When I talk to people about investing in mortgage notes, I usually get a confused look: “Wait, what do you mean? I have a mortgage on my house, is that what you’re talking about?” My answer is: “Kind of like that, yes. But when I buy a mortgage note, I’m the bank, not the borrower!” Then, they become curious!
But even though mortgage notes can return 9%, 14%, or even up to 20% rates of return or more – with a fixed rate of monthly ACH income! – why don’t more people know about these investments, or participate in them? After all, with no volatility and higher rates than stocks or bonds, they seem like a sure bet.
Not so fast.
While these investments are perfect for some, they’re definitely what I would call ‘alternative’ investments, in that you can’t buy them from your Robinhood account, and you can’t trade them like a stock on your mobile app. If you want to get into mortgage note investing, you’re going to need a little creativity, and to put in a little work to actually find good notes to buy.
This article will go over:
- what mortgage notes are
- how to invest in them
- the risks of buying private notes
- why investors should consider either investing in notes through funds, or by buying what are called ‘partials’.
That way, you’re not dealing with foreclosures and needing to potentially make debt collection calls to borrowers, yourself. (Because then it’s not an investment, it’s a business!)
Let’s get into it.
What are Real Estate Mortgage Notes?
A real estate mortgage note is like an IOU backed by a property. It’s the property owner saying “I promise to pay you back this loan, and if I don’t, you can take my property.” Simple as that.
Now, there are two sides to this – the promissory note and the security instrument (which can be a mortgage or a Deed of Trust, depending on where the property is located). The promissory note is the borrower saying “I’ll pay you back,” and the security instrument is what makes their promise carry weight. It ties the note to the property via a lien. So, if the borrower doesn’t pay as agreed, the lender (mortgage note owner) can sell off the property. (The catch here is that with a Deed of Trust, the lender can sell the property without going to court. With a mortgage, they have to go through the legal hoops to do it.)
For example, let’s say you’re buying a house that’s $270,000. You only have $55,000 cash, so you borrow $215,000 from a lender. To get that money, you sign a promissory note saying you’ll pay it back, and a mortgage tying your promise to your new house. If you can’t pay, the lender can take your house as payment. That’s the gist of it!
Again, that’s how a mortgage note works when you’re the borrower – but remember, you’re not borrowing, you’re on the opposite side of this transaction as the lender.
What Are The Different Types of Notes?
The main kinds of real estate notes you can invest in are called Performing Notes and Non-Performing Notes. In the industry lingo, you’ll also hear about “senior liens” (“first liens”), and “junior liens” (“second liens”), too. All that means is that the senior position has less risk, and gets paid first if there’s a loss, so be careful when buying second-position notes.
1. Performing Notes (PNs) are where the borrower is making their scheduled payments. The main thing that matters in this case is how much income the note offers now, since if you buy this note, that’s what you’ll be getting.
2. Non-Performing Notes (NPNs)are where the borrower is at least 90 days behind in making their scheduled payments. In this case, if you buy this note, you’ll have to negotiate with the borrower to restructure the terms of the loan (more grace period, good-faith payments, reduced interest rate, reduced balance, and other options are at your disposal). Or, you’ll need to foreclose on the property. The potential returns here are seriously good, but the risk is commensurately higher, and at this point, it’s less of an investment you’re making, and more of a business you’re running. (You’ve never had to get on the phone with the managers of AT&T and negotiate your dividend, have you?).
What Are The Ethics of Buying The Rights to Someone’s Mortgage?
When it comes to NPNs, some funds and asset managers specialize in residential non-performing real estate loans: they have a system for calling property owners, informing them that they’re serious about collecting on the mortgage, but they also remind the borrowers that they’re understanding. The new mortgage owner is willing to restructure the terms of the loan, to get the buyer back on track, in a way that’s favorable o the borrower. Needless to say, many homeowners really appreciate this. NPN funds have helped countless numbers of homeowners stay in their homes, at the expense of big banks who didn’t want to deal with the renegotiation or who aren’t able to due to regulations.
And that’s just wonderful.
Advantages of Investing in Mortgage Notes
Investing in private mortgage notes can offer investors several advantages, especially if they are interested in generating a predictable cash flow. Here are some of the reasons why:
- Be The Bank. Have you ever thought you might like to invest like a bank does? (Well, apart from First Republic and Silicon Valley Bank, that is.) This is your chance to take the other side of the home borrowing equation. Instead of signing up for years or decades of monthly payments, you’re signing up for monthly cash flow.
- Predictable Income: Private mortgage notes pay interest at a set rate, and you receive payments monthly according to the amortization schedule. This makes them ideal for investors who want a predictable income stream.
