Note buying 101- The basics

Buying real estate notes can, potentially, yield much higher returns for you, coupled with far lower risk, than many other investments available today.

Seller financed real estate notes are, in a great many cases, bought at a discount off face value, thereby creating a rate of return considerably higher than the original instrument– that is, unless you happen to be creating a new note (in which case you write the original terms of the note). Also, the note purchase can be structured in such a way that as your return increases, the risk decreases– unlike traditional market investments.

In a seller financed note transaction, the buyer of the property makes monthly payments on the note, according to the terms which are spelled out on the note. Typically, the transaction involves a note and a mortgage, which are two separate instruments. The party receiving the monthly payments on the note may, at some point along the line, elect to sell their right to receive the remaining monthly payments to another investor in order to raise cash.

Buying notes at a discount

Let’s better illustrate the concept of how a note may be bought at a discount.

Let’s say you own a home yourself that you bought through conventional financing, on which you are making regular monthly payments. At some point, your bank may, in certain cases, sell your loan to another party like a hedge fund or private equity firm (without you being aware of it because your monthly payments are always going to the same place– i.e., a servicing company address). That other party likely paid less than the outstanding balance (what you owed as of that point in time) in order to acquire the rights to collect the future monthly payments on the mortgage and note. We call that “buying at a discount” to increase the investor’s return (he likely paid less than face value to the seller of the note).

The reason notes are bought at a discount is all due to the time value of money— cash in hand today being worth more than having to wait months and years before collecting it. And, because the note investor paid less than face, he is getting a greater return than the interest rate you are paying because your payment amount on the note remains the same as it was originally.

Privately held, seller financed real estate notes can be, and are, bought and sold in this manner on a regular basis. A note holder who is collecting monthly payments may at some point decide to cash out of his position  by going out and finding a willing buyer for that note who does his homework and decides that the loan is a good investment. After performing proper due diligence, the note buyer arrives at a figure by determining his desired yield and offers to purchase the note for something less than face value. He is putting up cash today but will get his money back (earning a higher rate of interest than the original terms of the note) over a period of months and years. So, because he has to wait to recoup his money, he pays less than the outstanding balance.

The Time Value of Money concept is explained in greater detail here.

You are buying the note, not the property

An important distinguishing feature of a note purchase as opposed to real property is that you are only buying the note and not the underlying property which secures the note. The payer continues to make monthly payments as agreed. The only thing that changes for the payor is that he is now sending the monthly payments to a different address (yours).

If the payor defaults at some point along the line, you, as the note holder have the rights to foreclose and take possession of the property. So, you get all the security of real estate behind your investment but without the attendant hassles associated with landlording (i.e.tenants and toilets).

For reasons such as those cited above, many real estate investors are now buying notes instead of property upon discovering that discounted notes are safer, easier and more profitable for them than brick-and-mortar real estate investing while devoid of all of the inherent headaches.

What’s more, real estate notes are often bought without the note investor physically visiting the underlying property. The security for the note (the property itself) can often times be reviewed by conducting due diligence through websites that offer BPO (broker price opinions) along with a wealth of other information (including tax and buyer history, etc.).

Notes are not limited to real estate. You can buy notes secured by a whole myriad of things (almost unlimited possibilities or scenarios) including golf course paper, car paper, and business notes (which are plentiful and can be found rather easily through networking with business brokers, for example).

Mortgage note defined

A mortgage note is actually a note secured by a mortgage loan. The note spells out the terms such as interest rate, payment amount and other such stipulations. If you own a home and you bought that home by taking out a mortgage loan from a conventional lender, there is a note attached to it which spells out the specific terms. The note is a promise to pay and is essentially an IOU. Notes can be secured by a private mortgage as well as conventional (a privately held mortgage note is held by a private party as opposed to a conventional financial institution).

Privately held mortgage notes can be bought and sold exactly like real estate. And, in much the same way conventional loans are bought and sold by big banks to private equity firms or hedge funds or to entities such as Freddie Mac, the same practice goes on in the private sector– only on a smaller scale involving private money.

It is important to note that there are some regulatory considerations you may need to be aware of (depending on your particular approach to doing business) and you may want to check out this article for a more in-depth discussion and analysis. In certain cases, you may find it advantageous to have an outside firm service your transactions–  especially if you are doing this on a larger scale so as to ensure that you always remain in compliance. And it’s very smart to broker a few notes to the large investors, watch what they do and become thoroughly familiar with the due diligence process before you start buying notes for your own account with your own money. Quickread…

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