At first, investing in notes may sound like a complicated strategy. In reality, however, if you do your due diligence correctly, note investing can be one of the simplest and most passive forms of real estate investing out there because it provides consistent monthly cash flow without the hassles associated with tenants.
A Breakdown of the Basics
A performing note is simply a mortgage where the borrower is paying consistently every month. When you buy the note, you look through the collateral file. You should be able to see the following:
- Unpaid Balance (UPB): the amount left on the loan
- Term: the number of remaining payments
- Interest Rate (IR): the interest paid on the borrowed money. Investors typically buy notes at a discount, which raises the investor’s yield higher than the IR on the note
- Monthly Payment: investors collect the principal and interest payments
- Pay History: a record of how much and when payments have been made.
Step-by-Step Due Diligence for Note Investors
If a note is performing, that means that the borrower is paying on time and in full. Sounds like you’re ready to go, right? Wrong! You still need to do some due diligence to find out just how long that borrower has been making those payments.
For a performing note, ask:
- How long is that borrower’s pay history? A third-party statement is better than information direct from the note-seller, since that party has the ability to alter that history to make the note look more attractive.
- Does the borrower pay on time? Late payments often indicate a lower likelihood that the note will continue to perform.
- What is the current state of the collateral (the property)? Work with a local realtor to get a fair market value of the current or “as-is” condition of the property. This is important for your security since if you have to foreclose, you may have to take the property back and re-sell it.
- Are all taxes paid? If they are not, the county could take that property!
- What is in the collateral file? The collateral file should include the original promissory note and a mortgage or deed of trust. It may also include information on other transfers of ownership. It’s kind of like CARFAX for your note, and if it is incomplete then you need to find out why.
- Does the note amount compare favorably to local rental rates? If a borrower would have to pay more to rent somewhere else comparable, they are more likely to stay in the home and pay on their mortgage note than move (which increases the possibility that your note will continue to perform).
Those six points are a good start, but there are a few other factors to consider before making a final decision on a performing-note purchase:
- If the borrower has equity, they are more likely to continue making payments and you have a better margin of safety if they default in the future.
Find that margin by subtracting your purchase price from the fair market value of the house. Generally, most note investors look for an investment-to-value (ITV) ratio of 80 percent or less.
- Evaluate how the cost of the note compares to the unpaid balance.
The investor (you) gets a full payoff if the note pays off early. Usually, this will increase your return. If it doesn’t, think carefully before you buy.
Performing Note Case Study: Pennsylvania
This is an example of a performing note I bought in Pennsylvania:
- Unpaid Balance: $32,167.33
- Term Remaining: 138
- Fair Market Value: $47,000
- Monthly Payment: $375 (Principal and Interest, what I receive)
- ITV: 48.2%
- My yield: 13.2%
- This note shows exactly why performing notes are a valuable asset. It pays consistently, and I have never had to visit the property personally or interact directly with the borrower. I just receive a check every month.
Are Notes the Perfect Investment?
Of course, no investment is perfect. Here are a few things to consider before buying a performing note:
- Performing notes tend to be expensive.
Pro Tip: Buy non-performing notes at a discount and work with the borrower to make the note perform again or create your own notes by marketing properties you own via seller-financing.
- Notes must be serviced for good record keeping and to collect your monthly payments. Note servicers typically charge between $20 and $30 a month, and you should not try to service the note yourself unless you understand and can perform the accounting, borrower communications, and reporting to make everything legal.
- Even performing notes come with a risk of default. There is always a risk of default.
- There may be fewer tax benefits.
Although note investing is often compared to landlording, it does not carry the same tax benefits as rental properties.
In the end, it all comes down to your goals and circumstances, but a performing note can be a good diversification with a solid passive investment.