Rentals and fix-and-flips are the real estate vehicles we usually talk about for building wealth and reaching financial independence. But another, equally powerful technique should be on your radar if it isn’t already: private note investing.
A private note simply means you’re the lender instead of the owner of a property. And in case you hadn’t noticed, many of the biggest, most expensive buildings in towns and cities around the world carry the names of lending institutions. That’s no accident. Big institutional note investors paid for those buildings with profits, and as a smaller private note investor you can build your own net worth in a similar way.
Like other parts of real estate investing, private note investing has many niches and approaches. This lesson covers the main ones with real-world examples, along with the challenges and reality checks that come with them. But first, why consider private notes at all?
Why invest in private notes
I’ve been investing in real estate for 15 years. Like most investors, I started with flipping houses and buying rentals, and rentals are still a core part of my approach today.
But much of my success with both rentals and flips came from using other people’s money or equity in the form of private notes. I supplied a good deal, and they supplied most of the money. It didn’t take long to realize those private lenders were earning good returns, while I was doing all the work and taking most of the risk as the owner.
I didn’t give up my other strategies, but I did start building a private note portfolio alongside them. Here’s why.
1. Steady, consistent interest income
At the time of writing, with 1% bank CDs, 2% stock dividends and 3% bonds, high-yielding private notes were a luxury. That’s especially valuable when you need to live off your investment income.
Interest income is also a great wealth builder if you reinvest the earnings wisely and tax-efficiently. More on that below.
2. More passive
Private notes are more passive than rentals or flips. Notice I didn’t say completely passive. There’s no such thing.
That passive quality makes private notes a good fit for a self-directed IRA or 401(k), where you want to be more hands-off. Retirement accounts suit notes for another reason, too. Interest you earn personally is taxed at your ordinary income rate, but inside a retirement account there’s no tax on the interest until it’s withdrawn (and with a Roth IRA, qualified withdrawals aren’t taxed at all). If your goal is to build wealth with notes, a retirement account lets them grow and compound tax-deferred for years.
3. Greater control
I started investing in private notes because I liked the control. Like rentals, notes let you directly affect your results. You choose the borrower, the interest rate and the collateral (the property) you’ll accept.
For a beginner, that can be daunting. How do you know who makes a good borrower, what a good interest rate is, or what kind of property makes good collateral? This is why I don’t think private notes are a beginner strategy. You need some experience in the trenches so you understand the investors you’ll be lending to.
Even with experience, learning the fundamentals of notes and getting help from competent professionals is a must. Early on especially, other people’s experience can make up for what you don’t yet know.
The two main types of private note investing
As a private note investor, you’re in the role of the lender. Within that role, there are two main approaches:
- Private money lending
- Discounted notes
With private money lending, you’re in the business of lending money to other investors. The discounted note business involves creating or buying notes at a discount to their face value.
In both cases, you can own a whole note yourself or own part of many notes through a fund (a group of investors). A newer approach, real estate crowdfunding, lets you invest in pieces of many larger loans, in chunks of around $2,000 to $5,000, through online platforms.
How private money lending works
Private money lenders often fund some or all of the purchase when investors buy properties to flip or hold. For example, when investors buy rentals with the popular BRRRR technique (buy, rehab, rent, refinance, repeat), the upfront money often comes from a private money lender, or from a hard money lender, a business that lends on behalf of private money lenders.
These loans aren’t cheap. I’ve seen rates from 7% to 15% or more, usually with upfront fees and points on top of the interest.
Investors still use them because traditional lenders aren’t as flexible or fast with investment purchases, and having the money available lets them buy profitable deals they might otherwise lose. They then refinance or sell within a short time to avoid paying the higher rate for long.
Ways to lend
You can lend directly. For example, you could network in online real estate forums or at local meetups, find a fix-and-flip investor you trust who shows real competence, and arrange to fund their next project.
You could also work with an experienced local broker who finds, screens and services loans for you. You borrow their expertise and logistics in exchange for a fee that comes out of the interest and points charged to the borrower.
Or you could invest through group funds and crowdfunding platforms that spread your money across many loans. You usually need to be an accredited investor to use either option, but if you are, it can be a way to diversify your risk and let professionals screen deals up front.
Example: growing wealth with private money loans
Mike is 35 and has been investing in real estate for five years. He owns five rentals and has completed several fix-and-flips. He had challenges and made mistakes early on, but those battle scars made him a better investor.
Now Mike turns his attention to a 401(k) from an old employer. It holds $300,000 in stock index funds. Stock prices have risen significantly, and he wants to diversify some of it into private notes. So he rolls over $150,000 to a self-directed traditional IRA. Because the money goes directly from one custodian to another, it isn’t a taxable event.
