When one invests in a note, the note is purchased along with its security instrument. In other words, investors purchase the secured debt and become the lender, after which they are entitled to receive payments from the borrower. Generally speaking, note investors purchase notes at a discount to the remaining principal balance.
Before we get into different types of note investing strategies, it is important to cover the topic of lien position. When a debt is secured by real property, it is recorded as a lien against the deed. The rule for lien position is “first in time, first in line”. This simply means that lien position is established by the relative date and time a lien is recorded against the deed. For example, a first mortgage is in first position solely because it is recorded prior to subsequent liens like a second mortgage. There are a couple of exceptions to this. Delinquent property taxes is the most common exception. When a municipality liens a property for delinquent taxes, the lien cuts in line to the front. Lien position is important in note investing primarily because in the event of foreclosure, the lien holders are paid from the proceeds of the sale based on the position of their liens. The first position lien is paid first, and if anything is left over the second position lien is paid, and so on.
Common Note Investing Strategies
There are many strategies in note investing I will cover the common ones which are; Performing Note Investing, Non-Performing 1st Lien Investing,
Performing Note Investing – Buy and Hold
A performing note is simply a note on which the borrower is making regular payments, and investors purchase them to achieve a stream of recurring passive income. This is similar to purchasing a rental property but without the headaches of property management. These notes are generally purchased at a discount to remaining principal balance, providing the investor with a higher effective yield than the interest rate of the note. Double-digit yields on these investments are quite common.
Non-Performing First Lien Investing
In this strategy, the investor purchases a loan in which the borrower has stopped making payments. The banks have many of these on their books right now, and have chosen to sell some of them to investors to get them off of their books rather than take the time and incur the expense of foreclosure. Because these notes are non-performing, they sell at a steep discount to principal balance. Investors who purchase these have several exit strategies to consider:
- Workout – A loan purchased at a discount can be modified to forgive arrears and reduce the principal balance, thus lowering payments. Many borrowers with severely underwater homes have stopped paying simply because they don’t see a point in paying on a loan balance which is double or more the current value of their property. Others have suffered employment setbacks and have found themselves so far behind on payments that they can no longer bring the loan current, so they give up on it. Whatever the reason, a workout can solve a painful financial problem for homeowners and provide the investor with a re-performing loan acquired at a very nice discount.
- Deed-In-Lieu – When a workout is not possible or feasible, taking possession of the property via deed-in-lieu can sometimes be a workable approach. With this approach, the borrower signs the deed over to the lien holder as consideration for the debt. The thing to keep in mind with a deed-in-lieu exit is that any junior liens will remain on the deed.
- Short Sale – Just like a bank, the note holder can approve a short sale by the borrower. As with deed-in-lieu, junior liens can make this approach unfeasible because clear title must be conveyed in a sale.
- Foreclosure – This approach can be the only option in some cases. The downside is that it takes time and incurs holding cost and legal expense. The benefit is that junior liens are removed, leaving clear title.
As note investors we are purchasing existing loans, not originating new ones, and there is no limit to how many you can purchase.