In my early days in real estate, I shared an office with a ‘lifer’ — another realtor who had been selling real estate for over 50 years.
This realtor used to routinely make first or second mortgages to buyers, in order to help them purchase a home he had listed. Having firsthand knowledge of both the real estate that backed the loan and the buyers coming into the purchase made for a secure, repeatable investment.
However, with the passage of the Dodd-Frank Act, private individuals like our friend the lifer became limited in their ability to lend to consumers for a buyer-occupied first home, unless they are a licensed lender.
There is still an active market, though, for investors to get into this playing field by purchasing real estate-backed notes from lenders, or purchasing commercial and investment loans. Investing in real estate-backed mortgage notes offers an alternative, and often lucrative, way to participate in the real estate market without the challenges of owning and managing physical property.
Understanding Real Estate-Backed Mortgage Notes
A mortgage note is a legal document representing a loan secured by real estate. Essentially, when someone buys a home and finances it with a mortgage, the lender holds a promissory note — this is the mortgage note. The note specifies the loan amount, interest rate, repayment schedule, and other key terms, and is typically secured by a lien on the property, meaning the lender (or note holder) has a claim to the property if the borrower defaults.
Mortgage note investing can include both commercial and residential loans, and both owner-occupied and rental housing. There are two primary types of notes investors can purchase: performing and non-performing.
Performing Notes are notes where the borrower is making regular, timely payments — generally safer, since there’s reliable cash flow from the borrower. Types include conforming loans (paid on time, fitting standard lending parameters), loan modifications (usually originated by banks but modified from their original terms, often at the request of borrowers who had a financial setback like a job loss, medical crisis, or divorce but want to stay in their homes — many of these borrowers recover and become faithful payers), and hard money loans (short-term bridge loans made to house rehabbers who need capital to purchase and flip a home, with the goal of a quick resale or refinance).
Non-Performing Notes are loans where the borrower has stopped making payments. Investors can purchase these at a significant discount, but they involve higher risk and require more active management, since the investor may need to restructure the loan or foreclose on the property.
Why Invest in Mortgage Notes?
1. Consistent Cash Flow. For performing mortgage notes, the investor receives regular payments of interest and principal from the borrower, providing consistent, passive income — often with yields higher than traditional bonds or dividend-paying stocks. Interest rates on mortgage notes can range from 6% to 12%, depending on the terms of the loan and the risk profile of the borrower.
2. Discounted Purchase Prices. With non-performing notes, investors can acquire mortgage notes at significant discounts, sometimes 20% to 70% off the loan’s face value. The discounted price provides a margin of safety and the opportunity for higher returns, particularly if the investor is successful in working out the loan with the borrower or acquiring the underlying property through foreclosure.
3. Control Over Investment Outcomes. Unlike other passive investments, mortgage note investors have some degree of control over the outcome. If a borrower is behind on payments, the investor can renegotiate the terms — reducing the interest rate or extending the loan’s term to make payments more manageable — creating opportunities to recover non-performing loans and restore them to performing status.
4. Diversification. Real estate-backed mortgage notes offer diversification benefits for an investment portfolio, since they aren’t directly correlated to the stock market or other traditional assets, providing a hedge against market volatility. Note investing can also be an excellent option for a self-directed IRA or Solo 401(k), since retirement accounts don’t benefit from the tax advantages built into direct real estate ownership — notes can be a great addition for the real estate enthusiast who wants real estate exposure inside their retirement accounts.
Risks of Mortgage Note Investing
- Borrower Default: While this risk is lower with performing notes, it’s still a possibility. With non-performing notes, default has already occurred, so investors must be prepared to take actions like foreclosure, which can be time-consuming and costly.
- Property Depreciation: Since mortgage notes are secured by real estate, the value of the underlying property is critical. If the property loses value, it can affect the note holder’s ability to recoup the full investment in the event of foreclosure. Investors should conduct thorough due diligence on the property’s value and condition before purchasing a note.
- Foreclosure Costs and Delays: With non-performing notes, foreclosure can become necessary if the borrower doesn’t resume payments — but the process can be lengthy, complicated, and expensive, particularly in states with judicial foreclosure processes.
- Liquidity Risk: Mortgage notes are not as liquid as stocks or bonds. If an investor needs cash quickly, selling a note may take time, and the price received may not reflect the note’s true value. Investors should be prepared to hold the note for an extended period or accept a discounted price if they need to sell quickly.
Sources of Notes
Mortgage notes are mostly purchased from banks, mortgage bankers, and other residential mortgage loan originators that are in compliance with RESPA, the SAFE Act, and the Dodd-Frank Act when applicable. Private lenders are generally not a source here — the Dodd-Frank Act prohibits private money financing when the property is a buyer’s principal residence, unless the loan goes through a licensed mortgage originator. This mortgage originator requirement applies to residential mortgage loans made on a buyer’s principal residence, but not to loans made on a second home or investment property.
Types of Note Purchases
- Bundled Notes: Notes can be purchased as packages bundled together with other mortgages and sold, known as mortgage-backed securities (MBS). These are usually sold through ETFs, which can be purchased through investment advisors or an online brokerage account.
- Individual Notes: Notes can be purchased individually through websites like Paperstac, groups on social media sites like LinkedIn that pair buyers and sellers of commercial notes, or auction sites like Ten-X that sell commercial mortgage notes.
- Partial or Syndicated Notes: Notes can be purchased in part, with the holder receiving just a stream of income while a servicer collects payments and holds the primary note. Syndication of notes offers private ownership as part of a group or fund.
Conclusion
For investors looking for more passive options, purchasing mortgage notes after origination can be a great way to diversify and add another dimension to a real estate investing portfolio.
Many investors we work with appreciate the diverse approach we take to make sure their hard-working capital is producing the best return. Contact us today for a strategy meeting.
