Dispelling falsities in this noteworthy niche of REI.
Whether you’re a new investor or have been in the game for a while, you might be uncertain of real estate note investing because of what you have heard. Here are facts to dispel just some of the many myths surrounding this niche of real estate investing.
Myth #1: “You need a lot of money.”
Fact: You can buy seller-created real estate notes for a few thousand dollars. Or you can broker notes to institutional investment firms without using any of your own money and make enough to buy a note every so often. Many successful note investors started that way.
Myth #2: “The process is complicated and hard to understand.”
Fact: Buying a note is a lot less complicated than buying a house. You don’t need to deal with real estate agents, title companies, lawyers, appraisers, home inspectors, etc. It can be as simple as performing the due diligence and having the seller sign the note over to you. And there are no closing costs!
Myth #3: “High yields are usury.”
Fact: Note investors can make double- and triple-digit yields, but it is not usury. When a note is sold, the interest rate and the payments do not change. The investor’s yield comes from the discounted price paid for the note. For example, an investor finds a $10,000 note with an interest rate of 10 percent and payments of $132.15 per month. If the investor pays $10,000 for the note, his or her yield would be 10 percent, but if they pay $8,000, their yield is higher (15.63 percent). The note payor’s interest rate and payment amount never change. And there are no closing costs!
Myth #4: “Notes are very risky.”
Fact: No investment is risk-free, but unlike many investments, such as the stock market, when you buy a note, you have a great deal of control over your risk exposure. Suppose you pay $50,000 for a first lien note on a $500,000 house, and the payor defaults (unlikely, but it happens). You will lose your $50,000, and you will spend, for example, another $50,000 on foreclosure and repairs. You sell the house for a quick-sale price of $450,000. After closing costs of $35,000 and the $100,000 you have in the deal, you net $315,000.
Myth #5: “Notes are not liquid.”
Fact: Good notes are very liquid. There are many investment companies that buy notes all over the U.S. and can often close in a few days.
Myth #6: “Notes are easy to find.”
Fact: It is hard to find motivated sellers with good notes. There are about 90,000 first-position private (seller-originated) residential and commercial real estate notes in the U.S.* My favorite method of finding them is networking with people who come into contact with note owners, such as attorneys, accountants, real estate agents, title company officials and bank trust officers. You can also get involved with local real estate groups and let people know you are a note investor. Also, consider notes secured by land, such as farms and lots, which are often sold with seller-created notes. Businesses are usually sold this way as well. (Business notes may or may not be secured by real estate, but those secured by real estate are more valuable.)
Myth #7: “You can be a passive investor in notes.”
Fact: There are note funds that pitch investors with promises of high yields. The fund owns the notes, collects the payments, and promises to send money to investors. In the past few years, several note funds have been shut down by the SEC, and investors lost millions. This is why I do not allow note funds to exhibit at our Paper Source conferences. Some funds are probably legitimate and run by good people, but I recommend that you buy a note directly from a property seller, get the original note signed over to you, and have all the other documents. Get the note, not a promise.
Myth #8: “You must be willing to foreclose.”
Fact: In three decades of note investing, I have never foreclosed. There are alternatives to eviction: You can lower the amount of the payment to what they can afford and extend the term of the note. You can ask them to move (yes, that sometimes works). You can help them find another house. You can pay them to move (a.k.a. “cash for keys”).
Myth #9: “Non-performing notes are a passive investment.”
Fact: When you buy a non-performing note, you are buying a job. The job is to either work with the debtor to make the note re-performing, or to foreclose. If you try to make it reperforming, you become a “debt collector” as defined by the federal Fair Debt Collection Practices Act and most state laws. You must comply with the requirements of those laws, and you may have to be licensed. (A friend who has bought non-performing notes for years says, “I have learned that 99 percent of hunting down delinquent debtors is a waste of time.”) The alternative is to do nothing and hope that someday the debtor will try to sell the property and discover they can’t without paying you a lot of money. Non-performing notes are not easy and have more unknowns and “excitement” than most investors can stand. If none of that discourages you, and you have the time, knowledge, skills, and temperament, then go for it. It can be very profitable. But beware: always take title to the note, and do not buy into a fund.
Myth #10: “Non-performing notes are sold for pennies on the dollar.”
Fact: A few years ago, this was true for junior lien non-performing notes, but that ship has sailed. Today, if you buy a non-performing note for pennies on the dollar, you will get what you pay for.
Myth #11: “People who sell notes are the best ones to learn from.”
Fact: Would you take car-buying advice from a car salesman? Here is the best advice I’ve heard on this topic from one of the smartest people I know:
“There is an inherent conflict of interest with any education program that offers investment assets as well. Someone can’t be an impartial and expert educator and also offer assets for sale. The educator’s fiduciary obligation is to teach discerning and quality due diligence (and to help one master the art of the negotiation) to maximize the student’s profit from the acquisition of an asset. The note seller’s function is to maximize the asset’s sale price. The two are, by definition, in conflict. If you expect a two-for-one deal you’re merely asking to get fleeced.”
There are seminar companies that claim to school people on notes, charging tens of thousands of dollars, and then they sell them junk notes. Always check out someone’s claims against John T. Reed’s “B.S. Artists Detection Checklist”.
Myth #12: “Dodd-Frank has made seller-financing illegal.”
Fact: One can seller-finance a house sale to an owner-occupant once every 12 months, or to a non-owner occupant up to 25 times every 12 months, without violating Dodd-Frank. To do more transactions in 12 months, the seller either needs to become a mortgage loan originator or hire one.
Email W.J. Mencarow for a free report on how Dodd-Frank impacts note investors.