“Ouch! Honey, I got another paper cut. Can we buy an electric envelope opener? Also, please pick up some more deposit slips when you’re out, and some Grey Poupon.”
That’s about the worst a note investor has to complain about. Here is how paper stacks up against owning rental property, point by point.
Why loan-lording beats landlording
No more 3:00 a.m. calls
I remember the days of being a landlord (though a therapist would probably tell me to try to forget). Plunging toilets and chasing tenants for rent was never fun for me. Calls at 3 in the morning about leaky taps may be an exciting challenge for some people. A tenant rebuilding a Harley-Davidson on the living room carpet might be no big deal for a tough, hardened landlord, but I’d rather invest more safely and more profitably.
I’ve never had a mortgage call me at 3 in the morning. I’ve never had a trust deed get in a fight with the trust deed upstairs. Land contracts don’t lie to me. Mortgages don’t drive away in pickup trucks owing me money.
Lending is safer
With a tenant, you have no collateral for what they owe you. You are effectively extending credit to someone precisely because they can’t afford to buy. With a mortgage, the borrower has their own money in the property as collateral and a strong interest in paying you.
Better than triple-net
A tenant is not an owner. Much of the time, pride of ownership is lacking, and tenants can beat a property to pieces. As the landlord, you are responsible for all major and minor repairs.
With a note, the owner is responsible for all repairs and problems. The lender has a fixed payment and fixed costs.
How notes hold up when markets move
Falling prices and rents
In a market decline, a 20 percent drop in prices can wipe out a landlord’s equity. The lender’s equity takes priority. Fair market rents can go down, but mortgage payments are fixed.
Notes can appreciate too
Sure, in an appreciating market, real estate values can go up. I’ll never say it never makes sense to own real estate. But mortgages can appreciate too.
When property values rise, refinancing increases. As that happens, payors chase you down and pay you off at full face value.
That means a $10,000 note I might buy for $8,000 can pay off overnight for the full $10,000. A $100,000 mortgage bought for $75,000 pays off for a $25,000 profit.
I call that appreciation. I appreciate it every time it happens. It can happen in down markets too.
When rents and values are going up, it is also a good time to encourage extra payments on principal. I encourage payors to make extra principal payments to pay the loan off much earlier and save thousands in interest. When a payor on a discounted note increases the payment, my yield may double.
There are over a hundred ways to improve profits on notes, and they work in up, down or flat markets.
Using leverage on notes
The leverage possibilities with notes equal or exceed those of any other investment. It is not only possible but simple to invest in notes with 100 percent or more financing.
Using both private and institutional sources, I have routinely financed notes for more than my purchase cost. That would be risky in real estate, but not in notes. I can finance a note 100 percent and still have cash flow when I’m done. In some cases I can finance notes for as much as 200 percent of the purchase cost and still have cash flow.
Here’s a recent example from one of my students. A property sold for $52,000 with $12,000 down. The buyer paid on the $40,000 note for seven years, and then it went into default.
| Step | Terms |
|---|---|
| Defaulted note purchased for | $10,000 |
| Restructured note | $44,000 at 10%, $424.61 a month for 240 months |
| Investor’s loan against the note | $20,000 at 12%, $220.22 a month |
My student put almost $10,000 cash in his pocket and has a cash flow of over $200 a month for the next 20 years.
Most real estate investors take leverage for granted and don’t realize it is just as powerful when applied to other investments.
Tax advantages of notes in an IRA
People say paper has no tax advantages. But could a tax-deferred investment that costs you nothing be considered a tax advantage?
IRAs and pension funds can invest in notes. Your IRA can earn interest and a compounding cash flow, and you can even buy and sell notes inside it. Notes sell at a discount, and that discount is what makes the following example work.
