Investing in mortgage notes is an appealing alternative to purchasing properties outright and becoming a landlord. However, unlike a hard real estate purchase, you don’t own the property when you secure a mortgage note. Instead, you become the borrower’s (home purchaser’s) new creditor by taking the bank’s place in the transaction.
If you are looking for passive income without purchasing a physical property, mortgage notes can be an ideal real estate investment. You will receive a monthly income in the form of principal and interest repayments on the underlying mortgage. Depending on your long-term strategy, you have the option to hold the note until maturity or resell it in the secondary market.
What is a mortgage note?
A mortgage note is simply a promissory note used exclusively in real estate transactions. As the name suggests, it represents the borrower’s promise to the note holder (lender) that they will repay the obligation. These mortgage notes are typically not listed in the public record but are nonetheless legally binding documents.
Once the borrower signs the required documentation and provides the note, the lender holds the paper until the borrower makes the final loan repayment. However, while the loan remains outstanding, the lender can sell the note on the secondary market.
Mortgage notes can be structured in several ways but are usually broken down into the following categories:
• Secured: This means an asset of some value collateralizes the loan. In the case of a mortgage note, the asset is the property. If a borrower is unable to fulfill their repayment obligations, the note holder acquires the property.
• Unsecured: There is no collateral posted. These notes typically come at a cheaper price (higher yield) because of the higher inherent risk.
• Private loan: This is a note agreed to between the borrower and a private investor. A borrower typically chooses a private investor in lieu of a traditional loan when they have a low credit score or history of non-payments. In these cases, private lenders will ask for a higher interest rate for taking on the added risk.
• Institutional loan: This is a standard loan made by a financial institution such as a bank or credit union.
Understand the process of buying a mortgage note.
Once you are aware of how a mortgage note works, you will need to learn how to buy a mortgage note from the bank. Follow this process below and keep in mind some key tips to be successful.
1. Determine your objective.
Before approaching a bank, you should have a real estate investment plan already in place. First, you need to determine your risk tolerance and whether you plan on flipping or holding onto the mortgage note.
If you are looking for a steady payment stream that provides a high degree of income certainty, then you will likely look for stable and low-risk mortgage notes. If your goal is to make a big splash via a one-time trade and have the necessary risk appetite, you might consider a high-risk note trading at a significant discount.
2. Find a note to buy.
Two major drawbacks of exploring the secondary market for private sellers are the pricing inefficiencies and lack of regulation. These factors often create a seller’s market. Even the most experienced note brokers can spend countless hours searching online sites for attractive deals from private sellers.
This is where banks come in handy. Banks’ lending capacities are often hamstrung by the amount of perceived “bad debt” that they hold on their books. If they want to issue more mortgages, one way to increase capacity is to unload mortgage notes.
However, keep in mind that while a bank views mortgage notes as a risky asset, it does not necessarily mean the borrower has stopped making repayments. The particular risk profile might require such a designation independent of the borrower’s performance. Either way, banks often view selling the debt as an appropriate business decision, and this creates more favorable secondary market opportunities for note purchasers.
3. Review the “tape.”
A mortgage note “tape” is a datasheet that discloses some of the information necessary to evaluate the mortgage note’s investment value. The tape should be one of the first resources used in the decision-making process.
4. Skip customer service if possible.
You can save yourself time (and headaches) if you can position yourself directly in front of the bank’s decision-makers. As is the case with any products or services company, there will be barriers to entry for a new customer.
Not everyone who walks through the door, picks up the phone or submits an online appointment request is that interested in purchasing something. That is why companies have a customer service process in place — to reserve a decision-maker’s time for those looking to conduct real business.
That is the advantage of having a real estate investment plan. The company knows you’re serious, and more importantly, the decision-maker knows you will not be wasting their time.
5. Determine your bid price.
Both bid and offer prices can demonstrate inconsistencies, and the final price is often subjective.
There are objective factors to incorporate into a price calculation. They can include (but are not limited to) the borrower’s credit score, the borrower’s performance, the remaining number of payments, the loan’s interest rate, the loan type and the loan’s final maturity date (when the loan is repaid in full).
Get the rewards of a rental property without the fuss.
Mortgage notes produce a consistent income stream without the daily nuisances of landlord responsibility. It is an ideal way to invest in real estate without a ton of time and effort.
Banks will typically be your most reliable source because they are usually looking to unload inventory. Be sure you know how to buy a mortgage note from the bank, however, before approaching an institution willing to sell.
The information provided here is not investment or financial advice. You should consult with a licensed professional for advice concerning your specific situation.