One of my favorite asset classes for cash flow is notes – also known as mortgages, hard money loans, or private money loans. Think of it as becoming the bank – without the bureaucracy.

There are two common ways to invest in notes. The first is to invest directly in a specific note against a specific property. The second is to invest in a fund that invests in notes and leverage the fund managers to handle the details.

The core principle is straightforward: you provide capital, and in return, you receive a lien against a property and a promise of repayment with predictable returns.

The note terms are negotiated between you and the borrower: the interest rate and fees (such as points), when the loan will be repaid, whether there is a prepayment penalty or not, how much the payments are, when payments are due, whether the loan is amortized or interest only, and what happens if payments are late or stop completely.  Everything is written into the note, which is then used to place a lien against the property. Since the terms are negotiated on a case by case basis, there is no standard set of terms.

Notes can offer a compelling opportunity:

• Consistent Monthly Returns: Targeting 9%+ annual returns, paid monthly
• Predictable Income Stream: Unlike equities or value add opportunities
• Lower Default Risks: When done with proper due diligence

The downside is that there is no potential for equity growth – you get your original investment plus the interest and that is all. Further, the interest is considered portfolio income and is taxed at normal income tax rates so you don’t get any favorable tax treatment.  As a result, notes aren’t the best asset class for growing wealth, but are a great cash flow strategy.

Given the interest rates range from 8%-15%, a common question is why would the borrowers ever take out this type of loan. The ultimate answer varies from borrower to borrower, but they are a strategic tool in specific scenarios:

• Construction loans: When issued by a bank, these loans are at higher rates than traditional loans. This means the total cost paid is likely less for private loans, especially when they are smaller or for short terms.
• Short term loans: Banks do not like short term loans (under 2 years) given their costs for originating a loan, and so charge more for them percentage wise. They also require a certain amount of time before a loan can be refinanced, which may impact the borrowers plans. For borrowers who only need the money for a short period, it can be cheaper to use private funds.
• Small loans: Banks usually have minimum loan amounts, based on locations. If they will write the loan, they require a number of fees and assessments that are not typically required for private loans. Between points, administrative fees, appraisals, etc. the overall cost to the borrower is typically less using private money for small loans.

Of course, like any investment, there are risks associated with note investing. In particular, the borrower may fail to make their payments. This will lead to a series of penalties outlined in the note and ultimately to a foreclosure on the property being used as collateral.

If the lien that you hold is in first position, when you foreclose, you are taking over direct ownership of the property. Your lien has priority over any other liens, with the exception of property taxes so this is relatively straightforward as long as you follow the appropriate state regulations. Once you own the property, you can do whatever you want with it (sell it, fix it up, rent it out, move into it,…). However, you also become responsible for paying the taxes and any other ongoing expenses associated with the property just like you purchased it from the borrower.

If your lien is not in first position, the situation becomes more complicated since the first loan will have priority over your loan. In this case, you may need to assume or pay off the original loan in order to foreclose on the property. As this is a riskier proposition, these notes often have higher interest rates.  

While a foreclosure sounds like a great way to pick up a property for cheap, you need to keep in mind that you obtain the property as is. If the borrower was undergoing a major renovation, had gutted everything inside, and was unable to complete it, that is what you get. If they had the roof torn off and a storm came through causing water damage, that is what you get. If squatters moved in and started a fire, that’s what you get. As a result, the value of the property after you get through a foreclosure may be less than the what you put into the loan. Of course, the opposite is also true, it may be worth much more, but in that case, the borrower would likely do everything they can to keep it.

Ultimately, foreclosures are expensive and time consuming endeavors that you should work to prevent.

The best way to avoid them is to do proper due diligence before you make the loan. You should ensure you are comfortable with:

• The credit worthiness of the borrower
• How they plan to use the funds
• How they plan to pay back the funds
• The best and worst case payback timelines
• All existing liens on the property
• The current value of the property
• The projected value of the property after any renovations
• The foreclosure rules in the state that the property resides in

Assuming you are, then creating the loan is relatively straightforward. An attorney draws up the note document outlining all of the terms of the note and the title company records the lien against the property. You can then work with a mortgage servicing company to handle processing the payments and associated tax documents, or the borrower can pay you directly and you can generate them.  

If you don’t want to take the time to do all of this, then you may be better off investing in a note fund. In this type of syndication, the GP is responsible for performing all of the due diligence on the note and dealing with any issues that arise – including handling foreclosures and reselling any property that is ultimately foreclosed on.  As an investor, you also get the benefit of investing in notes across multiple properties, which decreases the chances that your monthly payments will be stopped. Of course, the returns that you get are going to be lower since the GP needs to be paid, but the investment can still generate strong cash flows.

If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.