Note Investing

"PASSIVE INCOME"

Ahhhhhh that term...it's what a lot of us are in search for.
It's what a lot of us are trying to build.
It's what a lot of us are struggling to grasp.

Passive. Frickin. Income.

Well, as I sit here, trying to evaluate my next investment opportunity, there's a huge pull for me to experiment in the world of note investing, which requires little to no work at all from me, but can provide very respectable returns. Let me explain.

Does the sound of bringing in passive income sound great?
What if it required absolutely NO work?

YES! I WANT THAT!

Here's where investing in performing NOTES comes into play and why it's so appealing. I've always heard about investing in notes...but honestly, it's been a somewhat difficult strategy to really grasp as there's not a ton of content out there! So, keep reading for some great information from BiggerPockets:

​What is a note?
It's a promise to pay. For example, a personal check is a note. When real-estate is sold with financing there is a document called a promissory note which defines the terms of the loan, including the loan amount, percentage rate, payment amount, the number, frequency, and timing of payments, late payment penalties, etc. The note, by itself, is simply a promise to pay and is not secured by collateral. In a financed real-estate transaction, the note is secured through a security instrument. This is either a mortgage or deed-of-trust, depending on the state. The security instrument ties the note to the deed as a lien on the property as collateral. It also spells out the lenders recourse (foreclosure) should the borrower fail to pay, among many other details which we won't go into here.

What is note investing?
If you invest in a note, the note is purchased along with its security instrument. Basically, investors purchase the secured debt and become the lender, after which they are entitled to receive payments from the borrower. Generally, note investors purchase notes at a discount to the remaining principal balance.

Lien Position
Before we get into different types of note investing strategies, we should cover the topic of lien position. When a debt is secured by real property, it's recorded as a lien against the deed. The rule for lien position is "first in time, first in line." This means that lien position is establish by the relative date and time a lien is recorded against the deed. For example, a first mortgage is in first position solely because it is recorded prior to subsequent liens like a second mortgage. There are a couple of exceptions to this. Delinquent property taxes is the most common exception. When a municipality liens a property for delinquent taxes, the lien cuts in line to the front. The other exception is HOA dues in "super-lien" states. In these states, delinquent HOA liens act like tax liens. Lien position is important in note investing primarily because in the event of foreclosure, the lien holders are paid from the proceeds of the sale based on the position of their liens. The first position lien is paid first, and if anything is left over the second position lien is paid, and so on.

Common Note Investing Strategies
There are many strategies in note investing and the common ones which are; Performing Note Investing, Non-Performing 1st Lien Investing, Non-Performing 2nd Lien Investing.

Performing Note Investing - Buy and Hold
A performing note is a note in which the borrower is making regular payments, and investors purchase them to achieve a stream of recurring passive income. This is similar to purchasing a rental property, but without the headaches of property management. This is what I'm really interested in!

Many of the performing notes for sale were created in owner financed real estate purchases, where the seller desires to cash out rather than continuing to receive monthly payments. These notes are generally purchased at a discount to remaining principal balance, providing the investor with a higher effective yield than the interest rate of the note. Double-digit yields on these investments are quite common. Why would someone sell at a discount? Sometimes life circumstances dictate that money now is more important than money over time.

Non-Performing First Lien Investing
In this strategy, the investor purchases a loan in which the borrower has stopped making payments.  The banks have many of these on their books right now, and have chosen to sell some of them to investors to get them off of their books rather than take the time and incur the expense of foreclosure. Because these notes are non-performing, they sell at a steep discount to principal balance. Investors who purchase these have several exit strategies to consider:
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• Workout - A loan purchased at a discount can be modified to forgive arrears and reduce the principal balance, thus lowering payments. Many borrowers with severely underwater homes have stopped paying simply because they don't see a point in paying on a loan balance which is double or more the current value of their property. Others have suffered employment setbacks and have found themselves so far behind on payments that they can no longer bring the loan current, so they give up on it. Whatever the reason, a workout can solve a painful financial problem for homeowners and provide the investor with a re-performing loan acquired at a very nice discount.
• Deed-In-Lieu - When a workout is not possible or feasible, taking possession of the property via deed-in-lieu can sometimes be a workable approach. With this approach, the borrower signs the deed over to the lien holder as consideration for the debt.  The thing to keep in mind with a deed-in-lieu exit is that any junior liens will remain on the deed.
• Short Sale - Just like a bank, the note holder can approve a short sale by the borrower. As with deed-in-lieu, junior liens can make this approach unfeasible because clear title must be conveyed in a sale.
• Foreclosure - This approach can be the only option in some cases. The downside is that it takes time and incurs holding cost and legal expense. The benefit is that junior liens are removed, leaving clear title.

Non-Performing 2nd Lien Investing

Because the lien position is junior to the first lien, non-performing 2nd liens can be purchased at extreme discounts. It's common for these types of notes to be partially or completely underwater with regard to property value. Workout is the primary exit strategy, as foreclosure and deed-in-lieu from 2nd position will leave the 1st lien in place. Because of this, non-performing 2nd lien investors tend to look for for notes with a  performing 1st lien, and scrutinize the quality of the borrower rather than focusing on the value of the collateral property.

In Conclusion
As you can see, the world of note investing can be quite intricate. As of now, I'm really only considering performing notes, as the appeal of having an on-time borrower paying monthly, without any headaches, is SUPER appealing.

​-Tyler

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