Buying, selling and creating notes secured by real estate has been a time-tested investing strategy for decades. Most investors and lenders focus on performing notes, but investing in nonperforming notes has become more popular, and the Great Recession made it possible on a large scale.
This niche strategy offers investors big discounts, and it can help homeowners, lenders and investors during times of economic hardship. This lesson explains the difference between performing and nonperforming notes, what it means to invest in nonperforming notes, and why an investor would pursue this strategy at all.
Performing vs. nonperforming notes
There are several ways to classify real estate notes, but whatever the type of loan, they fall into two broad categories:
- Performing
- Nonperforming
A performing note is a mortgage loan where the borrower is paying as the note requires. The borrower has paid, and continues to pay, without missing any payments.
A nonperforming note is a mortgage loan where the borrower is not paying as the note requires. Nonperforming loans include borrowers who are 30 days or more behind. Seriously delinquent loans, also called nonaccrual loans, are 90 days or more delinquent.
Why lenders sell nonperforming notes at a discount
In a healthy economy, most mortgage notes are performing and only a small share are nonperforming. Before the COVID-19 pandemic, in March 2020, mortgage delinquencies hit record lows: at the time of writing (2020), just 3.6% of all residential mortgage loans were in some stage of delinquency.
In hard times, delinquencies rise. That puts pressure on the institutions holding the notes, because less money comes in each month. For large lenders, this can upset debt and reserve ratios and reduce liquidity. For smaller private investors, a nonperforming note may be too much of a liability, too time-consuming or too costly to manage on their own.
Lenders sell mortgages on the secondary market, or to other investors, all the time, whether the loans are performing or not. That includes banks, credit unions and other lending institutions, and private investors who created a private or owner-financed note. Selling is a routine way to get cash up front for an asset that is normally repaid slowly over time.
Most performing loans sell at par, or close to the face value of the debt. A delinquent loan is a distressed asset, so it usually sells at a discount. Depending on who is selling, the discount can range from 40% to 80% off the property’s current market value or the unpaid balance, whichever is less. The sale takes the burden of the delinquent loan off the seller and gives them much-needed cash.
How investors resolve a nonperforming note
Investing in nonperforming notes means buying individual notes, or groups of loans, that aren’t paying. The investor then works toward a resolution: either getting the borrower paying again or liquidating the asset another way, such as a deed in lieu of foreclosure.
Because the note was bought at a discount, the buyer has more room to work with the borrower on a resolution that is good for both sides. That can mean a forbearance plan or a formal loan modification that reworks one or more terms of the original note into a more affordable monthly payment.
If the homeowner no longer wants the home, the lender can accept a deed in lieu of foreclosure: the borrower deeds the property to the lender instead of the lender foreclosing. The borrower moves on without a foreclosure on their record, and both parties are done with the note quickly.
In the worst case, the investor can take legal action, called foreclosure, to gain title to the property. This happens when the borrower can’t or won’t work with the lender, or the property is already abandoned. Most nonperforming note investors don’t want to foreclose, but it is part of the business model. Learn how foreclosure law works in your state, and budget for the time and cost of the process.
If you end up with the property through a deed in lieu or a foreclosure, you can do whatever you want with it.
Why the discount is the opportunity
It all comes down to the discount. In real estate, they say you make money when you buy. The bigger the discount compared with the value of the property or the asset, the more room there is for profit and the better your potential return. It is not always the case, but double-digit returns are fairly common when a nonperforming note is bought and managed correctly.
Buying nonperforming notes can also help during hard economic times. When large institutional lenders are flooded with delinquencies, their loss-mitigation departments get overwhelmed. Requests for foreclosure alternatives are often missed, or denied because they don’t fit the lender’s specific requirements, so borrowers don’t get the help they need.
A note owned in the private market is different. The discount gives the investor more flexibility, which in most cases leads to better outreach to the borrower and loss-mitigation solutions that work for both parties.
The risks of nonperforming notes
Note investing can be complex. There are many variables in valuing a note and the collateral behind it, especially when the loan isn’t paying. Most investors hope for a good resolution and want to avoid foreclosure at all costs, but sometimes it isn’t possible. Foreclosure can be costly and slow, especially if the borrower contests it, litigates or files bankruptcy.
Before pursuing this strategy, you need a thorough understanding of how to do due diligence on the loan, the borrower and the property, while staying compliant with federal and state laws and regulations.
Laws vary from state to state. They decide whether you need a license to own a note in that state, what the rules are for contacting the borrower (especially one in bankruptcy) and how foreclosure works there. This extra layer of complexity often calls for outside counsel and specialized knowledge. That is why it pays to have a solid foundation in real estate investing, and in how to invest in notes, before diving into nonperforming notes.
