Would you buy real estate hundreds of miles from home? Most people would say, “No way!” Would you buy a real estate note hundreds of miles from home? Before you say “No way!” again, think of the note as a stock.
Think of the note like a stock
Call the note a “stock” and you wouldn’t care where the real estate is, even if it’s offshore. Stock investors rely on the expected success of the company (the growth approach), the book value (the value approach, meaning the liquidation value of the assets), or both.
If a company goes under, stockholders stand behind both bondholders and owners of preferred shares. At best, stockholders are third-position lienholders.
So in a default, which would you rather own? A stock secured by a company’s assets, where you’re last to be paid (if there’s any money left) and share third position with hundreds of thousands of other investors? Or a note secured by a house, where you’re first to be paid and share that position with nobody?
Where a note beats a stock
Stocks almost always sell above book value. Mortgage notes almost always sell below it.
Want to sell a stock? Call a broker and take what the market pays. No matter how many brokers you call that day, you’ll get the same number.
Want to sell a note? Call investors and negotiate. You’ll get different numbers, some higher and some lower. If you don’t like them, sell the next several years of payments and keep the rest. Or sell half of each payment and keep the other half. Try that with a stock!
Watch your rentals, not your notes
Some people just don’t like the idea of buying a note on a house they can’t keep an eye on. I know the feeling, but it belongs in the right place.
When you buy a rental house, by all means know it. Kick the bricks. My rentals are all within 15 minutes of my house, and I drive by each one every couple of weeks. I want to see whether the lawn is mowed, whether vehicles are parked on the grass and whether trash is visible. I want my rentals to look just like the owner-occupied homes around them.
When you buy a mortgage or trust deed note, you’re not buying the property. You’re buying an IOU, a promise to pay. Like a stock, it shouldn’t matter much where the property is. Yes, if things go sour you may end up owning it, but if you buy right, that possibility is fairly remote.
Only buy notes on property you’d be willing to own
I won’t buy a note, no matter how good the deal looks, if I don’t want to own the property. What would I do with an abandoned factory, or a gas station with environmental problems? I do know what to do if I end up owning a single-family house, a farm or another property type I’m comfortable with.
The lesson is to stay within your comfort zone. In the unlikely event of default, if you did your due diligence before you bought and followed your personal risk criteria, even a default can work out well for you.
When the right precautions pay off
A friend once bought a first mortgage note at a considerable discount, with tremendous equity, at a yield well into the double digits. He had about $15,000 invested in an $80,000 property.
The debtor stopped paying after a few months, and my friend sent the usual letters demanding payment. In the middle of the night, the drunken debtor called and cursed him out: “I’m going to burn down this place right now!”
My friend, who as first lienholder was the primary insurance beneficiary, replied: “Don’t do that! Wait until I get there with the gasoline and matches!”
