because of those risks, these notes usually sell at deep discounts. The greater the risk, typically, the greater the discount.
Getting started: capital, LLCs and competition
Q: How much does it take to get started, and how many notes do you have to buy?
You can be as small or as big as you want. You can buy one or two notes at a time, or millions of dollars’ worth. Where you fit depends on how much capital you have and your experience.
Banks aren’t going to sell mortgage notes to small investors. They sell pools of loans, large groups of notes that can be performing or nonperforming, firsts or seconds, residential or commercial, to one buyer in one sale. Fannie Mae and Freddie Mac sell loan pools all the time, but to institutional investors: funds, hedge funds and private equity funds that specialize in notes. Those large players buy dozens or hundreds of loans at a time and manage the portfolio.
Sometimes those funds sell loans that don’t fit their criteria. Maybe they only want properties in 30 states, or only properties worth more than $200,000. Loans outside the criteria they either write off or sell to smaller investors. If you don’t have hundreds of thousands or millions of dollars, that’s where you’ll work.
When I started, I was in the smaller-investor category. I found funds that bought in bulk and sold either the assets they didn’t want, or loans they bought specifically to resell to smaller investors. I bought one or two loans at a time. As my experience and capital grew, I moved to five or 10 at a time.
How much you need depends on what you buy: performing or nonperforming, residential or commercial. You can pick up second mortgages on residential property for a few thousand dollars. I know people who have bought seconds for $500 and people who have bought seconds for $350,000. It comes back to the collateral and its value. If a mortgage only has a $2,000 balance, you won’t pay more than the balance. If the property is worth $50,000, you won’t spend much. If it’s a nice home in California worth $500,000 or more, expect to spend more. It depends on the market, the collateral and the balance.
Q: Do you buy through an LLC?
I definitely suggest investing through an LLC. The one place I wouldn’t bother is stock market investing, such as REITs, where I think an LLC would be more of a hindrance. But any time you are investing in something secured by debt or real estate, actively or passively, I think it should be done through an LLC.
We have separate LLCs. One holds nonperforming notes we expect to take back, which are shorter-term investments. Another holds our longer-term performing notes. They have different tax implications, so structuring the LLCs differently can help.
Q: Are you in competition with other note investors?
Yes. I don’t think there’s any market in real estate without competition. Even though the market is nationwide, note investing has become much more popular since the Great Recession. That makes a quality seller with worthwhile inventory really valuable, especially a seller who isn’t well known, because you may get access to well-priced notes, performing or not.
It isn’t only the banking world, either; you can find your niche within the niche. Private sellers create mortgages all the time through owner financing, or seller financing. They sell a property, and instead of the buyer getting a bank loan, the seller provides the financing and the buyer pays them over time, just as they would pay a bank. That’s a private mortgage, and there are billions of dollars of them across the country.
Private mortgages are another source of performing and nonperforming notes. You can send letters through a direct mail campaign to find private mortgage holders, and they may sell their notes at a discount too. There’s competition, but there’s also a lot of opportunity. The key is finding the opportunity that fits your financial goals and your skill set.
Evaluating a note and the property behind it
Q: What do you look at when you evaluate a potential investment?
This is one reason some people get turned off: it can feel like analysis paralysis, because there’s so much to consider. You evaluate the note itself: the balance, the number of payments remaining, the monthly payment. You also evaluate the collateral, the house or commercial property. That means the market, the competition in it, and the property’s value under current conditions.
In the end, I make my offers, performing or not, based on the return I want if the loan pays, and I make sure the price lines up with the property’s value. I never want to make an offer where, if I do get the property back, the deal no longer makes sense. Someone can always stop paying, so you have to be happy knowing you’d want that property in the end.
That means liking the market, feeling confident about its potential growth, and knowing there are likely buyers if you take the property back. If it needs work, will the repairs be worth it? Are there fix-and-flip investors in the area? Is that what people are looking for? It’s a lot to analyze, but there are processes and checklists you can follow to make sure you’ve checked all the boxes.
Q: Have you had to take ownership of a property and figure out how to dispose of it?
Yes, and that’s not a bad thing. When I started, I targeted nonperforming notes, and many were on vacant properties. I wanted the property back, because I was buying at such steep discounts that even in bad condition I could usually sell it as-is at a very nice profit.
We’ve taken properties back, rehabbed them and sold them. We recently did that with a property in Michigan City. I’ve never seen it, but it was vacant and we knew it needed rehab. I hired a local contractor who did everything, and we expect a very nice profit.
