Note investing – the purchase, sale, and management of performing and non-performing real estate notes – is quickly becoming a viable alternative to traditional investment options and there are several good reasons for its popularity.
As a collateral-backed investment that is unaffected by the day-to-day volatility of the stock market, note investing also enjoys limited sensitivity to fluctuations in interest rates and offers a larger, and sometimes quicker, return than is possible with other types of investments.
Note investing also offers versatility in realizing a return, and can be relatively easy to manage.
Note investing offers a range of advantages over traditional investment opportunities. The following information discusses some of the most common attributes.
One of the most attractive aspects of note Investing is the fact that it is collateral-backed. The physical property associated with the note offers a safety net against potential investment losses.
With stocks and bonds, an investor risks losing significant value in their original investment if the stock market declines. They may find themselves waiting an indeterminate amount of time hoping for a market rebound, and while they’re waiting, they’re losing out on any additional investment returns.
A note is different. Even if a borrower were to default on their mortgage, the physical property on which the loan is based and any accompanying equity, provides a note investor with the means to recover expenses associated with the default.
Foreclosing or obtaining a deed in lieu, and then rehabbing and selling the property, allows an investor to fully recoup their investment.
Return on Investment
Note investing offers multiple opportunities to realize a return on investment and can be a flexible, lucrative strategy.
One way in which a note investor realizes a return on their investments in through the collection of monthly principal and interest payments. The monthly payments provide a steady income and the investor will eventually regain their initial investment as well as realize a return from the interest portion of the payments.
Another way investors realize a return is through the collateral gap associated with the note. Performing notes are purchased at a moderate discount while non-performing notes are purchased at a steeper discount due to the depressed condition of the note.
When a borrower pays off their loan, usually through refinancing or selling the home to someone else, the note investor receives the difference between the discounted rate they paid and the actual value of the note.
An investor who purchases a non-performing note, rehabs it, and sells it to another investor at a higher price, can return an even more significant return.
Other ways a noteholder can make money and mitigate risk with note investing, include buying and selling partials (arrangements with other investors to buy or sell part of the payment term of a note) or borrowing against the note. In both cases, the investor uses the initial investment as a vehicle to free up funds that can then be used to invest in additional notes.
Ease of Management
Note investing is considered a passive investment that offers relative ease of management.
It’s true that performing notes require some amount of work in relation to the investment, including due diligence prior to purchasing the note. The management of mortgage payments, and escrow disbursements can be done by a servicing agent for a small monthly fee.
Non-performing notes may involve some work in regard to loan modifications, possible foreclosure proceedings, and rehabbing and sale of the property.
But unlike rental property, a noteholder isn’t responsible for any ongoing physical maintenance of a property or other issues that a landlord might encounter.
Because of this relative simplicity, it is feasible for an investor to own and manage multiple notes from the comfort of their office since much of the work is paper-based, allowing for an opportunity to earn a larger return.
Even though note investing is a great investment opportunity, it should never be considered as a “get-rich-quick” opportunity. It’s important to remember that any real estate investment involves a significant financial commitment and note investing is no different.
Cash Flow Limitations
Compared to traditional investments like stocks or bonds, the amount of money required to purchase a note is considerably higher. The investor is essentially paying, upfront, the cost of a house. While an investor will recover that upfront investment over time through the monthly payments received from the borrower, investors are nevertheless committing considerable funds to an illiquid and cyclical asset, which could otherwise be used for traditional investments such as stocks, and bonds.
While note investors count on appreciation of property value as one means of earning an investment return, appreciation is not guaranteed.
It’s also important to note that an investment loss doesn’t simply refer to a property that loses some of its market value or one that doesn’t generate the expected income. Rather, risks and losses must also be assessed in terms of missed opportunities and holding costs. For instance, if a high-yield corporate bond can earn you 5% interest, your real estate investment should seek to at least cover that “missed opportunity for income” and hopefully provide a higher return over a given period of time.
No matter how much due diligence an investor conducts, there is always a risk that a borrower will run into financial difficulty and cease to make regular payments on their loan. In this situation, the noteholder will have to work with the borrower to return the account to good standing or even may have to initiate foreclosure proceedings which can be costly.
Alvernia Capital Management buys and sells performing and non-performing notes and provides seller-backed financing to deserving homebuyers as part of an investment strategy that aligns with our mission to stabilize affordable neighborhoods across the United States without displacing deserving residents.
The following links provide additional, detailed information about the various aspects of note investing outlined in this article. Please feel free to review this material should you want to learn more about this unique arm of real estate investing.
Learn what a promissory note is and how it’s different from a mortgage.
Learn what a performing note is and the benefits of investing in one.
Learn why a non-performing note can be a great way to invest.
Learn more about seller financing.
How does the note-buying process work? Learn the steps of the note-buying process.