- No Property Management: Woo hoo! No fixing toilets, no tenant relationships, no nothing. Well… except in the unlikely but possible event that you have to foreclose. It’s out of your hands. The borrower is the property owner, therefore typically very incentivized to maintain their property and keep it in good shape.
- Higher Returns: Since notes carry higher risk and are less well-known than traditional investments like treasury bonds or CDs, they almost always offer higher interest rates – generally even higher than bonds and fixed-income ETFs.
- Security: Mortgage notes are secured by the underlying real estate property (be very careful if you’re offered a promissory note investment that actually has no security except the borrower’s promise to pay!). In case of default on a secured note, the investor can foreclose on the property to recover their investment. This collateral makes these notes relatively secure, unless the property can’t be sold for enough to recover their investment – which can happen if you buy the wrong note.
- Diversification: Buying private mortgage notes can offer a way to diversify an investment portfolio, and improve cash flow. They offer a different risk-reward balance than stocks, bonds, or traditional real estate investments, which might reduce overall portfolio risk.
- Control: As a private note holder, the investor can pre-select the terms of the loan, whereas corporate or government bond ETFs are entirely out of your control. With private notes, investors can negotiate interest rates, repayment periods, and other terms, which can help you stay comfortable and in-the-know about how your portfolio is doing.
- Ability to Buy at a Discount: One aspect of you having control over this investment is that you can simply “lowball” or offer less than the Unpaid Balance (UPB). Depending on whether a note is performing or non-performing, it might trade at a 10-80% (!!) discount from its UPB. Of course, a huge discount likely indicates the note is in terrible shape, and will need significant rehabilitation to get it back to a performing state. If you acquire the note at a discount, or participate in a fund that does this, it’s the equivalent of you earning a much higher yield than the borrower is paying in mortgage interest. For example, if you’re earning a healthy 10% on a note, the borrower isn’t necessarily paying that much in interest – you might just have bought the note from a bank at a discount, and thus increased your yield.
- Low Correlation with Markets: Mortgage notes tend to have a lower correlation with stock and bond markets, which makes them a good diversifier in a portfolio. In periods of stock market volatility, these notes can provide a more stable source of income. Obviously if the economy is doing terribly, it’s more likely you’ll need to foreclose on the property in the case of default, but that likelihood has historically never gotten quite too high.
- More Liquidity Than Many Alternative Investments: Even though it’s harder to sell a mortgage note than a public stock or ETF, it’s very possible. There are plenty of note buyers available for the average investor to sell to (although you might be taking a haircut if you do so).
- Passive “Mailbox Money” Income: The best advantage of all! Once the mortgage note is purchased, it generally requires little management unless the borrower stops paying, making it a more passive investment compared to direct real estate investments, which require active involvement in management and maintenance.
As we began to touch on, investing in private mortgage notes also comes with risks. They can be more complex and are absolutely less liquid than popular capital markets investments. There’s also the risk of default, which means the investor might have to deal with foreclosure proceedings – which is not impossible to deal with, but still a burden. It’s important to do thorough due diligence before investing in private mortgage notes, including understanding the borrower’s creditworthiness and the value and condition of the underlying property.
How To Buy To Real Estate Mortgage Notes
Buying Notes Directly
Unless you know of any private mortgage note holders that have good quality notes lying around to sell to you, you’ll need to get out there and pound the pavement, in a sense, if you want to buy mortgage notes directly. Here are some ways to do that:
- Visit PaperStac, NotesDirect, or one of the other mortgage note exchanges available.
- You can also find a mortgage note broker through forums or trade shows, although make sure to do your due diligence, because the broker isn’t going to do it for you
- For-Sale-By-Owner property owners in your local area, as well as real estate investment groups, might also be good lead sources for you.
Investing Via a Fund or Platform
A much-easier way to invest in mortgage notes is to do so through a fund that professionally acquires and manages the notes. This is how to make note investing a truly-passive endeavor, since if you’re buying notes directly, you’ve become a debt collector and administrator of a lot of paperwork.
Don’t take these as personal recommendations, and do your own diligence. That being said, here are some of the places I’ve invested, directly or indirectly, in mortgage notes through a passive investment vehicle:
I receive monthly income from all of those, from my mortgage note investments. However, I generally shy away from tech-enabled investment platforms, and as such limit my exposure to Fundrise, Techvestor, and Yieldstreet etc to no more than 2-3% of my portfolio.
Buying Partial Notes From Note Holders
Yes, you can split a note into multiple parts! If this sounds complicated – it’s not, really. Whichever mortgage servicer is managing the loan can break up the monthly payments they receive from the borrower, to multiple parties.
But why would you as an investor want to buy part of a mortgage note?