With the self-directed custodian, he can invest in alternative assets like real estate notes, and as the account owner he chooses where the money goes.
Finding borrowers
For many reasons, Mike doesn’t want to advertise that he has money to lend. Instead, he meets investors, finds the ones he likes and trusts, and raises private lending when it makes sense.
He networks heavily online and at local real estate investor meetings. It takes a while, but he gets to know a couple of fix-and-flip and rental investors he feels good about. He likes their character and honesty, and their competence at executing projects.
In a conversation with one of them, Regina, private money comes up. She finds more deals than she can fund herself and would like a private lender for a few extra deals a year. Mike tells her he has self-directed IRA money and would be interested in lending. They discuss details and agree to work together on the right deal.
The first private money loan
Within a month, Mike makes his first private loan. The property is a fixer-upper single-family house Regina plans to flip within six months. Her purchase price is $75,000, and she plans to put another $75,000 into repairs to make it a beautiful home that can sell for $225,000.
The house was a long-time rental and needs major updating, including a new HVAC system and a new roof. Regina also plans to overhaul the layout, kitchen, baths, landscaping and cosmetics. Here are the terms they agree on:
- Note and mortgage paperwork prepared by Mike’s attorney
- Title insurance required
- Hazard and liability insurance for a vacant property required
- $140,000 total loan
- $65,000 at closing (Regina makes a $10,000 down payment)
- Three repair draws of $25,000 (total of $75,000), with a third-party inspector paid by Regina
- 2 points (a point is an upfront fee of 1% of the loan, so 2 points = $2,800 here)
- $200 processing fee to cover the IRA custodian’s transaction fees
- 10% interest, with interest-only monthly payments
- 9-month term, no prepayment penalty
- 2% fee to extend the loan an extra 3 months
Regina is happy because Mike’s IRA funds the loan 10 days after her request, which lets her make a strong offer and get her low price. Mike is happy because he has a competent borrower, solid collateral and profitable terms.
Regina fixes the property and sells it in six months. After Mike is paid off, his results look like this:
| Result of the first loan | Amount |
|---|---|
| Points earned | $2,800 |
| Interest earned (6 months) | $7,000 |
| Total earned | $9,800 |
| Annualized return | 14% |
Regina made a profit of over $40,000 after all her costs. Mike earned an above-average return on a property and deal type he understands. Both are ready to do another deal together.
Building wealth over time
Not every deal will go like the first one. Some will be better and some worse, and Mike’s overall returns probably won’t be this high. Why not?
- Idle cash. Mike has $150,000 in the IRA but only $140,000 was invested, so $10,000 sat at the custodian earning nothing. That will be the norm, since it’s hard to keep every dollar invested, and there will be gaps between loans.
- Problem loans. Over the long run, collection, legal and foreclosure costs are almost inevitable, and they eat into returns.
- Professional help. Mike may use brokers and loan servicers to find deals, handle some of the work and monitor loans, and their fees take part of the return.
To keep the math simple, assume Mike’s average return on all his money is 10% a year. At age 60, after 25 years of consistent lending, his $150,000 would grow to just over $1,625,000. Assume the $150,000 left in index funds grows at 8% a year: it would be worth just over $1,027,000 after 25 years.
| Account | Starting amount | Assumed return | After 25 years |
|---|---|---|---|
| Self-directed IRA (private loans) | $150,000 | 10% | $1,625,000+ |
| 401(k) index funds | $150,000 | 8% | $1,027,000+ |
| Total | $300,000 | $2,652,000+ |
Most importantly, he could turn those funds into income to cover his living expenses in retirement. Even at a 6% yield from more passive investments, that would be about $159,000 a year (0.06 x $2,652,000). And if Mike has also done well with real estate outside his retirement accounts, his total retirement income could be higher still.
How discounted notes work
Borrowers on discounted notes can be investors or owner-occupants. The common thread is that you, the note investor, own the note at a discount. That discount gives you extra protection against risk and a higher return.
How do you get a note at a discount? Here’s a short example of my main approach to the business.
Say I buy a single-family house at a discount for $50,000 in cash. It needs work, and I put another $20,000 into making it a nice place to live. After the work, it’s worth $100,000, and I have $70,000 invested.
Instead of flipping the house for cash, I find someone who wants to buy it with owner financing. I screen them heavily with a third-party mortgage loan originator (more on Dodd-Frank below), test them as a renter for a year, and then sell them the house for $100,000.
The buyer puts $10,000 down, and I carry back seller financing, a private note, for $90,000 at 7% interest for 20 years. The note is secured by a first mortgage or deed of trust, so I can foreclose if I need to.
My net investment is $60,000 ($70,000 minus the $10,000 down payment), and I own a note with a face value of $90,000. The discount raises my return and gives me a bigger margin of safety if something goes wrong and the borrower stops paying.
