WHAT IS THE ASSET?
A contractual agreement backed by real estate to repay a loan between a borrower and a lender with set terms in place. For an investor, this can involve either providing financing for a house you are selling to a new buyer or purchasing a delinquent mortgage being sold by a private equity company, hedge fund, or other private investor.
Be the bank. What a powerful concept for an investor to embrace. In Primer #1, we looked at IBC policies—assets that are intended to give you control of your personal banking needs and, in essence, create your own bank. In this primer, we’ll look at how investing in residential mortgage notes is a natural complementary asset in your alternative investment portfolio because you actually get to use that personal bank in order to provide a mortgage to others.
It’s fairly common for me to speak to investors who use their high-equity cash value policies to purchase individual mortgage notes. Remember, those policyholders look for ways to safely arbitrage the amount they would pay in interest on their cash value loan and the funds they would receive on their investment. Mortgage notes allow investors to accomplish this with a fair degree of certainty because of the reliability of the “hard asset” they are purchasing. That’s not to say that the only way to invest in mortgage notes is through life insurance policies; both assets are merely tools that can be used together successfully.
A note can be originated by an institution (such as a bank) or by an individual. If an institution originates the mortgage, there is no guarantee that they will keep the mortgage on their own books. In fact, it’s common practice for banks to take delinquent mortgages, pool them together, and sell them to private equity companies, hedge funds, and private investors. In turn, large pool buyers often resell individual mortgages to smaller investors.
Let’s take a look at the other scenario, in which an individual originates the loan. For example, an investor who has a paid off a rental property may be looking to retire. But instead of selling their house for a one-time profit and being subject to the capital gains tax, the investor chooses to provide seller financing to the new owners. In this case, the investor would typically receive a down payment, followed by a stream of monthly payments for a set time period without having to deal with the stress of being a landlord. If the new borrower defaults, the original owner would foreclose on the property and take back the title while keeping the down payment as well as all of the payments that were made to date.
Residential mortgage notes like these are backed by the equity of the property, which provides security in case the borrower defaults on the mortgage.
This is why we refer to mortgages as secured notes. There are also unsecured notes, but they tend to come with higher interest rates because they are inherently riskier; if a borrower defaults, there is no easy way to recover your investment as a lender.
It’s important to note that these types of individual notes can be purchased by non-accredited investors, and in many ways, they provide many of the same benefits that smaller residential investments do—minus the legendary landlord stories. After all, when was the last time you heard a banker talk about getting a 2:00 a.m. toilet backup call?
When evaluating a note, it’s important to factor in its position in relation to other existing debt on the property.
The first debt placed on the property is referred to as the senior lien, and it takes priority over any other debt on the property. If there is not enough equity to pay the senior lien, the subsequent debt becomes insolvent. Because of the significance of the position of senior debt when it comes to repayment, a first position lien is considered a safer investment than a second-position lien or other junior lien, and it typically sells for lower yield.
Many new investors in this space aren’t aware that they can sell, partition, and even collateralize their notes because of the equity that’s attached to them—or they can leave them intact and receive the full advantage of the borrower’s payments over the complete amortization schedule, which may span 30 years like a traditional mortgage.
When it comes to selling a note, an investor has many options for exiting the investment. If the note is paid out early, then they receive a healthy premium since they would have to be paid back the full remaining unpaid principal all at once. For example, if there is a $100,000 unpaid balance, that note may be sold for $.80 on the dollar (or less if it’s not performing). But if the note is paid off early, the full unpaid balance still needs to be paid off—not just the discounted price the secondary investor pays for it.
Partitioning a performing note allows an investor to recapture some of their invested capital by selling only a “partial,”[1] which is a portion of the income that is coming from the note. This can be done as a percentage of the existing yield or as a fixed stream of income for a set number of years. For example, a 15-year note could be split, with the original investor selling the first ten years of the note to another investor, while retaining just the last five years of income. This strategy can be a win-win for all: It provides immediate income for the secondary investor, and it allows the original investor to recoup the majority, if not all, of their initial investment, along with an income stream during the last five years (which actually should be the safest period of the loan because of the steady increase in equity over time). By selling partials in this way, investors can diversify when and how they will receive income over time. As you can see from this example, aside from factors outside of the investor’s control, notes provide incredible flexibility for investors who are looking for yield. Can you imagine getting that level of control with dividend-paying stocks?
Through the process of collateralization, the investor can take out a loan against their note’s equity. Because the proceeds from the loan are tax-free, they can use them to continue investing in other non-Wall Street assets. If done correctly and conservatively, this process works effectively. While the note has to be in good standing before exercising this option, the equity provides reasonable assurances to the lender, which allows for favorable terms on the loan.
Notes can usually be purchased from one of four sources:
- Online networking
- Loan exchanges
- Servicing companies
- Note funds
While rare, the exit plan for a mortgage note may involve foreclosing on a property if the borrower fails to keep up with their payments. If the note was purchased correctly with equity protecting the investment—and the borrower really wants nothing more to do with the property—then foreclosure may be the only viable option, but it should still provide a net positive benefit to the investor because they are assuming a property with built-in equity. Most note investors don’t get into the business to foreclose, but it is a great back-up plan in this scenario.
[1] “Partial purchase note offer,” Amerinote Xchange (November 17, 2020), https://www.amerinotexchange.com/partial-purchase-note-offer/.
The Pros and Cons of Investing in Long-Term Mortgage Notes
PROS
- A note represents a hard asset backed by the equity of the property
- Investor enjoys all of the amortization benefits of a bank
- Potential large payday if the loan is closed prior to end of term since remaining balance needs to be paid off, and notes are usually purchased at a discount
- Great passive cash flow with no requirement to fix toilets or leaking roofs
- Mortgage can be serviced by a professional servicing company for a reasonable fee
- Easy to diversify between geographic locations, school districts, lien positions, etc.
- Third-party market exists for collateralizing notes, or selling partial or entire notes
- Socially conscious investing (if done right)
- Non-accredited investors can purchase individual notes
CONS
- Unfavorable tax treatment (some investors prefer to buy these only in tax-advantaged retirement plans)
- Foreclosure possible in case of default
- High demand during low-yield environments
- Many state and federal regulations
- No principal left after the owner pays off the note
If you liked this article and wish to continue on your path in learning about alternative investments, please make sure to check out my other educational articles as well as my book, The Alternative Investment Almanac: Expert Insights on Building Personal Wealth in Non-Traditional Ways.
Disclaimer: The information presented in this article is for informational purposes only and does not constitute professional financial or investment advice. The author does not make any guarantees or promises as to the results that may be obtained from it. You should never make any investment decision without first consulting with your own financial advisor and conducting your own research and due diligence. Even though, the author has made reasonable efforts to ensure that the contents of this article were correct at press time. The author disclaims all liability in the event that any information, commentary, analysis, opinions, advice and/or recommendations contained in this article results in any investment or other losses. Your use of the information in this article is at your own risk.