Well, your contract as an investor is not with the borrower, but (ideally) with a professional, well-capitalized mortgage note investor whose business it is to manage notes. They take on any debt collection that has to be done, as well as any foreclosure responsibilities. If you buy a partial note, you won’t need to call the borrower for any reason. In fact, the initial note holder will ask you not to do this. That removes one of the biggest hurdles in mortgage note investing, which is when you end up becoming a “mortgage note management business owner”, rather than a passive investor.
Okay, but now: why would the mortgage note holder sell you part of their note, if the note is so great?
Primarily, because they’ll offer you a lower rate of return than they’re getting, and they get to recapitalize. For example:
- Jack directly owns a Note with a balance of $25k, paying them a 16% yield.
- Jill has a target rate of return of 12%, and wants to invest $25k.
- Wonderful! Jill buys the Note from Jack for $25k.
- Jack now receives a monthly 4% yield on a $25k note, while having no capital in the deal. That’s kind of cool. They get to go buy other notes – say, ones that have even better returns. Or they can invest in whatever they’d like.
- Jill reaches their target rate of return of 12%.
- If anything goes wrong with the note and the borrower stops paying, Jack has to step back in and make Jill whole, so Jack had better be good for it and be ready to do that if necessary.
Jill gets the lower return in this scenario, but is more like an ‘investor’. Jack gets a higher return, but puts more of their time at risk. Jack is more like a business owner.
Risks for Investors When Buying Mortgage Notes
There are a lot of risks to think about when you’re looking at these ideal-seeming investments. Yes, they often have great rates of return, and passive income. While those are advantages, keep these risks in mind:
- The borrower stops making payments. This is the big and obvious one. If you own the note directly, it’s on you to get the borrower to start making payments again, and you need to stay within legal debt collection guidelines as you do so. If you own a partial note, the person who sold you the partial will need to make you whole however it’s listed in your contract.
- You bought a fraudulent note. If you didn’t do your diligence on the property or the borrower, you might have bought a worthless piece of paper with no security in it. That’s why due diligence is so important. It’s much less likely that AT&T is a scam, than the guy you found online offering to sell you a note he owns.
- You need to foreclose, and the underlying property isn’t worth enough to make you whole. Ouch. You need to foreclose, but when all is said and done, even after a hugely burdensome process with a borrower who didn’t engage with you and abandoned the property in bad shape… you can’t sell the property for enough to repay yourself. To add insult to injury, the foreclosure process made you incur legal and other fees.
- Interest rates increased and you tried to sell your note. This makes your note worth less, because people are less willing to buy fixed-rate debt when variable interest rates in the marketplace rise. Who would buy your 7% private note, if a 10-year Treasury pays 5.8%?
- The real estate market is way down. If the market is down and your borrower doesn’t see any path to getting back on track from being underwater, they’re much more likely to walk away from the property and leave you with it. Probably in bad condition.
- You tried to collect on your debt improperly in the wrong state, and broke the law. Remember, the borrower’s location and property location matter. If you own notes directly and you say the wrong thing when you call the borrower, you could be breaking the law.
- You need cash now, and you’re having a hard time selling your note for a good price. No Robinhood is coming to save you. The beauty and curse of mortgage notes is that they’re not very popular. You’re going to find many fewer buyers for them, if you need to unload the investment.
- You bought a partial note from a not-creditworthy owner. The borrower stops making payments, the note goes into default, and now you’re trying to be made whole on your partial note investment from a note holder that can’t make good.
- You forgot that this is still a real estate investment. If you have your entire portfolio in real estate, buying mortgage notes is only somewhat a form of diversification. It’s still a loan… backed by real estate. Real estate goes up and down.
- You were expecting FDIC insurance. Nope. This isn’t a bank account. There’s no SIPC, FDIC, or any other acronym coming in to save you if things go bad. You’re on your own with your wits and, hopefully, a good attorney.
- This part of the industry is lightly-regulated. This isn’t like buying a home you live in and getting a mortgage for it from a bank, where the federal government is controlling a lot of how banks and brokers can lend to you. Now you’re on the other side. If someone sells you a bad note and runs off, you’re going to have a hard time getting anything back.
That’s quite the list. Remember, there’s no free lunch in this world: if you learn intensively about an asset class, especially about how to manage your risk, you’ll give yourself a much better shot.
And that’s exactly what I recommend you do: read, consume information, experiment with small amounts of capital, and: network, network, network!
Conclusion
Buying real estate mortgage notes as investments can be a great addition to your portfolio, or it can even be a business that you actively manage. Don’t forget about the key risks involved, do plenty of diligence, and – most importantly – enjoy this asset class for what it can be, at its best: a wonderfully-passive vehicle and a relative secret among the average crowd of investors.
Good luck.
I wish to buy someone I knows mortage note. Its not a risk because I do not need this person to repay. The house is underwater and he has to stay…its complicated. I have the means but I do need to make a deal with the bank