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Why Buying Mortgage Notes Are Good Real Estate Investments

Debbie Carlson

People who want to invest in real estate but don't want to be landlords might consider buying mortgage notes.

The loans that borrowers take out to purchase a property are mortgage notes. Banks or lending institutions make the loans, and often these entities will sell those real estate notes to free up their cash flow. Note buyers step into the role of the bank, sometimes buying notes at a discount, and collect the borrower's principal and interest rate payment, says Greg Forest, a real estate advisor at Engel and Volkers in Palm Beach, Florida.

Mortgage notes can be a good real estate investment for people seeking passive income, but investors should know what they're buying. It takes some research into understanding the borrower's financial situation, property values and the different types of notes available. Here's what you need to know when diving into the world of investing in real estate mortgage notes:

-- Types of mortgage notes. -- Vetting borrowers.
-- Buying mortgage notes.

[See: 9 REITs Ideal for Beginning Real Estate Investors.]

Types of Mortgage Notes

Mortgage notes come in different asset classes, usually divided by residential or commercial loans, says Joseph Polakovic, owner and CEO of Castle West Financial in San Diego. Residential loans include single-family and multifamily homes, while commercial loans include malls, office parks, warehouses and other buildings.

Institutions like banks typically do mortgage notes. In a private mortgage note, a borrower makes payments to an individual entity directly and may be part of a portfolio, Forest says. There are two types of mortgage loans. A loan secured by a property is known as a collateralized loan. The other type is an unsecured loan, with nothing to back them.

There are also two main risk categories. Performing mortgage notes are when the borrower is current on the payment. Nonperforming notes are when the debtor has fallen behind in payments, Polakovic says. Nonperforming notes are sometimes called distressed notes.

"There [are] two ends of the spectrum of how conservative or speculative investors want to be," he says. "If you're looking for secured, very predictable income coming in, that's going to push you towards performing notes. If you want a higher internal rate of return, that'll push you further towards nonperforming notes."

Vetting Borrowers

Forest says note buyers should do their due diligence and vet the borrower, checking the person's credit history, income and payment history to get a feel on the borrower's ability to continue making payments.

The buyer should also know how much was borrowed, the loan's interest rate, the timeline for the loan's repayment and what happens in case of a default.

Forest says investors can get a good feeling about a borrower's payment patterns once the borrower has about two to three years of payment history. That's when many buyers will purchase a mortgage note.

"We see people moving every five to seven years. So that two-year mark is probably a good time to jump in because you know that person has been paying and they're probably not going to move for another three to seven years, so you'll get consistent payments," he says.

Notes are characterized as nonperforming usually after 90 days of nonpayment. At this stage the debtor is likely entering the initial stage of heading to default, Forest says. Often investors can buy these notes from banks or lenders at a discount and receive an interest rate higher than the nominal interest rate.

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Doug Fisher, principal at Essex Realty Group, says during the housing downturn during the 2008 financial crisis, buying and selling of distressed mortgage notes was prevalent. He says his firm was active in selling mortgage notes for institutions at the time.

When looking at distressed mortgage notes, the original lender will likely sell the notes at a discount to the actual value of the property. The buyer has a few choices: to help get the borrower current on payments by perhaps forgiving part of the loan balance, or to get control of the property when it forecloses.

He says investors who considering distressed mortgage notes need to look carefully at what they're buying. Usually, buyers are getting the mortgage for a lower cost than the value of the property. But there is still a risk. During the Great Recession, sometimes the property's value continued to deteriorate and fell under the amount paid for the mortgage, he adds.

"You don't have control over the underlying property with the mortgage; the owner has that control," he says.

Buying Mortgage Notes

Polakovic says it helps if investors have familiarity with real estate and understand building and land values.

"If everything goes south, you want to know what is it really worth," he says. "If it goes into a foreclosure situation and you become the physical owner, what is that liability and what is that value? Sometimes it's worth just the land value," he says.

[See: 8 Real Estate Investing Mistakes to Avoid.]

It can be tough for individuals to buy mortgage notes straight from banks, so many use brokers find mortgage notes, who can find both public and private deals, he says. Online marketplaces like NotesDirect.com, an online trading platform, can make it easier for retail investors to buy notes.

Like any investment, Polakovic says there is a fair amount of time-consuming research that goes into mortgage notes. He says buyers need to weigh a note's potential rate of return versus another financial benchmark such as the S&P 500's historical return to estimate if the note may be a worthwhile investment. That's especially true if buyers take a long-term approach and invest in performing notes.

"Historically the return in the S&P 500 is about 8% to maybe 10% over the long term. Your approach to mortgage notes should be: What can I expect?" he says.

He adds that if investors can find something that at least 10% or higher, it may not be worth it. Investors might be better served by investing in stocks.



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