Investing in Notes for Passive Returns

March 10, 2016

Guest post by Earl Green:

If you’re using a self-directed IRA, HSA or similar investment account, you’re probably looking for a strong and predictable alternative to the stock market roller coaster. If this is true, investing in notes may be for you. These wonderful pieces of paper can provide strong and predictable returns that can be secured with real estate. Notes are readily available, more liquid than traditional real estate and provide many of the same protective advantages without tenants, toilets, and termites. Recently, I even had a self-described “old timer” recount how retirement and notes were intertwined before big banks and the stock market got involved. The new generation would buy the real estate they needed and the older generation would hold the note. Payments on the note would provide retirement for the older generation and the cycle would continue.

The basics of notes are simple – to purchase real estate, most people borrow money or apply for a note (loan) from the bank. People promise to pay the note on time, every month or the bank gets to take the real estate. Simple! When you invest in notes, you become the bank.

Let’s use an example: A small home in Blue Collar, Texas, is worth $100,000. The remaining balance on the note (loan) is $80,000 at a 7% interest rate. Earl purchases the $80,000 note for $65,000 using his NuView self-directed IRA. Since Earl bought the note for less than $80,000, he’s earning more than the 7% interest rate of the original note. Every month, the homeowner still mails the same payment to the loan servicer, but instead of sending these payments ending up at the bank, they flow into Earl’s self-directed IRA. Earl’s self-directed IRA is now the bank. Yes, buying at a discount is common practice and yes, it’s good to be the bank. Below are three P’s to describe what’s so great about real estate notes.

Protection: Your investment is protected by real estate. If the homeowner stops paying, tell your note servicer to call their foreclosure attorney and start the process. In most instances, you are entitled to recover the full note balance, plus late fees, attorney fees, and anything else needed to recover your investment. In our example, the house is worth $100,000 and we buy the note for $65,000. That gives us $35,000 of protective equity to recover our entire investment, plus the cost needed to recover it. No investment is without risk, but I like these odds better than asking Wall Street for my investment back.

Predictable: Your returns on a note are predictable and can be calculated before making the investment. In the example, Earl bought at a discount and calculated a return higher than the 7% interest rate on his note. Every month you should see a predictable deposit in your account. You might be able to AVERAGE this in the stock market, but it’s nearly impossible to predict the return monthly, or even yearly. If you invest in a mutual fund today, it may be up 5% tomorrow and down 10% the next day. The same timing game will happen when you sell. Even stocks that pay a dividend are subject to the ups and downs of the market.

Passive: Notes are mostly passive. No tenant, toilets, termites or property managers to interrupt your vacation. Once you purchase the note, you’ll contact your loan servicer, arrange the transfer from the seller and confirm all of the associated documents have been provided. The loan servicer can handle all interactions with the homeowner. Do you call the bank when you have a leak at your house? Do you call the bank when your tenant won’t pay rent? Do you call the bank when a tree falls on your roof? Of course not. The bank’s role is passive and when you own the note, you are the bank. Even if a tree falls on the house, the homeowner’s insurance policy should include the bank (you). If the home is never rebuilt, you’re still getting paid.

Below are some additional questions or concerns that typically come up when discussing real estate notes.

• What if the note is paid off early or the homeowner refinances the loan?
  Answer: It’s even better. Based on our example, the note’s remaining balance is $80,000. Since we only paid $65,000, we would receive our entire investment, plus the additional $15,000. A lot of people in the note business call this a “kicker” and actually hope for it.
• Where can I find a note to buy or fund with my self-directed account?
  Answer: The best option is to get involved with your local note or real estate investment group and find a reputable attorney to do the paperwork. There are also a number of reputable websites that allow users to buy and sell notes. Some of the best sites will charge a fee, work as an intermediary to manage an escrow account and help ensure that all of the required paperwork goes smoothly. You’ll quickly identify the buyers and sellers. Just like traditional real estate, the best deals are always purchased direct from the seller or “off market.”
• Is it hard to buy or sell a note?
  Answer: Once you’ve established yourself amongst the note investing community or found an experienced friend, notes are far more liquid than traditional real estate. As long as all of the necessary paperwork is present, buying and selling is a simple transaction with some legal assignments and recordings. With the abundance of traditional and IRA investors looking for strong and predictable returns, the marketplace for notes is quite liquid.
• Is it illegal to service my note?
  Answer: No, but it is a major risk. With most note servicers charging $15-50 per month, there’s no reason to take on the risk. Let the servicer keep you compliant with the many rules and regulations related to servicing.
• Can I create my own note?
  Answer: Yes, but you won’t be buying it at a discount. Therefore, you’re unlikely to achieve the same strong return on investment. If creating a note, it is strongly recommended that all of the paperwork and underwriting be provided by a licensed mortgage loan originator. This provides a level of insurance that it is compliant with all regulations and will be more marketable if you decide to sell in the future.

Investing in notes can be a passive way to drive strong, predictable returns in your self-directed IRA, HSA or other investment account. They are readily available, relatively liquid and when purchased correctly, are protected by the equity of the associated real estate. Since everyone needs a place to live and most real estate is financed, most of us are already involved in some level of the note business. Maybe you should stop trying to time markets, macro-economic cycles or Chinese GDP and give real estate notes a try as a part of a diversified portfolio.

Earl Green is a Note Investor living in the Central Florida area. He also co-hosts the monthly Florida Note Investors Group meetup. The group is open to new and experienced Notes investors looking to network and learn. You can find Earl on Facebook, LinkedIn, Meetup, or by email: earl.green@startfreshinvestments.com