How to Invest in Notes (and 5 Other FAQ)
I wrote this blog post to answer the questions that people ask us the most often. These questions come from new note investors eager to learn as well as passive investors who are interested in investing in one of our funds but want to know more about how to invest in notes before they commit their hard-earned capital.
Let’s dive in with the 6 most frequently asked questions we get about mortgage notes.
1) What is buying notes in real estate?
Real estate notes are the loans that people take out when they borrow money to buy a house. Many people don’t realize that the original lender that provides them a purchase money home loan doesn’t keep the loan themselves.
The original lender (or originator) typically sells the loan on the secondary market for a premium to cash flow seeking entities or government sponsored entities like Fannie Mae and Freddie Mac, that are essentially market makers. The originator pockets the difference between what he can sell the loan for and what it cost him to originate it, then turns around and originates more loans.
For example: an originator creates a loan whose value is $100,000. He then sells the loan at on the secondary market for $106,000. The borrower owes $100,000 regardless of what others buy and sell the loan for.
Instead of buying real estate, these entities are buying real estate notes. They are pension funds, insurance companies, bond funds, and banks, all who are seeking stable cash flow.
2) What is a note sale in real estate?
A note sale in real estate occurs when one person or entity sells a real estate note to another. In the above answer, I mentioned that mortgage originators sell the loans that they originate for a premium on the secondary loan market.
Secondary Loan Market
Sometimes these notes are sold individually as whole loans. Other times, several are packaged together and sold as mortgage backed securities, which makes it easier for huge financial institutions to buy large numbers of real estate notes at one time. Each institution will have its own unique needs and will buy and sell mortgage backed securities or individual real estate notes as needed to fit those unique criteria.
Private individuals, smaller note funds, and other alternative investing vehicles also buy and sell real estate notes as their individual needs dictate.
For technical details: See #3 and #4 below.
3) How does buying mortgage notes work?
Buying mortgage notes is a lot different than buying real estate.
With mortgage notes, the seller might not indicate a listing or selling price first. It’s up to the buyer to look at what’s for sale and make the offer or bid first. The seller will make a counteroffer. The buyer and seller will go back and forth on price until they agree.
The second phase is due diligence. During this time, the buyer should order one BPO (“Broker Price Opinion”) to value each collateralized property, an O&E title report, and third party due diligence services, if desired. The buyer has the opportunity to examine all of the digital images of the mortgage loan file that the seller normally shares. If the buyer discovers issues with the collateral, he should notify the seller immediately. The seller will fix the issue, re-price the mortgage loan, or pull the loan from the trade. The buyer accepts the fix, agrees to the re-price, or withdraws his bid.
MLPA & Funding
Once due diligence is complete, the buyer and seller sign a Mortgage Loan Purchase Agreement (“MLPA”). The buyer wires the purchase price to the seller’s bank account within 24-48 hours.
The seller or their designated custodian (called a “bailee”) ships the original paper files to the buyer.
This is how buying mortgage notes works for me and is typical when buying institutional real estate notes from large hedgefunds.
Smaller banks, smaller funds and individual note investors may have different processes.
4) How do you buy notes?
For the technical details of buying notes, see the answer to #3 above.
Buying notes from Hedge Funds
I wrote an article on how to buy real estate notes from hedgefunds that goes into more detail. Here, I’ll mention the highlights:
To buy notes from hedgefunds you need access to the right people, professionalism, and ready access to capital.
The right people mean the traders and decision makers at hedgefunds and private equity firms that trade whole loans.
Professionalism means understanding the traders and decision makers. Why do they act they way they do? What is important to their decision making? How do they expect you to act? Once you understand the traders, act in the way that’s professional for that industry. Put in the time and effort to develop the right relationships. Then, keep your promises. Do what you say you’ll do and close your deals on time.
Ready access to capital means that you have the ability to fund your trades within 24-48 hours of signing your loan purchase agreements, which is standard when buying notes from hedgefunds.
Buying from private individuals
To buy mortgage notes from private individuals, you can employ the same tactics that real estate investors do when marketing to buy properties directly from owners. Find notes from private individuals that want to sell.
You can find them by having your title company do a search of Mortgages or Deeds of Trust recorded by non-bank entities or individuals. You can check these yourself at the county recorder’s office.
You can try finding them at online marketplaces for notes for sale such as PaperStac. Develop relationships with people that encounter privately held notes during their course of business. Attorneys, accountants, bankers, and other professionals that you network with are all good potential sources.
5) How do you invest in notes?
Wondering how to invest in notes? There are several different ways to invest in notes:
For the hands on, do it yourself, real estate note investor, you buy them by yourself, in your name or in the name of your favorite investing entity (LLC, Trust, S-Corp, etc). You develop your own sources of leads: seller financed notes, private lender notes, attorneys, accountants, probate, direct mail. Generally, the same tactics that are used by real estate investors to buy real estate directly from owners can be used to buy real estate notes for sale, directly from private individuals and possibly from small banks.
