There’s an almost universal belief in investment circles that investing in real estate is one of the best investments because they say the land-or the house, for that matter will always be there. But seasoned real estate investors know that managing investment real estate for rentals can give you a lot of headaches. You’ll have to deal with vacancies, nonpayments of rent, damages and repairs, etc.
One way of investing in real estate, though, without having to directly manage physical properties is by investing in real estate notes. The basic idea behind real estate notes is that the lender or investor lends money to the property buyer or borrower and earns from the interest payments. You can learn more about real estate investment notes by reading about how it works.
In this article, let’s take a quick look at how these investment notes work.
1. Mortgage And Real Estate Notes
A real estate note is a legal and commercial document that entitles the holder of the note, who’s usually the lender or the investor, to be paid a certain amount based on the terms of the note and the amount that he lent to the borrower under the note. There’s usually an interest rate stated in the original real estate note, but this can be changed when the note is sold or bought by other people who weren’t part of the original loan transaction.
In other words, a real estate note is basically a loan agreement whereby the lender agrees to lend a certain sum of money to the borrower, usually with a fixed term or period within which the loan should be paid and usually with an interest rate stated. The real estate note or loan contract is separate and distinct from the real estate mortgage serving as the collateral and security for the loan.
The basic difference is that the real estate note covers the money lent by the lender to the person who borrowed the money to purchase the house or building. The mortgage is the legal instrument that attaches or ties up the real estate property to the loan as collateral. Analysts say the mortgage security is the investment advantage of real estate over stock investments.
If the borrower defaults on their payments or isn’t able to pay back what they borrowed, the lender may foreclose the mortgage if the mortgage is also attached to the real estate note as security collateral. But the real estate note may be sold or transferred to another person separately from the real estate mortgage.
2. First And Second Liens
The real estate note usually has a lien on the real estate property, which is attached or tied up to the note through the real estate mortgage. A lien is basically an assurance that the obligation or the amount owed to you would be the priority, should the mortgaged property be foreclosed by the person holding the mortgage. For instance, if a USD$100,000 house mortgaged under a real estate loan is foreclosed and sold, the real estate note with a lien of USD$80,000 would be paid back.
But you have to understand that liens are given some sort of ranking or hierarchy when it comes to who’ll be paid first, and whether payment would be made in full or just partially paid. If there’s a first lien and a second lien, then the first lien would be paid first from the foreclosure. The second lien would only be paid if there’s still money left from the proceeds of the property under the foreclosure sale.
3. Performing And Nonperforming
One way of grouping or classifying real estate notes is based on whether the borrowers under the notes are paying back the amounts due on the notes or not. The words ‘performing’ and ‘nonperforming’ here refer to the real estate loan contract as an asset from the point of view of the lender or investor. If the borrower is paying back what is owed under the note, then the asset is said to be a performing asset. Otherwise, the note is a nonperforming loan.
Here’s what you can do with both:
- Handling Performing Notes: Performing notes are some of the most stable forms of real estate investments. If a real estate note is performing, then all the lender or investor has to do is sit back and earn passive income from the notes as the borrower makes the monthly payments on the loan. An interest income of 8%–10% is usually considered very profitable in the real estate market.
- Handling Non-Performing Notes: The other kind of notes are nonperforming notes. This means that the real estate note has already been classified as a nonperforming loan because the borrower has not been able to pay for more than 90 days. This is a riskier kind of investment because it’d take more time, effort, and resources to collect on the note, especially if the property has to be foreclosed.
Another way of handling nonperforming notes is by adjusting the terms and interest rates. This is usually done by renegotiating the terms of the real estate note with the borrower. You have to find out why the borrower has defaulted on the payments. If they just need some slack and some time, then you can decide to give that to them and adjust the terms of the note.
Investing in real estate notes is a kind of innovation in investment tools by allowing lenders and investors to invest in real estate without having to directly manage physical real estate for renting or sale. It’s also considered by analysts as one of the profitable ways of diversifying your investment portfolio.