What Are Real Estate Notes, and Are They Good Investments?
December 14, 2022
Sign up for our educational newsletter and get updates on our products.
You’ve probably heard the term “real estate notes” before, but you may not be entirely sure what they are. Investing in real estate notes can be an attractive way to generate income and build wealth, as the returns can potentially be higher than what you might receive from a traditional bond investment.
In this article, we are going to give you a crash course in real estate notes so you can better understand this investment strategy. We'll explain what real estate notes are, the available types, and how to find a real estate note investment opportunity.
What Are Real Estate Notes?
Real estate notes, also known as mortgage loans or deed of trust notes, are debt investments secured by real property that generates income for the investor.
Usually, these notes get created when a borrower takes out a loan to purchase property and agrees to make payments over time with interest included in the repayment amount. The lender then sells the note to an investor, who collects payments until the loan is paid in full.
For example, a real estate note might pay out a return of 5.5% per year. If you invested $10,000 in a fund, you would receive an annual return of $550. Investors may also purchase one or more real estate notes directly rather than pooling money in a note fund.
First-Position vs. Second-Position Lien Real Estate Notes
First-position lien real estate notes are one of the most secure type of note. They are secured by a mortgage or deed of trust that is the first priority over all other liens on the property. If the borrower defaults on their loan obligations, the investor holding the first-position lien note is paid off before any other parties with an interest in the property.
Second-position lien real estate notes are less secure than first-position lien notes, as they are subordinate to any prior mortgages or liens. That means even if all payments have been made on time and in full from a borrower, prior liens must still be satisfied before second-position investors receive payment.
With either type of lien, investors can invest in real estate notes from various sources such as banks, private lenders, and apps like Concreit.
It is important to note that investing in real estate notes carries certain risks and may not be suitable for every real estate investor’s portfolio. However, when done properly, they can provide an attractive income stream and help build wealth over time.
Benefits of Investing in Real Estate Notes
Rather than holding on to the note, lenders will often sell it in the secondary market to investors. This sale does not affect the terms and repayments for the original person who took out the loan.
When you invest in a real estate note, the buyer makes payments to you instead of the bank or servicer. In other words, you become the new lender and earn money from payments made by the buyer.
What are the benefits of investing in real estate notes? Real estate note investment is quite common and appeals to many investors due to several upsides. Potential advantages for investors include:
- Earning passive income: The regular repayments from the buyer can provide you with a passive cash flow stream.
- Hassle-free: Unlike buying an investment property and running it, or hiring a property manager, investing in real estate notes allows you to enjoy a regular income without the hassle of managing the property. You can also invest outside your state and avoid local estate tax regulations that come with a physical investment property.
- Versatile: Real estate notes are just as versatile as investing in physical properties, allowing you to sell or use them as collateral.
- Lower potential risk: Investing in real estate notes gives you the rights the financing bank or servicer had. Since all rights associated with the mortgage become yours, the underlying collateral, the property, passes to you. If the buyer does not repay the note, you can foreclose the property and take it back.
- Higher liquidity: The real estate market is one of the most illiquid investment assets. That can make selling a property challenging for an investor. On the other hand, real estate notes are more liquid in the secondary market. As such, it is typically easier for investors to offload them when needed.
Types of Notes in Real Estate
Before diving into the investment journey that is real estate notes, you need to understand the available options. You can choose from several types of real estate notes.
Secured vs. Unsecured Notes
Secured notes are backed by collateral such as real estate or other assets that can be repossessed if the loan is not paid back. Unsecured notes do not require any collateral but often come with higher interest rates because they are riskier for lenders.
Performing vs. Non-Performing Notes
Performing notes mean the borrower is current on all repayments. A non-performing note means the loan is delinquent and the borrower has missed one or more payments.
When you invest in non-performing notes, you can modify the terms of repayment so it better suits the borrower. For instance, you can allow them to make a lump sum payment or foreclose if necessary.
Private Party vs. Bank-Originated Notes
Bank-originated notes come from more mainstream banks. These are the most common types of mortgages.
However, not everyone can or wants to get a loan from a standard bank—some people prefer getting mortgages from other individuals or private institutions. Private parties offer these types of loans.
Finding a Note Investment Opportunity
There are now more ways than ever to invest in real estate notes, thanks to traditional banks and note funds, as well as online platforms like Concreit.
Of course, as with any other investment, there are potential risks. Some common risks associated with real estate notes include the borrower defaulting, foreclosing, and selling the property at a loss.
However, that doesn’t mean you cannot invest in real estate notes. You just need to be careful and do your due diligence when finding a note investment opportunity. Here are some tips on getting started and finding an investment opportunity in real estate notes.
Analyzing The Deal Structure
The structure of every loan is designed specifically to meet the lender and borrower's needs and risks. Because of this, deal structures vary between loans. To properly analyze a note's deal structure, you should look at its key characteristics, which include:
- Amount of debt
- Rate of interest
- Fixed vs. variable interest rate
- Monthly payment
- Whether repayment includes interest and the principal amount or is interest only
- Term of the debt
- Underlying security
Understanding The Terms and Conditions Involved
In addition to examining the deal's structure, you must also read the terms and conditions related to the investment. Are there any additional costs? What legal action can you take if the borrower does not make payments? How long will it take to foreclose if necessary? Always remember that many important details are often contained in the fine print.
Assessing The Risk and Reward Ratio
Consider the risks and rewards when making any investment, including the leverage risk and property type.
Determine the leverage risk by assessing the likelihood of losing the investment if things go wrong. For example, if a property has a high loan-to-value ratio (LTV), then the borrower made a small down payment. Consequently, there's a greater chance that this borrower might default on their payments.
Risk levels will differ if the property is for commercial use, a personal residence, or a residential rental property. Weigh the pros and cons either way before making your decision. For instance, a rental property with continuous tenant turnover may be riskier than one that keeps its tenants long-term.
The 3Ps represent the Paper, the Property, and the Payor. These enable you to weigh how secure and attractive the deal is.
- The Paper refers to the various types of paperwork associated with investments and property, such as the note, deed, payment history, and settlement statement. When analyzing these papers, take note of the type of interest rate, current balance, and due dates.
- The Property means conducting an appraisal. To appraise a property, you'll need to look at more than just the building itself. You'll also want the details on who occupies the space (if rented), how long they've been there, and the going rental rate for similar properties. All this information will help give you a better idea of what the property is worth.
- The Payor represents the borrower. Although you may be unable to contact the payor, you can still get the necessary information through the lender. Look for their repayment history, if they defaulted, how far behind they are if the debt has defaulted, and their employment status.
How Concreit Makes It Easier to Invest in Real Estate Notes
Concreit is a platform that allows investors to participate in fixed-income first-lien mortgages. During economic turndowns, debt-based investments in real estate may be more attractive and provide steadier returns than equity-based investment strategies.
With Concreit, your investment is managed by a team of experts with more than $10B asset management experience and your money is spread out across many high-yielding income-focused mortgages in the United States. This cash flow strategy is similar to those used by hedge funds and private equity firms investing for wealthy individuals.
With over 100,000 investments made on the platform and backed by industry leaders, including PayPal and Betterment, Concreit is trusted by over 40,000 clients.
If you want to diversify your portfolio and enjoy the financial benefits of real estate without the hassle of property ownership, then first-position real estate debt is definitely worth considering.
This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security which can only be made through official documents such as a private placement memorandum or a prospectus. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Neither Concreit nor any of its affiliates provides tax advice or investment recommendations and do not represent in any manner that the outcomes described herein or on the Site will result in any particular investment or tax consequence.Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Concreit does not guarantee its accuracy.