Lending against real estate notes can be lucrative. If you’re a note buyer, you’re probably having trouble finding notes. There are plenty of notes out there, but most aren’t for sale, and most of those are real estate notes, secured by real estate. That gives you an opportunity note investors have used for many years: you can lend money to the people who hold those notes, with excellent security, the borrower’s real estate note.
A note secured by a note
Like everyone else, holders of real estate notes sometimes need cash, don’t want to sell their assets and would rather get a loan. Lending against real estate notes is common, but there are pitfalls that even experienced lenders have fallen into.
A word of caution first. Making a loan on a real estate note creates a new note between you and the borrower, and that new note is secured by an existing real estate note. So two notes are involved: a note secured by a note. That can be confusing, so in this lesson we’ll always say which one we mean, the new loan note or the existing real estate note.
Who borrows against a real estate note
Who is a likely candidate for a loan against a real estate note?
- A real estate note holder who needs cash but doesn’t want to sell the note.
- A note buyer who needs to borrow some cash to buy an attractive real estate note.
These people, and others like them, may find a loan the best way to handle their situation.
Rule one: take possession of both notes
If you make loans to people like this, how do you protect your money? The first rule is that you must end up holding both notes involved.
You will obviously hold the new note for your loan, signed by the borrower. Less obviously, you must also take physical possession of the real estate note you are lending against.
Why does that matter? You need that real estate note as collateral, or you may suffer serious consequences. Under the Uniform Commercial Code, possession is the proper way to “perfect your security interest” (make sure you have collateral), so that you are a secured creditor. Holding the real estate note protects you if your borrower fails to pay or declares bankruptcy.
If you don’t hold the real estate note and your borrower doesn’t pay or files bankruptcy, you will likely end up an unsecured creditor. You’d have to share the proceeds of the real estate note with other unsecured creditors, which could mean a substantial loss.
An even worse problem can come from not holding the real estate note. Your borrower may sell it, or borrow against it from someone else, and the note could end up with that third party. Then you, the lender, could lose everything.
Other creditors who face the same risk
Lenders aren’t the only ones who need these precautions. Any creditor holding a new note secured by an existing real estate note is in the same position as a lender and needs the same careful documentation.
Real estate agents with deferred commissions
It’s fairly common for a real estate agent to take a “deferred commission” when the seller can’t pay cash. The agent accepts a new note instead of cash, usually secured by a real estate note on the sold property. The agent is extending credit, which is much the same as making a loan, so all the precautions of a loan apply.
A spouse in a divorce settlement
If a married couple’s assets include a real estate note, a divorce settlement may give one spouse ownership of the real estate note and give the other spouse a new note signed by the ex. That new note is secured by the real estate note, and the same precautions are needed to protect its holder.
Partnerships and estates
Any situation where a real estate note is collateral for a debt is the same, such as a partnership dissolution or the settlement of an estate among heirs. The real estate note goes to one party, and another gets a new note secured by it.
In every one of these examples, the holder of the new note must take physical possession of the real estate note as security, even though the person who owes the money legally owns the real estate note.
The documents that protect your loan
Beyond possession of the real estate note, you need:
- A formal endorsement of the real estate note to the lender (or creditor), normally with language such as “pay to the order of [lender] for security purposes only.”
- A security agreement signed by the borrower, explaining how and when you can foreclose on the real estate note.
- An assignment of the deed of trust or mortgage for security purposes only, recorded in the county where the real estate is located. This is prudent, not strictly required.
- Control of the servicing of the real estate note, so its payments come to you and can be credited against the new note’s balance.
Lending laws differ from state to state, so it’s essential to have an attorney prepare these documents and make sure you aren’t making an unsecured loan. Also make sure you aren’t charging an illegally high rate of interest, which would make it a usurious loan.
And of course, do routine underwriting, such as checking the borrower’s creditworthiness and the value of the real estate securing the real estate note. Follow these steps and lending against real estate notes can be a rewarding opportunity.
