A real estate note is simply an IOU secured by property.
In a conventional real estate transaction, a buyer makes a down payment, obtains a loan, and signs a note promising to pay a certain amount each month to the lender until the loan, plus interest, is paid.
In a private real estate transaction, a buyer makes a down payment, does not obtain a loan, but instead signs a note promising to pay a certain amount each month to the seller until the price of the real estate, plus interest, is paid. The seller becomes the bank.
One is a loan, the other is an installment sale.
If the buyer defaults on a private real estate note, the seller’s collateral is the property. They can either modify the terms of the note, pay the buyer to move, or foreclose.
Over $17 billion in first lien private real estate notes are created annually. About 100,000 are created each year — almost 300 a day!1 That number could double if second liens are included.
Few people know that real estate notes can be bought and sold. Fewer still know the secret that makes investing in notes so profitable: They are sold at a discount from the balance. That discount gives the investor a higher yield than the interest rate of the note. For example, you find a note with a $50,000 balance at six percent interest and120 monthly payments of $555.10. If you bought it for $50,000, your yield would be six percent. Not bad. But, what if the note owner needs cash right now and will accept $40,000? Put that in a financial calculator and you find that your yield is 11.18 percent.
Before you buy a note, you need to know how to analyze what I call The 3 P’s of Note Investing: The Paper, the Property, and the Payor.
The Paper
The “paper” means the documents; the note, mortgage (or trust deed or contract for deed), property settlement statement, payment history, etc. If you are new to notes, or are not familiar with the laws of the state where the note was originated, have a real estate attorney in that state review the documents.
These are the questions you need to ask about the paper (assume it is a first lien):
- Is the note performing, non-performing or re-performing?
- If non-performing, what is the status of foreclosure, if any?
- Is the note secured by a mortgage, trust deed or contract for deed?
- What was the original balance?
- What is the current balance?
- What is the interest rate?
- What is the amount of the payments?
- Are they due monthly or otherwise?
- What was the date of the first payment?
- When is the next payment due?
- How many payments have been made?
- How many remain?
- Is the note fully amortized?
- When is the final payment due?
- Is there a balloon payment due? If so when is it due and what is the balloon amount?
Ask the seller for copies of the payment history. If the note is serviced, the servicing company will provide it. If the seller collects the payments, ask for copies of the deposit slips or bank statements.
The Property
Get a current appraisal of the property paid for by the note seller; if necessary, offer to reimburse the seller for half the cost if you buy the note. If that doesn’t work, offer to pay the full amount, but only after you buy the note. Do not spend any money before you buy the note. Also, the best appraisal is a complete one, inside and out. Second-best is a drive-by appraisal. Third-best is a real estate broker’s opinion of value.
Here are the questions you need to ask about the property:
- What kind of property is it (e.g., single-family house, duplex, etc.)?
- What is the address?
- Does the note payor occupy it? If not, is it currently rented?
- How much is rent?
- How long has the tenant been there?
- What was the sale price of the property?
- What was the sale date?
- How much cash did the buyer put down?
The Payor
Do not contact the payor; get this information from the note holder. Here are the questions you need to ask about the payor:
- Have they ever been late making the payment? If so, how many times?
- Are they current on payments? If not, how far behind are they?
- What has the note holder done to bring them current?
- What is the payor’s employment?
- What is the payor’s name(s), address, and (if known) Social Security number?
Closing the Note Transaction
Buying a note can be as simple as the seller writing on the back of the note that it is assigned to you and signing it. But it is best to use a title company or attorney in the state where the property is located to ensure that the documents are prepared properly. Have the note assignment recorded to protect your interests.
Prepare a letter from the note seller to the payor instructing them to now send their payments to you. Have the seller sign it. You then send it to the payor via a service with proof of delivery.
Follow the “3 P’s” and you will be on your way to making double-digit returns!
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