Nonperforming notes may not seem like a worthwhile investment since the borrower isn’t paying anymore. They have a high risk of default, and that's bad for cash flow.
But investors often use these notes to acquire real estate at a discount. Once the tenant defaults, the investor can take possession of the property and create a long-term rental, fix and flip the house, or simply sell it.
There are significant risks to using mortgage notes in this way, but if you're smart about your investment strategies, it can pay off.
Investors can also modify the terms of the mortgage. For example, if you buy a nonperforming note, you might lower the balance of the note, reduce the interest rate, decrease the monthly payment, or otherwise assist the borrower in making good on their loan. This can result in very high yields if you buy the note at a discount.
Over the past 10 years, the cost of nonperforming notes has risen -- but you can still get them at 20% to 40% off of the current market value or loan balance.
Where can I find mortgage notes to buy?
Banks create and sell mortgage notes as a part of their business model. They make their money from lending and receiving interest. The more they lend, the more they make.
There are guidelines for how much money a bank has to keep in reserve in order to lend -- this amount is called a reserve ratio. If a bank has low liquidity, they may sell some of their loans in a "pool," which is a group or package of mortgage notes. Other banks, hedge funds, and private individuals can buy these pools.
Hedge funds and banks are the largest buyers of mortgage notes direct from banks because you typically need millions of dollars to purchase them in bulk. For this reason, it can be difficult for individual investors to buy directly from banks, though it can be done.
Individual sellers that created a private mortgage note may also want to sell simply for the benefit of having cash now. Maybe they're experiencing hardship and need cash today rather than waiting for the remaining term of the note to pay off.
You can find private sellers of mortgage notes on online marketplaces like Notes Direct or Paperstac. You can also buy a list of private individuals who own or hold a note from a company like Listsource. You might send the noteholders a series of letters or postcards or get in touch with them another way to see if they're interested in selling.
If they need cash, banks and individual sellers will sell at a markdown. When you buy at a discount, your rate of return is higher than the nominal interest rate on the note.
Performing notes are typically more expensive. While you can buy them at a discount, it’s typically only a slight discount from the remaining balance of the note. Nonperforming notes are often sold at steep discounts from the balance owed or the value of the property, whichever is less. Pricing is also higher on first-lien mortgage notes compared to junior liens. The more secure the position, the higher the price.
Let’s look at a few examples to see how this works.
Buying a performing mortgage note
Let’s say you find a private mortgage note that the seller needs to get rid of. The note is secured by a mortgage on a single-family home. The property originally sold for $150,000 and the borrower put down $15,000. That means the original loan was for $135,000. The note is a 5% fixed-rate 30-year loan, making the borrower’s payment each month $724.71.
The borrower has been paying the loan for seven years and is current. So, at the time you're evaluating the note, the unpaid balance is $118,725.68. There are still 276 months (23 years) left.
You decide you'll only buy this note if you can receive a 10% return on your money, or a 10% yield to maturity, so you offer $78,162. That’s $40,563 less than the current unpaid balance, or a 34% discount to the face value of the note.
This may seem like a big loss, but the seller gets $78,162 immediately and has already collected $60,875 in principal and interest to date. If the seller takes the cash now, he or she is essentially collecting $146.97 less per month from the borrower's P&I payment over the remaining 23 years.
If the seller needs the cash, they may accept that offer. In that case, you receive a nice 10% internal rate of return (IRR) and a passive $724.71 of cash flow each month, provided that note keeps performing for the remaining 23 years.
Buying a nonperforming mortgage note
Let’s look at a different example. A hedge fund finds a bank with a low reserve ratio and a high proportion of non-accrual loans (180+ days past due). The bank sells a pool of nonperforming loans to the hedge fund. The hedge fund keeps some of the notes that meet its criteria but decides to sell the notes that don’t fit its investment model.
The hedge fund sends you a list of nonperforming loans for sale and you look through the list to determine which assets you want to buy.
A nonperforming note where the borrower has not made a payment in over two years piques your interest. The current unpaid balance is $128,934 with 214 payments remaining. The note is secured by a nice single-family home in Georgia that you believe is worth $140,000 as-is. The original note had a 5.5% interest rate for 360 months (a 30-year loan) with a monthly payment of $794.90. Because it’s nonperforming, you're able to pick this up for a steep discount -- just 58% of the unpaid balance, or $74,781.
Now that you own the note, you can reach out to the homeowner and see why they stopped paying. Then you can find out if they want to keep the property and work out a plan to get them paying again if they're interested.
Because of the discounted purchase price, you have flexibility in the terms of the loan. You could lower the interest rate, re-amortize the loan, decrease the balance, or offer other conditions to make the home more affordable. If you simply get the borrowers to start paying their monthly mortgage of $794.90 again without adjusting any of the terms of the original loan, you'd get a 10.92% yield to maturity.
