We recently explored several reasons why you should consider investing in notes. It can be a very lucrative place to invest, but investing in notes does have its challenges. These ten things that you must know shouldn’t be enough to keep you from considering buying notes, but you certainly should understand these ten items in order to build a thriving practice.
- Dealing with Servicers: As government regulation continues to increase in the note arena, note owners are now more than ever required to let licensed mortgage servicers service their loans. Unfortunately, many servicers seem to milk more and more money from note holders. A prudent note holder is wise if they stay on top of their servicers to ensure that they are staying on top of their loans. That is easier said that done.
- No Appreciation: Real estate is an asset that tends to increase in value over time. Notes, however, amortize and become less and less valuable with each payment the borrower makes. Unlike real estate, notes do not appreciate.
- Underwriting Takes Some Expertise: I spent 25 years in lending and banking prior to becoming the portfolio manager for Castle Rock. That’s a quarter of a century looking at tens of thousands of loans. Most note investors don’t have that background. In order to be a successful note buyer over the long haul, one must truly learn the ins and outs of loan underwriting and collections.
- Foreclosure vs Eviction: If you own real estate and a tenant won’t pay, it’s a pain to evict them. If you have a note, however, you must go through the foreclosure process to recoup your investment. In Deed Theory states (states that use a deed of trust to secure the loan…otherwise known as a non-judicial state), the process to recover real estate collateral is usually relatively quick and painless. In Lien Theory states (states that use a mortgage to secure the loan…also known as judicial states), however, you could be tied up in the courts for months or even years trying to recoup the collateral. Foreclosure can sometimes take a long, long time…time in which you will not be receiving payments.
- Tougher to Get Financing: Institutional and Hard Money Lenders have popped up all over to provide financing for real estate fix-n-flippers. The same can’t be said for note investors. It’s much more difficult to obtain financing for a note purchase than it is for the purchase of a property.
- Finding Notes to Purchase: The MLS, wholesalers, and consumer sites such as Realtor.com and Zillow make it easy to search for properties to purchase. In order to purchase notes, however, you need to know where to call to find notes to buy.
- Tougher to Do Due Diligence on the Collateral Property: When you purchase real estate, you are normally allowed to visit the property and do inspections. Not so with a note. Someone else owns the property. You will be able to review the actual loan file, but you usually won’t be able to access the property itself.
- The Paperwork is Different: Most investors know the process of purchasing real estate inside and out, but the paperwork for a note is entirely different. If you have a background in lending, banking, and special assets, you’re likely familiar with the contents of a loan file, but to those that don’t have that background, the paperwork can read like Egyptian hieroglyphics.
- Potential High Legal Fees: Particularly in a lien theory state, foreclosure costs and legal fees can get pricey.
- Subordinate Liens Could Face Deteriorating Lien Position: Many note investors love to purchase 2nd liens. These subordinate liens can be cheap. The problem with purchasing these subordinate liens is that you are not only behind the first, but if the borrower isn’t paying their first mortgage, the legal fees, late fees, back interest, and other costs that the first mortgage holder incur come before your loan. In a liquidation of the collateral, all of that gets paid first. You can see your secured second mortgage or deed of trust become an unsecured loan very quickly.
Don’t let this gloom and doom shy you away from investing in notes. They can be a very lucrative and rewarding place to invest. You simply need the right mentor to guide you down the path to financial freedom in this asset class.