Mortgage Note Investing

When you buy a house, you get a loan and make monthly payments on it. That’s a Real Estate Note. What many folks don’t realize is that these notes are actively traded behind the scenes. Have you ever received a letter telling you to send your payment elsewhere? Your loan was simply sold to another lender.

When a loan is sold, all the rights associated with that loan go along with it. Because it is “secured” by the underlying property, the new lower of the loan can foreclose if the loan is not paid.

Investing in real estate notes is generally the purchase of an existing mortgage. And when you purchase a mortgage note, you become the lender. You have all the rights of the lender. You don’t own the real estate, but you have a right to take the collateral if the borrower doesn’t pay.

The two broadest classes of Real Estate Notes are commercial (e.g., apartments, office space, industrial, etc.) and residential (single family homes). For the purposes of this guide, we will focus on the latter.

What Types of Notes Are There?

There are two broad categories of residential real estate notes you can invest in – performing notes and non-performing notes. If you want to break it down further, though it’s beyond the scope of this guide, within each category investors can focus on senior or junior lien positions. A further breakdown into these categories is explained below:

1. Performing Notes – these are notes where the borrower is making their scheduled payments. As an investor, the primary focus is on current income.

• Loan Modifications – these notes are usually originated by banks, but have been modified from their original terms (hence, “modification”). Most modifications are initiated at the behest of the borrowers who had a financial setback, like a job loss, medical crisis, or a divorce, but want to stay in their homes. Most might assume these are “bad” notes, but that is not necessarily the case. For instance, many borrowers recover from their financial setbacks and become faithful payers, grateful to keep their house. In other cases, the property value may more than cover the value of the note. Banks aren’t well-equipped to hold these types of mortgages and will sell them at deep discounts to investors, in many cases well below their intrinsic valueWhen purchasing an existing note, an investor assumes the role of the bank, with all the same lender protections that the bank has, as well as the right to re-work the terms of the note or foreclose on the property if the borrower ever stops paying.
• Private-Finance – private financing is when an individual (as opposed to a bank) directly lends money to a borrower (usually to purchase a home) who either can’t or doesn’t want to get a traditional loan from a mortgage lender. The borrowers then typically make a monthly mortgage payment to the individual as they would to a bank.Most of the time, these deals are born out of personal networks, meaning Joe down the street who wasn’t approved for a mortgage from his bank happens to meet Cynthia, an investor friend of Joe’s dentist, who he spoke to about his predicament in passing. Cynthia offers to finance Joe’s mortgage, and they draft up a promissory note outlining the interest rate and schedule of payments.
• Hard Money Loans – these are often short-term bridge loans made to house rehabbers that need capital to purchase and flip a home. Hard money loans are usually made to an investor who becomes the borrower. The goal is to rehab the property and either sell it or refinance at better terms in a short time period.This is likely the type of residential real estate note that most investors are familiar with. And while these types of investments can be attractive, they can be risky as they tend to track the highly cyclical construction market, and because the borrowers are investors, not homeowners. More on this in a moment.

2. Non-Performing Notes – these are generally sold by banks and other financial institutions and are sold at generally very deep discounts, perhaps between 50-90%. Since the borrower is not making their scheduled payments, the goal as an investor is to either modify the loan in conjunction with the homeowner, reach a lump-sum settlement with the homeowner, or foreclose on the property if needed. Returns can be higher, but often carry more risk.