How To Create Passive Income With Real Estate Note Investing
Real Estate Note Investing
I’m all about investing in real estate but also want to avoid the hassles that come with being a landlord. A few years ago, I thought I wanted to start investing in single family homes and reached out to some local investors that did it full-time.
When I saw the amount of time and energy it took to deal with tenants on a daily basis, I knew that it wasn’t for me.
Honestly, I didn’t know much about them and don’t ever recommend investing in something that I don’t understand (and neither should you.)
But this wasn’t the first time I’d heard about someone recommending note investing. What got me really excited was the fact that it moves you from being a borrower to now becoming the bank.
Here’s what I found out about real estate note investing so you can make a decision if it’s right for you….
What Are Real Estate Notes?
I’m sure you’ve written a check before, right? And when you do, you’re PROMISING to pay someone for something. For instance, when you write one to your cable company, you’re promising to pay them for their services brought into your home or office.
In essence, a note is a promise to pay such as an IOU. Anytime you borrow money and create a document that says you will pay someone back, you create a note.
If you’re like me and had to take out student loans, you had to sign a note agreeing to pay back the lender.
If you’re a home owner, you signed a promissory note which defined the loan’s terms such as:
- loan amount
- percentage rate
- payment amount
- number, frequency, and timing of payments
- late payment penalties
By itself, the note is a promise to pay and is not secured by collateral. Whenever you go through a financed real-estate transaction, this note is secured through a security instrument such as a mortgage or deed-of-trust.
This instrument ties the note to the deed as a lien on the property as collateral. Remember, the note by itself is not secured by collateral.
If the borrower fails to pay back their promise, the mortgage or deed-of-trust spells out the lenders recourse (foreclosure).
Therefore a real estate note can be bought, sold and traded like any other asset that guarantees payments or other rights with regards to the collateral.
Whenever you hear someone talk about real estate note investing, what they’re really doing is acting as a bank or lender and buying “the paper.”
This paper is an agreement stating a borrower is to pay the debt they’ve taken in order to acquire some piece of real estate. If they default on this, it gives you, the real estate note holder, the right to collect.
Real Estate Note Investing Example
In order to make this clearer for you, let’s start off with an example from Note Investor:
Let’s say a property sold for $120,000 and the buyer put down a $20,000 payment. The seller of the property carried back a note in the amount of $100,000.00.
Let’s also assume they wrote the note at 10% interest. If so, the note would look like this:
- 360 payments of $877.57.
Now, you have an opportunity to buy the note after five years have passed by (it could be any number of years, just picking a round number for this example).
That means there are 300 payments remaining.
The “Present Value” or current balance owed on the note would be $96,574.32.
If you wanted to earn 12% on your investment you would pay $83,322.39 for the note.
How your risk is managed
The value of the property is $120,000.
That means your investment to value is 69% or that there is $36,677.61 of “equity” in the property.
In our example, you’re earning 12% on a non-traditional investment backed by something traditional – real estate.
Because you’re acting as the bank, if the payer can’t make the payments, you can take back the property via foreclosure. You can then turn around and either sell it for cash, resell or create another note.
Notes can also be purchased with retirement account money via a self-directed IRA.
That way the monthly note payments and interest earned can stay in the retirement account tax deferred or even tax-free.
4 Ways You Can Invest
Hard Money Lending
Hard money lending is nothing more than a short-term loan that provides a borrower money that’s secured by property.
You’ve heard of fix and flips, right? This a hard money lending example of a builder needing a loan to purchase property and for the rehab.
A bank, however, will not typically loan money in this case.
Hard money is lent out privately outside of banks usually by private individuals.
Some real estate crowdfunding sites, like Patch of Land, can be a way to connect developers looking for hard money loans with investors looking to lend.
This is what a fix and flip investment looks like on their site:
They were able to raise #195,000 for a multifamily fix and flip that paid out over 12 months with a 12% interest rate.
Here’s an example of a hard money loan I invested in a few years ago:
Lending Club and Prosper are two peer-to-peer lending platforms that create notes from people looking for funds to consolidate debt and make purchases.
They are linked to investors who are promised a return for a certain term based on the specifics of the notes.
Here’s an image from Lending Club’s website of how their process works:
Performing Real Estate Notes
If you’re currently paying a mortgage on a monthly basis then you have a performing real estate note. You’re not in default.
Investors searching for another stream of passive income can purchase these and act as the “bank.”
This is no different than someone that purchases rental property without having to deal with management headaches. You essentially hold the mortgage while the borrower pays off the note.
Many of these types of notes were created in owner financed real estate purchases, where the seller desires to cash out rather than continuing to receive monthly payments.
Now you maybe asking yourself, “Why would someone want to sell these notes if they’re paying each month?
It’s the same reason I was able to get a used 4-wheeler in great condition from a guy that needed the money ASAP to pay for a “new” one he just had to have.
Sometimes people need money “now” and sell off things to get it.
Non-Performing Real Estate Notes
Non-performing real estate notes are loans that the borrower is behind on or has stopped making payments all together. Typically banks would foreclose on them but now some are selling the notes without doing so.
To avoid having to go through the foreclosure process, the holder of these notes try to sell them at a large discount.
Investors who know their way around the collection process or know what to do with the underlying property can do quite well with these types of notes.
When it comes to returns, it all boils down to the amount of risk you’re willing to take. Usually with great risk comes greater potential for a higher return.
On average, non-performing notes are going to have a higher potential return versus performing notes.
Hard money lending typically has returns that range from 6-20% but again, if you don’t understand what you’re getting into, don’t do it until you do.
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