In this difficult real estate market, many real estate investors are starting to look at note investments as a new opportunity to earn above market returns. Note investing, for purposes of this article, is defined as the origination of new, or the purchase of existing real estate secured mortgages and/or trust deeds. Many investors use language such as “Buy Notes” or “Note Investing” because the terms of a mortgage are detailed in the promissory “note.”
There are many similarities between investing in real estate and investing in notes, including evaluating the collateral, and working with title, escrow and insurance companies.
The old adage of real estate, “location, location, location” also applies to notes, although it may be more appropriate to say, “collateral, collateral, collateral.” Value the underlying collateral of your note investment as if you will own the property (because you just might). If possible, get an independent interior appraisal, visit or drive by the property.
If the property is older, or has any unique characteristics, you may also wish to have the collateral inspected, just as you would when purchasing real estate. Inspections are easier to conduct when originating new notes than purchasing existing notes because the inspection can be made a condition of the note funding. Once a note is funded, the occupant may not be as cooperative.
Just as you want clear title when purchasing a home, so too is the case when investing in a note. For new notes, you will obtain a lender’s policy to insure your note will record in the desired lien position. For existing note purchases, you will want to review the existing final title policy (not a preliminary report) and obtain an endorsement from the title company when the assignment is issued at closing.
Escrows are used to originate new notes but are less common when purchasing existing notes. For a new note, escrow is often collecting borrower signatures, obtaining proof of insurance, and managing the closing of the original note. For an existing note, there is less for escrow to do because the note has already been funded. Instead of a traditional escrow, many purchasers of existing notes use a sub-escrow which is managed by the title company. The title company obtains from the note seller, the endorsed promissory note and a notarized assignment. The buyer sends the note purchase funds to title. When the documents and funds are in hand at the title sub-escrow, the assignment is recorded, along with the selected title endorsement(s) and the funds are transferred to the note seller.
Note investors should make sure the borrower has appropriate insurance for the collateral and that the note investor is listed as the Mortgagee on the Evidence of Insurance certificate issued by the insurance company. When listed as a Mortgagee on the insurance policy, the insurance company knows to issue a check to both the Mortgagee and the Borrower. In addition, if the policy is changed or canceled, the Mortagee is notified and can take corrective action.
Although the investment in notes is similar to purchasing real estate, there are a few significant differences.
Lien vs. Ownership
The first difference is the most obvious. The real estate is not owned by the note holder: the note holder has a lien position against the real estate. If the borrower breaches the terms of the loan agreement, the lien holder can foreclose upon their interest and acquire title to the property.
Borrowers vs. Tenants
Note investors manage their borrowers, and real estate owners manage tenants. Both tasks can be outsourced. Note investors may outsource the collection tasks to a note servicing company just as real estate owners can outsource rent collection and upkeep to a property management company.
As a note holder, your main responsibility is to collect the payment and make sure taxes are being paid and insurance is current.
When making a decision on a note investment, the borrower’s credit and capacity to make regular payments, is equally as important as the value and quality of the collateral. The process of evaluating the borrower’s credit and ability to pay is called “underwriting” the loan. Banks underwrite borrowers to a set of rigid standards set forth by either the government, or their own board of directors. Individual investors should set standards for their borrowers in accordance with their own appetite for risk.
In purchasing real estate, there is typically a purchase agreement and a Deed. The purchase agreement details the terms of the purchase and the deed is recorded to put the public on notice of the new owner, and that the transaction closed. In a note purchase, there is also a purchase and sale agreement which spells out the terms of the note purchase, but instead of a Deed, the instrument that is recorded is called an Assignment. The previous note holder is assigning the beneficial interest of the note to the new note owner.
When a note investor is not paid, foreclosure is the recourse. The process of foreclosure varies by state and may be judicial or non-judicial depending upon how the state statutory scheme is set up.
Real estate investors can think of foreclosure like an eviction of a non-paying tenant only more time consuming and more expensive. Foreclosures may require substantial upfront fees paid to attorneys and/or trustees and can be a stressful process for a note investor to undertake. Many investors shy away from note investments because they do not wish to have to foreclose on a borrower.
The risk of foreclosure is directly related to the quality the note investment and the quality of the borrower. Good quality borrowers are as important to note investors as good quality tenants are to real estate investors.
 In some cases, the note holder may escrow the taxes and insurance payment and is responsible for keeping these current.
Leverage is relatively easy to obtain on real estate and is one of the driving forces behind many investors’ desire to own the asset as an investment. Leverage gives the owner the ability to enhance (or lever) the financial return. For example, if an investor purchases a $300,000 single family home and borrowers $210,000, the amount of equity invested is $90,000. If the property appreciates $20,000, the investor, would earn 23% on his equity ($20,000 / $90,000) from the appreciation. If this same investor did not apply leverage against the real estate, the return would be $20,000/ $300,000 for a 7% return on equity. In this example, the leverage applied to the real estate (e.g. the $200,000 loan) enabled the investor to achieve a 23% return vs. a 7% return.
Leverage is more difficult to obtain for note investors. Although it is possible to obtain a loan against a note investment, it is far less common and reserved only for the highest quality investors, and usually at above market rates. Returns may also be enhanced by using a retirement account to hold your note investments.
Notes are not nearly as easy to find as real estate investments. Investors can look to buy notes directly on a note exchange such as LoanMLS.com, or you may choose to work with professional hard money lenders (a.k.a. private money lenders) specializing in note investments. Education about investing in notes and investment opportunities may be found at the PrivateMoneyLendingGuide.com
SummaryNote investments will take a little getting used to for most real estate investors. But with a little education and due diligence real estate investors will find notes an excellent way to diversify their holdings, and earn above market returns with consistent, long term income.
 This calculation is highly simplified for illustration purposes and excludes many of the factors used to calculate a true return on the investment.