Given that real estate is today’s best investment, why do relatively few people take advantage of it? Usually it’s because of the hassle. Real estate — in this case rental properties — is no straightforward investment. You’d need to invest in renovating and maintaining the property, ensuring the tenants pay their monthly rents, fixing toilets at 2 a.m and so forth. It can be a headache!
With promissory mortgage notes, you can invest without the hassle. In this type of investment, you buy the promise to repay the mortgage from the lender, not the property. The property is sold to you for a discount (as much as 40% off). The borrower pays you debt and interest each month, and you come away with a clean slice of earnings.
This type of investment is really smart because even if the debtor fails on the loan, you have a lien on the property, which can result in foreclosure. You can do what you want with it!
Here’s how it works.
What Is a Mortgage Promissory Note?
The loans home borrowers take out are called “mortgages.” The documents they sign — laying out the terms and conditions of these loans and “promising” to repay them — are called “promissory notes.”
The banks and lending institutions that make these notes typically sell them when they need cash or no longer want to be responsible for the loan. Sales could be attractive, ranging $20,000 to $50,000, depending on items that include the age of the note, its payment history, interest rate and loan-to-value ratio.
Buy these notes and you (should) get the borrower’s principal and interest rate payment. So if you’re savvy and know how to recognize good notes from bad and how to turn non-performing notes around, you could earn consistent, long-term passive income with none of the trouble and cost of buying and renovating homes or managing rental property.
All About Mortgage Promissory Notes
With mortgage promissory notes, debtors pay note holders principal and interest. With savvy investment, you can get long-term passive income on these notes.
Should You Invest in Promissory Notes? Best Practices for CRE Investing
The key to investing in promissory notes is to recognize diamonds from duds. According to the U.S. Securities and Exchange Commission (SEC) that registers these notes:
“For sophisticated or corporate investors, promissory notes can be a good investment. These instruments provide a reasonable reward for those who are willing to accept the risk.”
The problem is that the notes the SEC verifies to register are only those nine months and over. Loans under nine months fly under the radar and could be fraudulent. Furthermore, promissory notes marketed broadly to the public often turn out to be repayment scams.
The SEC has a list of identifiers:
- “Insured” or “guaranteed” returns where, in reality insurers are non-existent or not legitimate to offer insurance in the U.S
- The promise of above-market returns. Highly questionable
- Promise of fast rewards. No fast rewards here. Expect long-term investments of eight to 10 or more years.
- “Risk-free” notes. No such thing as low-risk, high-reward investments.
- A startup’s notes labeled “prime quality.” In the securities industry, prime quality investments come with long-established companies. A startup and “prime quality” is an anomaly.
- Short-term notes — since these are exempt from SEC registration.
- Notes from a stranger. Usually, not always, promissory notes hawked by a stranger are “strange.”
As long as you conduct due diligence, steer clear of nine-month promissory notes, fully research the opportunity and buy only from licensed or registered securities brokers or lenders, you should be good to go and can enter into what may eventuate as the promise of a lifetime.
3 Types of Mortgage Loan Sale Categories
If you do decide to buy these loans, you have three risk categories:
Performing Whole Loans
That’s where the borrower is current on payments. They’re the most expensive of all notes and if they’re discounted, that discount is meager.
The debtor pays the lender irregularly, so you get a slightly steeper discount.
The debtor has gone AWOL (meaning payments are long overdue), so these notes give you the steepest discount of all. At the same time, they’re the riskiest too, since you may not recoup your investment.
The last two categories are naturally the cheapest because these are the rejects — they’re the duds, the ones you’re expected to put the most effort into and the ones companies are eager to get rid of. They can, however, become the most lucrative if you can upgrade them into re-performing loans, sometimes as a method of claiming ownership of the property (foreclosure).
How Do I Buy Promissory Notes?
Look for these notes from:
- Banks, credit unions and other lending institutions.
- Investment companies and private lenders (like hedge funds and private equity funds; note brokers, loan sales advisors)
- Federal Deposit Insurance Corporation (FDIC) loan sales. The FDIC, a government agency that regulates financial institutions, sells non-performing loans through sellers that are FDIC-approved.
- Loan sales marketplaces. They’re out for themselves and their reputation varies. Notes Direct and Paperstac are two trustworthy ones.
- Individual sellers – You can buy their names from companies like Listsource.
Reliable brokers carry the appropriate securities license or registration.
The process includes signing the following:
- Non-Disclosure and Confidentiality Agreement (NDA) to safeguard the borrower and guarantor information.
- Letter of Intent and Loan Sale Agreement outlining terms of the sale and giving you time to conduct due diligence. FDIC loan sales or deeply discounted loans may come as-is with little to no due diligence period.
- Due Diligence checklist similar to any initial loan checklist for indebtedness secured by commercial real estate.
- The Closing with its three documents:
- (i) allonge endorsement to note
- (ii) assignment of security documents
- (iii) general (omnibus) assignment of loan documents.
You may also get a “hello letter” that notifies the borrower to make future mortgage payments to you.
Benefits of Investing in Commercial Promissory Notes
So why would you want to engage in these risky opportunities?
