When most people plan to invest in real estate, they picture buying a property and either sprucing it up to raise its value or renting it as-is. Those approaches can generate income, offer tax benefits and grow your wealth and equity. But they aren’t the only ways to invest in real estate. Another is mortgage note investing, also called real estate note investing.
What a mortgage note is and how note investing works
When you buy a property and can’t pay the full price at closing, you go to a lender for a loan. In exchange, you sign a promissory note and mortgage documents. The note describes the loan and your obligation to repay it: how much you borrowed, from whom, the payment schedule and the other terms you agreed. The mortgage makes the property collateral, so if you fail to honor the note, the lender has a legal right to the property.
Note investing happens when a lender sells a mortgage note to an investor. The investor then collects the loan payments and interest from the borrower. In other words, when you invest in notes, you buy debt and become the new lender.
Notes fall into two broad categories:
- Performing notes: the borrower is making payments on time. Lenders rarely sell these, but sometimes they do. Your main focus is the income from payments and interest.
- Nonperforming notes: the borrower has stopped paying, which often leads the lender to sell. There’s a real risk of losing your investment, but that risk is also the basis for negotiating a good discount.
Nonperforming notes may not seem like a worthwhile investment, since the borrower isn’t paying anymore. They carry a high risk of default, and that’s bad for cash flow.
But investors often use these notes to acquire real estate at a discount. Once the borrower defaults, the investor can take possession of the property and create a long-term rental, fix and flip the house, or simply sell it. There are significant risks to using mortgage notes this way, but if you’re smart about your strategy, it can pay off.
Investors can also modify the terms of the mortgage. If you buy a nonperforming note, you might lower the balance, reduce the interest rate, decrease the monthly payment, or otherwise help the borrower make good on the loan. Bought at a discount, this can produce very high yields.
Over the decade before this was written (2020), the cost of nonperforming notes rose, but they could still be bought at 20% to 40% off the current market value or loan balance.
Where to find mortgage notes to buy
Banks create and sell mortgage notes as part of their business model. They make their money from lending and collecting interest. The more they lend, the more they make.
Banks have to keep a certain amount of money in reserve in order to lend. This is called the reserve ratio. If a bank has low liquidity, it may sell some of its loans in a “pool,” a group or package of mortgage notes. Other banks, hedge funds and private individuals can buy these pools.
Hedge funds and banks are the largest buyers of notes direct from banks, because you typically need millions of dollars to buy in bulk. That makes it difficult, though not impossible, for individual investors to buy directly from banks.
Individuals who created a private mortgage note may also want to sell, simply to have cash now. Maybe they’re facing a hardship and need the money today rather than waiting out the remaining term of the note.
You can find private sellers of mortgage notes on online note marketplaces such as Notes Direct or Paperstac. You can also buy a list of private noteholders from a list company such as ListSource, then send them a series of letters or postcards, or reach them another way, to see if they’re interested in selling.
Banks and individual sellers who need cash will sell at a markdown. When you buy at a discount, your rate of return is higher than the note’s stated interest rate.
How notes are priced
Performing notes are typically more expensive. You can buy them at a discount, but it’s usually only a slight discount from the remaining balance. Nonperforming notes often sell at steep discounts from the balance owed or the value of the property, whichever is less.
Pricing is also higher on first-lien notes than on junior liens. The more secure the position, the higher the price. Let’s look at a few examples to see how this works.
Whatever the price, the best way to judge a note is to evaluate the property that secures it. You’re buying the paperwork tied to the property, so always make sure the collateral is a quality asset.
Buying a performing mortgage note
Say you find a private mortgage note that the seller needs to get rid of. The note is secured by a mortgage on a single-family home. The property originally sold for $150,000 and the borrower put down $15,000, so the original loan was $135,000. It’s a 5% fixed-rate, 30-year loan, and the borrower’s monthly payment is $724.71.
The borrower has been paying for seven years and is current. When you evaluate the note, the unpaid balance is $118,725.68, with 276 months (23 years) left.
