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February 27, 2019
Finding the right vehicle for investing your IRA funds can be challenging. With the wide range of investment strategies, it’s hard to know which vehicle will provide the highest yield with the lowest amount of risk. Many self-directed IRA owners chose more common investments such as single-family fix and flips or rentals as their main investment vehicle for their IRA. While those provide decent returns, there is still an element of risk and liability because you have to physically own the asset. Not to mention you’re now dealing with tenants, taxes, and the cost of unexpected repairs on the property. While there is nothing wrong with these vehicles of investing, what if I told you there was an easier way to put your IRA money to work that offered security, collateralization, and double digit returns without ever having to own real estate?
Buying or creating mortgage notes is one of the best ways to grow your retirement funds passively and consistently. I’ve been investing in debt like real estate mortgage notes, for nearly 7 years, both in and out of my IRA. While I’ve been able to reap the benefits of the note business for my retirement, I noticed far too little SDIRA owners are utilizing this niche of real estate investing and are missing out a major opportunity. So today, I’ll be sharing what note investing is, how to find passive notes to invest in, and discuss what the risks are when investing in notes.
What is Note Investing?
A note is simply a promise to pay a debt. Notes are either secured (backed by an asset such as real estate) or unsecured (not secured by anything other than the debtor’s “promise to pay”). Since we are talking about investing in real estate notes, you would be investing in a promissory mortgage note, which is a signed document that stands as a promise to pay a specific mortgage loan. The note outlines the terms, rates, dates, and requirements to fulfill the promise, and the mortgage is the security that collateralizes the promise to pay.
When you invest in real estate mortgage notes, you’re investing in the note and mortgage, or in other words the debt and the property that secures it. You can do this by buying a note and mortgage someone else created, or you can create your own. Let’s look at an example to see how a note and mortgage would be created.
Creating or Buying a Note
Mr. Brown owned a rental property free and clear. He’s ready to retire from the rental business, but doesn’t want to get hit with taxes from a traditional sale of the property. So, he decides to hold financing on the property. The buyer, let’s call her Mrs. Green, has the owner carry or hold financing instead of going to a bank or paying cash. Mrs. Green is put on title, pays the taxes, and takes care of the property since she owns the home, but still has to pay a monthly principal and interest payment to Mr. Brown. In this scenario Mr. Brown is getting a passive return by creating a mortgage note secured by a property without having to own the home anymore.
Now let’s extend this example a little further. Mr. Brown now has a great paying note that is providing him with a higher than average rate of return, but something’s come up and he would prefer cash for his note now than having to wait 10 – 20 years for it to pay off in full. So, Mr. Investor (someone like me) reaches out to Mr. Brown and offers to buy this note for cash now at a slight discount. Mr. Brown realizes the benefit of getting cash now for the note, and decides to sell at the discount. People create and sell notes all the time both on private level and institutional level.
How Do I Find Passive and Profitable Notes to Buy in my SDIRA?
There are several ways to find real estate mortgage notes to invest in. The most common way is to market directly to sellers who own mortgage notes! You can buy a list of potential sellers or people who created a private mortgage note. You’ll send them a a series of letters or postcards, and hopefully get a few calls where you’ll negotiate a deal to buy a note at an awesome price. Once you buy the note from the original seller, you have the right to collect on the note and mortgage, you become the bank!
If you don’t want to have to buy a list, send letters or postcards, talk with potential sellers, then negotiate a deal with them in order to find a note to buy, start looking for note brokers. A note broker is similar to a wholesaler for traditional real estate. The broker finds quality notes to buy and negotiates a set price to buy the note at from the seller. The broker then finds a note buyer, like you, who is willing to buy that same note at a slightly higher price. You buy a quality note that typically yield 8% – 12%, sometimes more, and the broker makes a fee from the difference.
The other opportunity of course, is to create a mortgage note yourself! If you have a piece of property you own free and clear or if someone wants to buy a house cash but needs money to do so, you can create a note and mortgage collateralizing the property. You get to determine the terms of the note, meaning the interest rate they pay you, how long you hold the financing for, and can get creative to get a payment that provides you with a nice return monthly.
What’s the Risk?
No investment is risk free, but some have a higher risk than others. Notes have a relatively low risk level. In most scenarios, the greatest risk is if the borrower stops paying. In this event, you as the note owner, are responsible for either working out a new payment plan with them to get them paying again, coming up with a deal to get them out of the home and title back into your name, or absolute worst case, foreclosure. While this may not sound appealing, since you’re buying notes at a discount and the note itself is secured by real estate, if you end up with the property, you now own the property and have the freedom to sell it as- is traditionally, create another note and mortgage, or make it into a rental if you so desire. In all of those scenarios you should be walking away profitably, it just turned into a slightly more hands on investment than the passive performing loan you originally bought.
Real Note Buying Case Study
Let’s take a look at a real example of a note I bought in my 401K. I found this contract for deed from a note broker. If you’re unfamiliar with a contract for deed, it is similar to a note and mortgage, where the owner of the property finances the debt to the buyer, but instead of the buyer getting put on title when the “buy” the house, the seller stays on title until the loan is paid in full. Sellers sometimes use contracts for deed because it can be easier to foreclose if they stop paying.
At the time, the borrower was behind on the payments and had filed chapter 13 bankruptcy. It was clear she wanted to stay in the home and could pay now, as she had made over 12 months of on time payments in her bankruptcy plan. Since this was technically a delinquent loan, I was able to pick it up for a pretty steep discount, just 48% of the unpaid balance!
At the time I bought the note, the borrower owed $33,000 and I bought the note for $16,000. According to the original agreement for deed, the monthly payment was $741, but because she was behind, she has to make additional payments of $407 to catch up in the bankruptcy. That means I am receiving a payment of $1,149 every month and I only paid $16,000 for this contract and note. I do have a small holding fee of $50 for a licensed servicer who tracks and reports the payments made for me, but all in all I have a tax free investment that yields me an 82% cash on cash return on my money! Even when the borrower catches up with her payments in the bankruptcy plan and goes back to making only $741 a month payment, I’ll still be making a 55% yield to maturity without having to maintain the home, pay the taxes, or call to collect the “rent”. Did I mention if the borrower stops paying all together, the property is worth around $80,000 in it’s as-is condition, so I would make an even better return if I take the property back?
Notes truly are an incredible vehicle for building wealth and because of their passive, hands off commitment they are ideal for investors looking for better than average returns on their money in their 401K or IRA. Not all notes will be home run deals like the example above but it’s not uncommon to find notes for sale that provide very comfortable returns.
About the author
Liz Brumer-Smith is an active note investor and seasoned educator in the note space. She initially began investing in defaulted or non-performing mortgage notes in 2012, and has since grown a portfolio of notes with a value of over $3 million in unpaid balances. Liz now travels full-time with her husband in their RV while investing in mortgage notes. She teaches others how to invest in debt and become the bank at Note Investing Academy, an online note training program.
*This site contains educational content provided by third parties. NuView Trust does not endorse, recommend or approve any of the companies or individuals or investment vehicles or strategies that may be discussed. NuView Trust encourages clients to seek legal or tax advice as necessary and to perform their own due diligence before engaging in any investment vehicle or strategy.