I created the note in this example, but there’s also a large business in buying seller-financed notes like this one. Individually or through note funds, you could buy those $90,000 notes from people like me, at a discount, of course.
Example: growing wealth with discounted notes
In the example above, I financed $90,000 at 7% over 20 years, so the payment to the note investor is $697.77 a month.
| Item | Amount |
|---|---|
| Purchase price plus repairs | $70,000 |
| Sale price with owner financing | $100,000 |
| Buyer’s down payment | $10,000 |
| Note (7%, 20 years) | $90,000 |
| Monthly payment | $697.77 |
| Net investment | $60,000 |
| Yield on net investment over 20 years | About 12.9% |
Your actual return is much better than 7%, because you own the note at a discount. Your net investment after the $10,000 down payment is only $60,000. Run it through a financial calculator, and your return on that $60,000 over 20 years is about 12.9%.
If the buyer pays off early, say in 5 or 10 years, your return is even better, because you collect a big chunk of the discount you built in up front.
Mike, with his $150,000 self-directed IRA, could use this approach too. Instead of, or in addition to, private lending, he could buy a couple of houses at a discount and sell them with owner financing. The safety and returns over time could be just as good or better.
What I like about creating or buying discounted notes is that they’re more consistent. I created discounted seller-financed notes in 2008 and 2009, and nearly ten years later, when this was written, most of those buyers were still happily paying me. With these notes, you do most of the hard work up front and keep collecting for years.
Regulation: what private note investors must know
Like any business, private notes have challenges. For me, the shortcomings fall into two big areas: regulation and risk.
The long-term trend is for private note investors to be regulated like big institutional lenders. More than anything, that increases your costs and hassles to stay compliant.
For example, the Dodd-Frank Act was signed into law in 2010 in response to the turmoil, and in many cases mischief, in the lending markets before the 2008 Great Recession. The law cast a wide net that caught seller financing and other small lending operations in the same rules. Many other state and federal laws also apply to both private lending and discounted notes.
Get educated and get advice
The first lesson is to learn the regulations and get professional advice before jumping in. Online forums where experienced note investors answer questions are a good place to start.
Also plan on local legal counsel from an attorney who understands private notes and real estate investing. You may find one through local real estate meetups.
Learn the exemptions
The second lesson is to learn the legal exemptions. For example, the rules that came out of Dodd-Frank apply to owner-occupant borrowers, so if you lend to investors, those particular rules don’t apply. Other federal and state rules still do, but compliance is less cumbersome.
Under Dodd-Frank, investors who seller-finance three or fewer properties a year also face fewer regulations than others. By knowing the rules and the exemptions, you can build your note investing in a way that stays compliant and safe.
The main risks of private note investing
All investments carry risk. Here are the big ones to watch for with private notes.
Default risk
Your borrower could stop paying or default some other way. If the borrower is uncooperative, you’d have to hire an attorney to foreclose, and a bankruptcy could delay even that. Be prepared for major delays and costs if a loan defaults.
That’s why experienced note investors stress a margin of safety between your investment and the value of the collateral. It protects your principal. I like to be at 65% loan-to-value or less.
Defaults are also why you should keep cash reserves. If you lend out every dollar, you can put yourself in a very bad position.
Borrower risk
Your borrower determines much of your success. A borrower with little character, who won’t follow through when things get tough, will make lending miserable. A borrower with character will do right by you even when a deal or the economy goes downhill.
Finding good borrowers starts with getting to know people. You can and should also use proxies for character, like credit and background checks. Then, if possible, require skin in the game (their own money in the deal) and a personal guarantee.
Property risk
The property is your ultimate collateral and the safety net for most other risks. Problems with the property, the title or the local market are major risks.
- Always hire an attorney to research title and protect it with a title insurance policy. Title problems could stop you from selling the property if you have to take it back.
- Have the property inspected thoroughly by knowledgeable inspectors and contractors before you fund the deal.
- Hire an appraiser to understand the property’s market value, and study the neighborhood trends yourself. Local market fundamentals are too important to leave entirely to third parties.
Here’s my number one rule for private notes:
If this isn’t a property you’d be excited to buy for the same price as your loan amount, don’t do the deal.
You may be the lender, but there’s always a chance you’ll become the owner after a foreclosure. So think like one.
Treat private notes like a business
There are many profitable niches in real estate investing, and private notes are an important one to consider for building wealth and long-term income.
You might invest in notes on the side, to complement your rentals and flips. That’s what it’s been for me. Or you might decide notes have enough promise to be your main strategy, as some investors have done successfully.
Whichever you choose, treat private note investing like a business. Get educated, network with successful investors, and hire professionals to help.
