In an era where savings rates are negative in some areas of the world and stock market volatility has made dividend yields not worth the risk to capital, investors are continually looking to alternative investments where they can receive an appropriate yield across the risk spectrum.
Enter the world of buying private mortgage notes.
What exactly is a private mortgage note?
A mortgage note is simply a promissory note secured by a specific piece of real estate. Note, one mortgage note can secure multiple pieces of real estate. The mortgage deed of trust is the actual document that imposes a lien on the title to the real property.
The mortgage note specifies the loan balance, interest rate, and the time to pay the mortgage note off.
The terms of mortgage notes can vary dramatically.
Below are some common types (based on payment structure) of mortgage notes:
- Fixed-rate: The rate does not change for the duration of the entire mortgage
- Floating-rate: The rate changes based on a given index. Note, the rate can change daily, monthly or yearly
- Fixed/Floating: A lot of commercial loans are fixed for the first 3 or 5 years then the rate floats.
- Balloon: Where a borrower has a fixed-rate, then the principle is due at the end of the balloon period, but before the loan is paid-off.
The First Private Mortgage Note I Bought [Case Study]
Actually, it was a consulting customer that bought the note, but I handled everything involved in the transaction.
I have worked at lending institutions for over 15 years and now specialize in real estate. I thought since I have been involved with so many types of loans I knew a fair amount about the private note world.
This deal was bizarre!
A high net worth friend told me that a note broker had approached him about a certain deal and would like for me to underwrite the deal exactly how I would at the bank.
I agreed and ran multiple scenarios (best-case, base-case, and worst-case) exactly like I would as a commercial underwriter. The deal worked very well cash-flow wise. The deal looked like this:
Collateral: 3 triplexes with a total appraised value of $286,000
UPPB (unpaid principal balance of the loan): $192,000
Cash-flow: $4,500 a month from renters through a subsidized program
The borrower was a non-profit group that owned the three triplexes. They were failing because they were required to pay for all utilities of the tenants. Additionally, the organization was failing because of a number of lawsuits unrelated to these triplexes.
The bank wanted to sell given the above scenario. They were actually even refusing payment. The organization had the properties under contract and were scheduled to close in 45 days.
Ultimately, the borrower wasn’t making payments because they thought they had the properties sold.
The bank offered the note for $120,000 and my customer negotiated them down to $90,000. The prime negotiating tactic that worked really well was offering to close within 24 hours. Some banks need these notes gone FAST.
Immediately after the purchase my customer started the foreclosure process.
Foreclosure processes vary greatly based on county procedures but here is a rough outline:
- Demand letter is sent – If no money is received then a notice of default is issued and processed at courthouse. Also note, this is what you usually see in the newspapers…
- Approximately 90 days after the notice of default is issued the property is foreclosed on at the courthouse steps.
Note you will want an attorney that specializes in foreclosures to handle all your paperwork. This process can cost a significant amount of money. Most foreclosures cost two to three thousand dollars.
My client showed-up at the courthouse fully expecting to take title and ownership of the properties the day the foreclosure auction was scheduled. However, the sale ended up going through and they handed my client a pay-off check literally an hour before the actual foreclosure.
My customer made a gross profit of $100,000 in less than 90 days. He paid my consulting fee and the note broker fee, but still ended up with a significant profit.
The best part (aside from the money) for my customer was that he literally didn’t have to do anything but show-up at the court house.
How do I get my money out?
My customer in the above example actually wanted to foreclose because he was a real estate investor. He was looking at it as buying 3 triplexes worth at least $286,000 for $90,000. Additionally, market rent for the triples were close to $1,000 a unit. Therefore, his gross potential rents were$9,000 a month or $108,000 a year for a property he had bought for $90,000 plus legal and consulting fees.
The “downside” scenario happened and he was actually upset.
I joke with him all the time that I love it when the “downside” is making $100,000 without doing any work!
A lot of note investors try to get the borrower to pay and then resell the note at a higher value. Other note investors like to foreclose and then sell the property. There are hundreds of ways to get your money out of a note deal. The important part is to identify how much risk you are comfortable in taking.
That’s a nice segue into our next section on collateral.
What kinds of private mortgage notes, based on collateral support, are out there to buy?
- Performing 1sts – if you are not in the lending business you probably think you can’t make significant money buying performing loans. However, this assumption would be false. There are several reasons why a lending institution would sell a performing 1st lien loan at a discount. The primary reason is regulatory pressure. Other reasons lenders might sell performing first lien loans are industry concentration and too much exposure to one particular borrower.
- Performing 2nds – second lien loans are not highly desirable as you typically are not compensated by the risk you take. However, when buying second lien loans there is substantial money to be made depending on the discount you buy them. Remember when buying second lien loans: to foreclose on the property you will need to buy out the first lien.
- Non-Performing 1sts – obviously non-performing loans are selling at a substantial discount.
- Non-performing seconds – a lot of gurus talk about buying these types of loans and making a lot of money. This is the riskiest type of loan out there other than unsecured loans. The recovery rates on these loans are very small.
Originating Source and Where to Buy Notes
- Bank notes – the vast majority of notes (debt) out there is originated at a bank or other regulated financial institution.
- Non-bank lending notes – non-bank lending notes that might be available to purchase are primarily hard money lenders. The notes they are trying to sell are usually cases where the borrower has taken longer than expected to pay the loan back.
- Seller-financed notes – there is a significant amount of trading in the note world with seller-financed notes. The primary reason is these notes are very attractive to investors. Why are these notes so attractive? For a multitude of reasons, these notes are usually first lien notes and are priced at a very high yield.
By selling the note, the owner of the note is able to quickly monetize their loan(s).
How to buy notes?
If you are looking to simply do everything online…good luck! Fortunately for some and unfortunately for others, the note investing world is largely a good’ol boy network.
However, don’t let this discourage you! It’s fairly easy to pick up the phone and ask to speak with a small community bank or small credit union’s CFO. Ask if they ever sell any loans off.
If they say yes, ask for what type of loans they generally sell-off.
If they say no, ask if they know anybody who does sell notes.
If you make 10 calls I guarantee you will start to gain some traction in finding fellow investors and note sellers.
There are websites that sell notes. However, I have found that because of the competition to buy the notes the yields on these notes are smaller than the ones you can buy privately and directly from the seller.
Nevertheless, below are some sites where you can buy notes. Please note, I have never bought a note online and am not endorsing these sites in anyway. Do your own due diligence!
Please note these are 3rd parties and AlternativeInvestmentCoach.com can not be held responsible for performing due diligence.
- Free Deal Analyzer – We’ve put together a free deal analyzer for you to determine how much you could make on any deal. Download the file here (Disclaimer: Use at your own risk, always check your numbers. We are providing this resource free and cannot certify its accuracy.
- http://www.noteworthyusa.com/ – this site is pretty basic but has some very useful information
- https://www.distressedpro.com/blog/ – this site has excellent content and even a podcast. The owner of the site is very well known in the industry and has a great reputation. The software he sells is very useful for finding bank officers quickly.
Private mortgage notes can be an excellent way for investors to generate substantial income to a private investors portfolio. Hopefully this article gives you a good general overview of the process of how you can make money investing in private mortgage notes.