How to Start a Real Estate Note Fund
Investing in real estate can be hard work.
You might make some good returns off buying, fixing, and flipping houses, but the amount of effort involved can take a real toll on your health and lifestyle.
There is an alternative way to make a return on real estate investments and that’s through investing in real estate notes. No fixing or flipping required.
Like other forms of alternative investments, this does hold some risk for the investor and won’t be suitable for everyone, but let’s dive in and take a look at how this type of investment works:
What are real estate notes?
A real estate note is a lien or “promissory note” that is secured by a mortgage loan. When a person borrows to buy real estate, they usually go to a bank or other lending institution for a mortgage.
That lending institution can then sell “notes” secured by that original mortgage contract for all or a portion of the loan amount to investors.
The notes are a contract where the borrower agrees to pay the note holder a portion of the loan within a certain amount of time and under specific terms for interest rate and any penalties for late payment.
Should the borrower fail to make repayments, the holder of the note has a claim against the original lien on the property.
How is this different to real estate investing?
First of all, some things are similar.
Before purchasing a note you still want to be certain of the value of the collateral (property) as you would if you were buying the real estate yourself.
Sometimes property inspection is actually made a condition of the funding of the note.
Secondly, matters such as having clear title, going through escrow and ensuring that the property owner has insurance are all important parts of originating a new note (if you’re purchasing an existing note, there is less involved with escrow as the note is already funded).
Real estate notes are different because:
- You don’t own the property, you hold a lien against it.
- Your main responsibilities are collecting payment, ensuring taxes are paid and that insurance is current. You are not responsible for upkeep of the property as a landlord/property owner is.
- As a property owner, you’d evict a non-paying tenant. As a note holder, you’d initiate foreclosure, which is more time-consuming and expensive.
How do investors make money off real estate notes?
Investors make money primarily through the interest paid on the loan by the borrower.
Should the borrower fail to make payments, then the lien-holder can foreclose on the property.
The hope here is that the investor at least gets the value of their investment back through the sale of the property, although it’s possible there will be a loss, or a capital gain.
Not all notes are created equally.
There is a hierarchy of lien positions which put first liens as senior to second liens (which have been recorded later than the original lien).
The associated risk for a second lien is greater than that of the first because, while first mortgages will always be at least partially backed by the property value in the case of a bankruptcy, second liens may be stripped by a bankruptcy court.
There are a couple of other terms that potential note investors should understand:
Performing notes – These are notes where the mortgagee is making their payments. They show 12 consecutive months of on-time payments.
Non-performing notes – These are notes where the mortgagee is in default and are often sold by lending institutions at significant discounts. Why would an investor purchase these? Either to acquire the property in question, or to restructure the loan payments to something the mortgagee can afford and sell the note after 12 months as a performing note.
What are the risks involved in real estate notes?
We’ve already briefly touched on the difference between first and second ranking liens, showing that a second lien runs the risk of complete loss of investment funds.
A first-ranking note isn’t immune to this risk – should you be in a foreclosure situation and the property value doesn’t meet the lien amount, then you could make a significant loss (hence the need to do due diligence on properties before investing).
Here are some other associated risks:
- Legal issues – There must be a complete chain of title and ownership on a note in order for foreclosure to go smoothly. This has come up as an issue for note holders who may have proceedings dragged out as they are forced to prove ownership. Other legal issues may include things like payment of back-taxes or homeowner’s association fees in a foreclosure situation.
- Property condition – The condition of the property may decline if owners find themselves heading toward foreclosure and don’t look after it.
- Market value – If the property market goes backwards, you may find that the value of the mortgaged property doesn’t meet the lien amount.
- Fewer tax benefits – You can’t claim depreciation like you can as a property owner. There may be tax breaks if you’ve invested from an IRA or similar though.
How to get started with note investing
Here are a few steps for starting your own real estate note fund:
#1. Have a clear strategy
You’ve got to understand the risks involved with the various note options and acknowledge what your own tolerance is. From there, you can build a strategy for your note purchases. For example, here are some common goals:
- Property acquisition. Investors who have this as a goal look at non-performing notes and do plenty of homework on property values and condition. They aim to acquire property at heavy discounts.
- Cash flow. Investors wanting steady cash flow with lower risk will look at performing notes on good properties.
- Reselling performing notes. This is done for a referral or finder’s fee.
Helping distressed homeowners.
Yep, this is an emerging goal among some investors. It’s not that they forego a return on their investment, but they are motivated to find a way to keep owners in their homes.
This might involve purchasing non-performing notes and helping the homeowner by refinancing.
They still profit as these notes tend to be sold at a heavy discount (although profit may not be as great as it might be if they decided to foreclose).
Will your strategy involve buying performing notes, non-performing notes, or both?
Many investors like to mix it up so that they have a portfolio of varying risk and relative returns.
#2. Find notes to buy
There is no one “right” place to find and purchase real estate notes. These may be sourced from:
- Banks and credit unions directly. (Note: Big banks tend to sell notes in bigger lots to large investors rather than individually to small investors).
- Note exchanges and marketplaces.
- Private note holders, such as on seller-financed property.
- Private equity funds. These usually buy in bulk from banks then on-sell to their investors.
#3. Do your homework on the note
As with any investment, risk is the biggest consideration so it’s important to do your homework. Here are the things you should know:
- All upfront fees for the note.
- Property value and condition.
- Credit check on the borrower (for new notes).
- You should have a written agreement for the purchase and paperwork showing a clear title trail.
For any of those “due diligence” tasks, there are experts whom you can hire to check on a note for you.
Sometimes it’s not one note you are buying, but a pool of notes being sold together. Due diligence should be completed based on your overall strategy.
#4. Make an offer to buy
The actual note buying process will vary according to the seller. You will usually find one of the following methods:
- Letter of Intent (LOI) – You send this laying out any terms and conditions of your offer to purchase. (For example, a condition may be that the property must pass an inspection).
- Bidding – Banks often require this, either by open or sealed bid. They usually have timelines and terms fixed so that all bidders are on the same page.
- Indicative bid – This is when you don’t have all required due diligence information already. You submit an indicative bid which basically says “I will pay $X on the condition that due diligence meets my expectations.”
#5. Pay binder
This is the deposit you put down to prove that you are serious about your offer. This is usually safe to put down, but you can lose it if you violate any of the agreement terms. A common binder is 10% of the total.
A warning here is that reputable sellers will typically use an escrow account rather than have you wire funds directly.
#6. Close the note
With all conditions met, you now close and take possession of the note. You should have copies of the following documents:
- The promissory note signed by the borrower.
- The mortgage or trust deed, as recorded with the county.
- The assignment – this is the document which says that you are now the lender.
Now the note is yours!
Investing in real estate notes is not for anyone who wants something low-risk.
While it removes some of the stresses of property ownership, such as being responsible for repairs or difficult tenants, it doesn’t remove you from typical property risks.
You are effectively now “the bank” to the mortgagee and need to manage payments coming in or foreclosure on delinquent loans.
You’re also exposed to the usual risks that the property market entails in terms of values.
Having a good strategy is the key to doing well.
Do you spread your risk with multiple smaller investments as second tier liens?
Or, do you sink a large amount into being the sole first tier lien holder? Performing or non-performing notes?
The best place to start is to do your research and understand the possible risks and investment types very well.