Why Buying Notes is a Good Investment
The following is an article that appeared in Yahoo.com finance Dec 3rd 2019.
People who want to invest in real estate but don’t want to be landlords might consider buying mortgage notes.
The loans that borrowers take out to purchase a property are mortgage notes. Banks or lending institutions make the loans, and often these entities will sell those real estate notes to free up their cash flow. Note buyers step into the role of the bank, sometimes buying notes at a discount, and collect the borrower’s principal and interest rate payment, says Greg Forest, a real estate advisor at Engel and Volkers in Palm Beach, Florida.
Mortgage notes can be a good real estate investment for people seeking passive income, but investors should know what they’re buying. It takes some research into understanding the borrower’s financial situation, property values and the different types of notes available.
Here’s what you need to know when diving into the world of investing in real estate mortgage notes:
— Types of mortgage notes.
— Vetting borrowers.
— Buying mortgage notes.
Types of Mortgage Notes
Mortgage notes come in different asset classes, usually divided by residential or commercial loans, says Joseph Polakovic, owner and CEO of Castle West Financial in San Diego. Residential loans include single-family and multifamily homes, while commercial loans include malls, office parks, warehouses, and other buildings.
Institutions like banks typically do mortgage notes. In a private mortgage note, a borrower makes payments to an individual entity directly and may be part of a portfolio, Forest says. There are two types of mortgage loans. A loan secured by a property is known as a collateralized loan. The other type is an unsecured loan, with nothing to back them.
There are also two main risk categories. Performing mortgage notes are when the borrower is current on the payment. Nonperforming notes are when the debtor has fallen behind in payments, Polakovic says. Nonperforming notes are sometimes called distressed notes.
“There [are] two ends of the spectrum of how conservative or speculative investors want to be,” he says. “If you’re looking for secured, very predictable income coming in, that’s going to push you towards performing notes. If you want a higher internal rate of return, that’ll push you further towards nonperforming notes.”
Vetting Borrower
Forest says note buyers should do their due diligence and vet the borrower, checking the person’s credit history, income, and payment history to get a feel on the borrower’s ability to continue making payments.
The buyer should also know how much was borrowed, the loan’s interest rate, the timeline for the loan’s repayment and what happens in case of a default.
Forest says investors can get a good feeling about a borrower’s payment patterns once the borrower has about two to three years of payment history. That’s when many buyers will purchase a mortgage note.
“We see people moving every five to seven years. So that two-year mark is probably a good time to jump in because you know that person has been paying and they’re probably not going to move for another three to seven years, so you’ll get consistent payments,” he says.
Notes are characterized as nonperforming usually after 90 days of nonpayment. At this stage the debtor is likely entering the initial stage of heading to default, Forest says. Often investors can buy these notes from banks or lenders at a discount and receive an interest rate higher than the nominal interest rate.
Doug Fisher, principal at Essex Realty Group, says during the housing downturn during the 2008 financial crisis, buying and selling of distressed mortgage notes was prevalent. He says his firm was active in selling mortgage notes for institutions at the time.
When looking at distressed mortgage notes, the original lender will likely sell the notes at a discount to the actual value of the property. The buyer has a few choices: to help get the borrower current on payments by perhaps forgiving part of the loan balance, or to get control of the property when it forecloses.
He says investors who considering distressed mortgage notes need to look carefully at what they’re buying. Usually, buyers are getting the mortgage for a lower cost than the value of the property. But there is still a risk. During the Great Recession, sometimes the property’s value continued to deteriorate and fell under the amount paid for the mortgage, he adds.
If you want to know more about notes, please contact me or we can make a call.
Why Buying Notes is a Good Investment