Ever hear of real estate note investing?
Note investing is a real estate investing strategy that might be appealing to beginner real estate investors for its apparent simplicity compared to buying a rental property.
But what is real estate note investing, and is it really as simple as it sounds?
In this article, we are going to cover the process of buying mortgage notes, so you can determine if this real estate investing strategy is right for you.
What Is a Real Estate Note Investing?
Before we dive into note investing, let’s talk about what real estate notes are.
Real estate notes, or mortgage notes, are legal documents that describe a loan and create an obligation for it to be repaid.
It is important to understand that notes are different from a mortgage. The two are separate documents, though created at the same time. A mortgage is a document that ties real property to the note as collateral for the loan. Meaning, if the note does not get paid or the contract is breached, the lender may assume ownership of the property.
A note defines how much money was borrowed by whom, from whom, and it defines the terms of the borrower-lender agreement. For instance, it states a time frame for repayment and the rate of interest to be collected by the lender.
What Is Real Estate Note Investing?
At this point you might be asking: how do mortgage notes make money?
Real estate investors make money with note investing through buying mortgage notes from lenders who no longer want them. Essentially, they purchase the debt. As a result, the investor is able to collect mortgage payments and interest much like banks do.
If you’re like most people, you are thinking this is a genius real estate investment strategy. On the surface, note investing seems like a simple, easy way to collect passive income. However, there is much more to be said about note investing, and real estate investors who do it successfully are very skilled. It is also important to understand that note investing requires quite a bit of risk tolerance.
Related: Real Estate Note Investing vs Buying Rental Property: Which Is Better?
Non-Performing Notes vs. Performing Notes
A bank would almost never sell a note to a real estate investor unless the homeowner stopped making payments. Another scenario might be that the bank is suffering and does not have enough capital. In most cases of note investing, the first situation is more common.
This means that investors are purchasing debts that are not being paid. These kinds of notes are called non-performing notes. A performing note is one that is being continuously paid off by the homeowner.
As you can imagine, this can be a difficult and risky situation for real estate investors. There is a high potential for losing out on money.
How to Deal with Non-Performing Notes
Adjust the Note Terms
One way that real estate investors deal with non-performing notes is by adjusting the terms of the note. Investors can choose to extend the time frame the homeowners have to pay back the money they owe, thus lowering their monthly payments. Once the monthly payments are lower, homeowners might be able to afford to make their payments again.
It is also possible for investors to increase the interest rate while extending the time frame. In this case, monthly payments could potentially still be lower for homeowners, and investors will make more over the life of the loan. It can be a win-win if negotiated correctly.
Assume Ownership of the Property
Another possible option with note investing is to be rigid with the terms of the note, meaning the homeowner will likely continue to not pay. Then a real estate investor can try to strike a deal with the homeowner and offer to waive the debt if the investor can assume ownership of the home.
If this works, the investor can gain equity at what was likely a huge discount. Because the lender is trying to get rid of the note quickly, they often sell them at wholesale value. That means an investor might only spend $50,000 on a note that has $70,000 in principal remaining. This could be the note to a home that is worth $100,000, for example.
Once the real estate investor has possession of the property, they can flip it, rent it, or use any other applicable real estate investment strategy to turn a profit.
Individual situations vary, but investors sometimes seek non-performing notes for this reason. It’s an opportunity to buy investment property at a steep discount.
Benefits of Real Estate Note Investing
The benefits of note investing are definitely enticing, and some real estate investors are able to make this method work for them.
With note investing, you can reap the following benefits:
- Truly passive income (you don’t have any of the hassles of maintaining an investment property).
- The chance to help homeowners retain their property by being flexible with terms.
- Lower on-going expenses (most investors hire a servicer to handle the note for a small, usually $20-$50 monthly fee).
- A potentially higher return on investment, as you can negotiate your own interest rates.
One benefit of real estate note investing is that you may secure a high return on investment.
Disadvantages of Real Estate Note Investing
On the other hand, note investing is a risky business that is not suitable for most people who are looking to get into real estate.
Some of the drawbacks to real estate note investing include:
- A high risk of the homeowner defaulting on the loan. With non-performing notes, if the homebuyer doesn’t agree to the investor repossessing the property in exchange for waiving the debt, the property might go to foreclosure. In this case, it will go to auction and the proceeds go to the investor. If the property is sold at auction for less than what the investor paid for the note, the investor loses money.
- It is difficult to determine the profitability of a particular note investment because there are too many variable factors. There are many ways for investors to make money with real estate note investing, but nearly all of the methods rely on the cooperation of the homeowner. Unfortunately, an investor cannot determine this factor before purchasing a mortgage note.
Related: Return on Investment and Risk in Real Estate
The Takeaway:
While real estate note investing can be a profitable endeavor, it is only for investors with experience and high-risk tolerance.
As an alternative, we always recommend sticking with the tried and true here at Mashvisor: buying rental properties.
Owning real estate is one of the most reliable ways to earn passive income while building equity if you use real estate investment software to get started. Not only is it a secure strategy, but when done right, it is an easy way to build wealth. As long as you have Mashvisor’s real estate investment tools, you can find profitable investment properties for sale.
Related: How to Become a Real Estate Investor Using Mashvisor