Same as above except that you partner up with one or more like minded investors who share the same dream. Combine resources and abilities to invest in notes and purchase more than you’d be able to on your own. Although you’ll be sharing in the profits, you’ll also be sharing the risk in case things don’t go as planned and you lose money.
Joint Venture with Experienced Note Investors
Find experienced note investors at online forums such as Biggerpockets.com, local real estate investment clubs, local note investing meetups, and conferences put on by Noteworthy and Paper Source.
Experienced note investors have developed their sources to acquire notes for sale, know how to invest in notes, and how to manage and/or liquidate them. They get to a point where they tie up all of their own capital. Then they tie up the capital of close friends and family (if they allow them to invest).
Once experienced investors learn how to invest notes and become good at making money, they need to find more capital.
Many are open to partnering up with new note investors who want to be involved in note investing but don’t have the time, business relationships, or experience to do so on their own. For the new note investor who has capital, this is a good option to invest in notes and learn the note business at the same time.
For these types of joint ventures, the newer investor puts up 100% of the capital and the experienced investor provides the acquisition, management, and liquidation skills. Depending on your agreement, the experienced investor will provide training to teach you how to invest in notes yourself.
Generally, the capital partner receives their initial capital back first, then the profits are split 50/50.
Another way to invest in notes is by investing in a note fund.
In this option, the note fund is sponsored by an experienced note investor or group of investors. These private offerings are typically issued under SEC approved guidelines that allow the sponsors to pool investors’ capital to buy pools of notes.
Accredited investors or not…..
Some offerings are only available to accredited investors while some are available to both accredited and sophisticated but not accredited investors.
Preferred returns, profit splits, and terms
Depending on the offering, the sponsors offer the investors a preferred return and/or a split of the profits. The investments generally are illiquid and will tie up the investor’s capital for 2-5 years before returning principal.
Each fund is run differently, has different business models with different targeted returns, and offers investors various types of returns.
Coastline Capital example
For example: currently our investment funds offer an 8% preferred return to investors plus a 50% split of the profit. $25,000 minimum investment. 3 year maximum time commitment. Accredited investors only.
When the fund closes to investors, the fund will buy one or more pools of non performing notes and commence with liquidations. Once liquidations occur, we will not buy additional assets.
Instead, 100% of net proceeds go back to investors until their initial capital has been returned. After that, net proceeds will used towards the 8% preferred return that was accruing on investors’ capital while it was in the fund. Further net proceeds go 50% to the investors and 50% to the sponsors (us).
We charge a 2% management fee of Assets Under Management. Other note funds out there offer different returns and time commitments.
Investing in a note fund is for the passive investor who wants to let the professional note investors do the heavy lifting. This type of investor is focused on other pursuits and doesn’t want to or can’t commit to the full time job of getting access to non performing notes, managing, and liquidating them.
6) Is buying mortgage notes a good investment?
I’m definitely biased! Of course, the answer is that investing in mortgage notes is a fantastic idea!
Seriously, though, mortgage notes have some great advantages, the biggest of which is that they are backed by a hard asset: real estate. Stocks, commodities, and bonds can and sometimes do go to zero value.
If your house burns down, you should have insurance which will turn your loss into a gain. If you don’t have insurance, you at least have the land underneath the house. The value won’t go to zero.
Multiple Exit Strategies
There are several exit strategies for non performing notes, which means that are different ways that you can pivot depending on the circumstances of the time that will still allow you to make money.
For example: if you foreclose on a property and it becomes REO during a real estate downturn, you can turn it into a rental until the market recovers. You can collect rent in the meantime and your loss will turn into a gain.
Work & Manage Remotely
Investing in notes means you can work from your office. No need to travel to see the property since you own the note, not the property. Even if you own the property as REO because of a foreclosure or deed in lieu of foreclosure, you don’t need to go to the property unless you want to. You can use real estate agents or other proxies.
If you’re an active investor, consider buying mortgage notes in quantity so that you can spread the risk among all of the loans in your portfolio. What the borrower does is out of your control and any one of your mortgage notes has the potential to lose you money when things go wrong. By having many notes, the winners will carry the occasional note that doesn’t do so well.
If you’re a passive investor, do the hard work of vetting the funds or partners that you decide to do business with. Once you’ve done that, those you’ve trusted will do the hard work and earn the returns for you. Finally Generally, investing in mortgage notes provides stable returns and limited downsides compared to stocks, commodities, forex, or other risky and volatile assets. Buying mortgage notes should be considered for the bond or alternative investing parts of your investment portfolio.