Real Estate With None of the Hassle
Mortgage promissory notes are your perfect real estate investment if you are looking to generate passive income but do not want the hassle of flipping and renting. There’s the discount that’s anywhere from 40% to the very steep 80% for distressed loans. If you can find a way to persuade the delinquent borrower to space out his payment, you could collect on both the debt and on the discount. At the end of the day, you win. (Of course you also lose out, if the plan fails).
Monthly Payment, No Risk
This is not like investing in stock, where you have to wait till you sell the stock to hopefully recoup your money plus profit. Here, your portion of your principal (the amount you invested) with each month’s payment, reducing your risk.
Shielded From Market Fluctuations
Notes are different from other investment vehicles in that they are shielded from market fluctuations. You get the same returns, regardless of the market. You become in effect the “bank” and you get the repayment until the loan is complete. This is reliable passive income in the truest sense of the word. All you need is the right note broker and servicer (if you hire one) to find, buy and manage your mortgage notes.
Regulations on Investing in Promissory Notes in CRE
Laws vary from state to state and dictate whether registration is required to own a note in that state, what the rules are for contacting the borrower (especially if they’re in bankruptcy), what the foreclosure process is, and so forth. For this reason, you’ll need a solid foundation of real estate investing to invest in these notes. Your other alternative is to hire an online marketplace like NotesDirect.com or American Note Capital that help you navigate the process – naturally at a cost.
3 Aspects to Check Before Buying Promissory Notes in CRE
There are three factors you’d want to check: The borrower, the property, the seller.
In regard to the borrower, you’d want to vet the following:
- The person’s credit history,
- Payment history. Two to three years of consistent payment history are a good sign.
- Real estate experience
- Schedule of real estate owned
- Personal financial statements such as net worth and liquidity
As regards the property, there’s a saying in the industry: If you wouldn’t want to own the property the note covers, don’t buy it.
Items you’d want to check would be the same as if you were buying the property. These include:
- The value of the property in its as-is condition
- Its neighborhood, environment. (Is it safe, clean, attractive)
- If there are any liens or encumbrances on the property that might affect or jeopardize your position
- The property’s annual tax rate
- Whether the property has unpaid taxes or potential tax liens
Regarding the seller — also known as the lender — items you’ll want to check include:
- Does the current lender have all required paperwork (the original note, mortgage, and other documents)?
- Is the current lender security registered or licensed by the SEC (That’s crucial)?
4 Best Practices for Buying Promissory Notes in CRE
1. Research Note
Weigh a note’s potential rate of return versus another financial benchmark such as the S&P 500’s historical return to decide whether the note is a worthwhile investment. You can also run market checks to see what participants are paying for your type of loan. The FDIC lists the strike prices for their assets. You may want to check these, too.
2. Research Borrower
Make sure the borrower has made a substantial down payment or has equity in the property. These type of debtors have more stake in the property, so more to lose if they default on their payment.
3. Buy This Type of Mortgage Loan
Buy mortgage notes with low loan-to-value (LTV) ratios. This calculation tells you how valuable the property is. Divide the amount of the mortgage (loan) by the value of its property (the value). The higher values (anything above 80%) are more risky, making it a potentially problematic investment. Lower values (below 60%) generally mean you are more likely to quickly resell the promissory note and at a discount to recoup your investment.
4. Tips for Nonperforming Loans
Research rent prices and ensure they are higher than the borrower’s loan payments. If the borrower defaults and rent prices in the area are higher than the borrower’s mortgage payment, you can fall back on renting the property to ensure you receive a return on your investment.
Savvy investors can make a killing off non-performing loans. Get the worst notes on the block within reason, those that go for the steepest discounts. Adjust the mortgage term. Make them more attractive to motivate the holder to pay, so you recoup the debt. Ideas can include a forbearance plan, formal loan modification, or reducing the monthly payment.
Still not paying? You can provide a deed in lieu of foreclosure, where the holder deeds you the property instead of foreclosing.
In the worst case where, say, the property is abandoned, you can pursue legal action, called foreclosure, to regain title to the property.
In this case, you could do what you want with the property, including:
- Sell it as-is
- Fix it up and sell it
- Renovate and rent it out
- finance the property by creating a new mortgage note.
Either way, you profit.
In short, remember these three action items, and you’re good to go:
- Check with your state securities regulator or the SEC’s EDGAR database on whether the note is registered or exempt from registration.
- Avoid short-term notes that are often fraudulent and don’t come with the redress that registered notes offer.
- Buy only from licensed or registered securities brokers. Contact your state securities regulator or the Public Disclosure Program of FINRA to verify a broker’s license.
Mortgage Notes: High Returns for your CRE Investment
According to a recent Deloitte report, now’s the best time to invest in promissory loan sales. The pandemic’s almost over, the economy’s on a swing and many banks want to relinquish their sub- and non-performing loans so they can recoup their money. Look for registered sellers with legitimate notes, comb through details of the debtor, property and note, know your market, proceed with patience and savvy — and look forward to a consistent trove of wealth-generating passive income. Better than fixing toilets at 2 a.m., isn’t it?