There are several other scenarios where you could increase the overall yield to maturity by adjusting the terms of the loan. You might increase the interest rate, re-amortize the loan, or shorten the length of the loan to meet your desired rate of return.
In many cases, these adjustments are temporary. A borrower might agree to pay you a lump sum upfront to show good faith, then pay a lower amount each month until they can get back on their feet. There are many situations you might encounter when buying nonperforming notes, and you'll have to assess each one individually.
If the borrower isn’t interested in keeping the home or can't pay, there are other options. You can work out a deal where the homeowner signs the deed over to you and you eliminate the mortgage and their obligation to pay the debt. This is often called a deed in lieu of foreclosure. It’s not always the best solution, but it's an option for many lenders and homeowners.
If they aren’t interested in either option, you can start the legal process of foreclosure. Foreclosure varies from state to state in cost, length, and procedure. It’s important to know the relevant state foreclosure laws before you buy a note. After you foreclose, the home goes to public auction. If an investor buys the property at the auction, you get paid. If it doesn’t sell, you're put on the title and own the physical real estate.
Once you gain title to the property, you can:
- sell it as-is, like an REO sale;
- fix it up and sell it;
- keep it as a rental (you may have to do repairs); or
- sell it by creating a new mortgage note.
It’s important to note that this strategy of active real estate investment has inherent risk. The borrower could trash the home before they leave. Or they could contest the foreclosure and cause delays and legal expenses. They could even file bankruptcy, which can halt your collection efforts completely.
Nonperforming notes can be a lucrative way to create passive income by working with the borrower to create a performing note. They're also a great way to gain title to the physical real estate at a discount. But they can also be very risky.
The best strategy with mortgage notes is the one we’re going to talk about next.
Creating a mortgage note from your own real estate
When I first started investing, a wealthier and more experienced colleague told me to buy real estate, rent it, and create a note when I'm ready to retire. It’s great advice.
With this method, you can take advantage of the tax benefits of owning physical real estate, make money through the cash flow of a rental, and enjoy the appreciation of the property. Then, when you’re ready to sell, you create a seller-financed note in which you hold the mortgage, receiving passive income in the form a P&I payment. Pretty genius, right?
An added benefit of this model is that you break up the tax hit from capital gains over the life of the loan rather than paying it in one tax year. From a tax perspective, it’s one of the best things you can do once your depreciation calendar runs out on a property.
Let’s say you own a single-family home that you kept as a rental for 30 years. You had a mortgage on the property, but using the additional cash flow from the rental, you paid off the 30-year fixed-rate mortgage in just 15 years. You now own the property free and clear. It’s performing well, but your depreciation calendar has run out. You no longer have the tax advantages of holding this physical property and would rather buy a new rental to take advantage of the tax deductions. But if you sell, you'll be hit with capital gains tax. So instead, you create a mortgage note.
You list the property for sale at $200,000 and offer owner financing. A nice couple wants to buy the property at your full asking price and has $30,000 to put down. Their credit is good, but they're unable to get traditional financing because they're self-employed. You offer them a 20-year fixed-rate mortgage at 6.5% interest. They’re happy to find a dream home they can finance and you’ve just created an additional passive income stream with tax benefits.
You now get to collect $1,267.47 every month and have zero responsibility in maintaining the home, paying taxes, or insurance -- the new homeowner does that.
Because you collect interest, you won’t only get your $170,000 back, but you’ll also make an additional $134,194.71 in interest over the entire 20 years!
To keep you compliant with the Dodd-Frank Act, it's best to use a licensed mortgage loan originator (LMLO) to underwrite and create your mortgage note. LMLOs charge nominal fees for their services. They'll prepare the loan paperwork and confirm that the potential buyer qualifies and can afford the home.
There's always a risk that the borrower stops paying, which turns this from a passive investment strategy to a very active one. You'll have a lot of work to do if you want to get them paying again or resolve the situation another way. This is especially true if you lend to someone who can't qualify for bank financing because of financial problems. Consider this risk before determining if creating a mortgage note is the right investment option.
What are the expenses of owning a mortgage note?
Expenses are rather low with mortgage notes, especially compared to rental property.
Most people hire a third-party servicing company to handle the loan. The servicing company keeps records of the payment history, can collect payments on your behalf, provides the borrower with their balance and statements, and separates the interest and principal received in each payment.
While you can service a loan yourself, this industry is heavily regulated. To keep your risk mitigated, we suggest paying the low monthly cost, which can range from $20 to $40. The servicer can deduct the fee from the buyer's mortgage payment, making it even easier.
Nonperforming loans have more costs associated with them. There are legal fees involved with regaining the title, as well as securing and maintaining the property.
Additionally, the borrowers may not have paid their taxes or insurance in several months or years -- those payments become the responsibility of the bank or noteholder.
Experienced note buyers factor these costs into their offer price and know exactly how much they expect to spend.