Other times the property was in far worse condition, especially early on, when I knew much less than I do now. I made mistakes. Sometimes I bought in a market that didn’t have demand. In those cases I rehabbed the property, but instead of selling it as-is, I offered owner financing. I stepped back into the lender role and now collect on a performing note. It might not have been a home run as an as-is sale, but it became a passive income stream. Because I’m holding it longer, I’m gaining tax benefits, and it ends up a good deal in the long run, where selling right away wouldn’t have been.
We’ve also taken properties back, fixed them up and made them rentals. If you’re used to traditional real estate investing, this can be a way to buy at even deeper discounts than at foreclosure sales or other popular distressed-property channels, because you’re getting in a step before all of those. You’re acting as the bank.
Foreclosure timelines and building your team
Q: There’s a lot of competition for foreclosures and pre-foreclosures. Does being the bank speed the process up?
Sometimes yes, sometimes no. As the noteholder, you’re the one foreclosing, so you must follow that state’s legal process, which is either judicial or nonjudicial. Timelines and costs vary dramatically by state. In Florida a foreclosure can take 10 months to two years. We have one in Pennsylvania that we’ve been working on for more than four years. Others have taken three to six months.
It also depends on the borrower. If they litigate and fight the foreclosure, it can drag on and add legal costs you may not have planned for. And a bankruptcy filing stops a foreclosure wherever it is, even the day before the sale. That has happened to me many times, and you have to wait out the bankruptcy proceedings. I’ve had borrowers file bankruptcy three or four times in one case as a stall tactic.
You can’t control the timeline. What you can do is assess the likelihood of these risks and adjust for them with a deeper discount when you buy.
Q: What team members do you need?
A team is crucial, because you’ll be working in many markets. The core group:
- An attorney who can handle both foreclosure and bankruptcy. A borrower can always file bankruptcy, so you want someone who knows how to navigate it.
- A loan servicer. We use nationwide servicers so that whatever state a loan is in, it can be handled, which simplifies our back end.
- A contractor, if you plan to take the property back and work on it, or at least a realtor you trust who knows the market. Our realtors are usually happy to drive by and check on a property, occupied or vacant.
- A property preservation company, if you don’t have a realtor in the area. Nationwide companies will board up windows, change locks, mow the lawn, plow snow and winterize a vacant property where frozen pipes are a risk.
- A title company. We run title searches on every note we consider, to catch liens such as code violations or judgments that could complicate working with the borrower or foreclosing.
That last point matters because in many states a foreclosure does not wipe out code violations. They stay attached to the property and become the lender’s financial responsibility, so you want to know about them beforehand.
What Liz was watching in late 2020
Q: What are you watching as a note investor for the next year or so, with eviction and foreclosure moratoriums in place?
Every state, and even every county, was changing its rules on eviction and foreclosure moratoriums, and that greatly affects note investors. If you buy a nonperforming note expecting to work with the borrower or foreclose, and you can’t foreclose, you face a long wait. You aren’t collecting, but you’re still paying costs such as servicing fees.
Still, I expected big opportunity in many markets. With unemployment where it was, a lot of long-term nonperforming loans were inevitable. Forbearance postponed the problem, but those balances eventually come due and some people still can’t pay. Finding a solution with those borrowers, or helping them move on from the home in a positive way, is a huge opportunity, similar to what we saw after the Great Recession.
On the positive side, real estate values had risen and were stronger, and borrowers were generally higher quality. Underwriting had been stricter on recent loans, so borrowers tended to have higher credit scores, making them slightly more likely to start paying again.
I also saw big opportunity in commercial mortgages, because some sectors of commercial real estate were hit so hard that defaults were inevitable. Those balances are large, so banks would be under more pressure to sell loans to keep their ratios within required limits. Overall, I expected a resurgence of mortgage loans hitting the market over the following one to two years.
Q: Probably on the commercial side first, with hotels, for example?
Absolutely, and retail as well. Fannie Mae had already held two mortgage loan sales, so nonperforming residential inventory was starting to reach the market. At first it trickles down to the big institutional buyers, but over time that inventory becomes available to small investors too.
I’m not rooting for people to stop paying their mortgages. We want people to stay in their homes if they can pay. But there are creative solutions that help people move on with dignity. It’s a unique industry and it’s not for everyone. If you enjoy the analytical side of real estate, online research and working through paperwork and due diligence, and you like being able to invest remotely, it can be a wonderful way to profit and to help borrowers in need.
