Real Estate Notes: A Smart Investment Alternative

The supply of real estate notes available at discounted prices has not dried up yet.

By Joel Cone | Contributor March 2, 2015, at 8:55 a.m.

After three decades of working in different areas of the real estate business, including owning a number of rental properties, the three T’s of landlording, tenants, toilets and trash, were wearing thin on Don DeMarco. The Silver Spring, Maryland-based real estate entrepreneur has seen a lot, making a lot of money and then losing it due to economic downturns.

After years in the home improvement, real estate development and then mortgage business, in January 2014, DeMarco decided to retool his real estate career once again and looked for another viable option to make money based on the current state of the market. He found that option with investing in real estate paper.

“I’ve always had a desire for real estate and enjoyed working with it,” DeMarco says. “When I saw the downturn in the economy in 2007 and the market just dropped out, I ended up struggling with my business, and in 2010, I ended up filing for bankruptcy and gave up my business.”

In the past year, DeMarco has bought 20 non-performing notes. In some cases, he has been able to negotiate loan modifications, while others are in various stages of being foreclosed on.

“I wouldn’t say it’s hard. It is time-intensive. No matter if you do all the due diligence yourself, or hire virtual assistants, you want to buy the right assets,” DeMarco explains. “For the right investor, I think it’s a fantastic way to get into the real estate business. It’s not the normal landlord type of scenario.”

Why notes? One key reason to focus on buying notes in the present market is simply because there are so many of them out there following the nation’s most recent foreclosure crisis that began in 2006.

RealtyTrac reported that, at the end of 2014, there were still more than 7 million residential homeowners seriously underwater in this country, representing 13 percent of all properties with a mortgage. Those underwater homeowners mean the supply of real estate notes available at discounted prices has not dried up yet.

Ample supply is one thing, but nationally recognized experts teaching and coaching investors in buying notes point to a more important reason to specialize in notes, instead of purchasing brick-and-mortar real estate: the greater number of exit strategies available to note buyers.

“It’s important to educate yourself first, because notes are a completely different animal than just buying a piece of property, fixing it up and selling it, or buying it and renting it out,” says Scott Carson, president of WeCloseNotes.com. “With buying a rental property, that’s the strategy you’re going to go with. With notes, you have more exit strategies,” he says.

From a deed in lieu of foreclosure, to cash for keys, loan modification and foreclosure (plus having access to the federal Hardest Hit Funds in states where they are still available) these exit strategies only apply to first mortgages, not second mortgages.

“What I love about notes is you go directly to the bank. You’re seeing things six to 12 months ahead of time, depending on the state. The fact is that you’re buying debt well below what a retail investor would pay,” Carson says. “You create a win-win with the homeowner, and more often than not, it turns into a really good yield for us.”

Firsts versus seconds. When it comes to the pecking order of mortgages, the first (or senior mortgage) sits in the driver’s seat. Should the borrower default on the first, then any junior liens (such as second mortgages) are in serious trouble. So, as far as investors are concerned, in today’s market, buying the first puts the investor in the best position possible.

“Firsts are always easier to raise capital for,” Carson notes. “Plus, when you’re in first position, you have more exit strategies, and there is five times more inventory out there. The concern with buying seconds is you’re worried about the first becoming non-performing and wiping you out.”

Investing in seconds fell out of popularity with investors after property values dropped precipitously due to the market crash in 2006. Any market left today for seconds can only be found in regions of the country where property values are high and home equity is plentiful, such as in California, notes Donna Bauer, president of The Original NoteBuyer LLC.

Great potential with non-performing notes. Given that the nation’s housing market is still in recovery mode from the Great Recession, investors looking for different investment vehicles are turning to real estate paper – particularly buying non-performing notes. Investors usually buy buy them from banks, hedge funds and private equity firms that are willing to sell them off at significant discounts.

As the name suggests, non-performing notes are first mortgages secured by real estate where the borrowers have stopped making their monthly payments for various reasons. As mentioned above, investors looking to buy no-performing notes have a variety of strategies available to them.

Once the note is purchased, the investor now owns the note, literally becoming the bank. As such, the investor can then approach the borrower directly and offer to work out a loan modification, or in the worst-case scenario, the investor can always foreclose, and either sell or keep the house as a rental.

“The reason people buy [non-performing notes] is twofold: to acquire the property - use the note as leverage to either negotiate a deed in lieu, or foreclose and take the property,” Bauer says. “The second strategy is to create a very high-yielding passive investment. In that case, you do a forbearance and modify the mortgage. You restructure to an amount the borrower can afford to pay. Once it’s seasoned for 12 months, then it can be sold as a reperforming note.”

As Bauer explains it, the larger banks sell their notes to hedge funds, who then split them up and sell pools of notes to smaller hedge funds and private equity firms, which is where the mom-and-pop investors buy them either in pools, or as one-offs.

A “one off” is either a single note or a small pool of notes (maybe 10 or less) purchased from small hedge funds and private equity firms. In other words, the investor can actually cherry-pick the notes he or she is interested in buying.

“A lot of people got caught up in the market. Through no fault of their own, they ended up in default. They may have wound up upside down on the house and froze and didn’t know what to do. When you go to the homeowner, you have to assess what their situation is,” Bauer says.

Whether the investor’s goal is to build up a high-yield portfolio of passive investments, or a portfolio of rental properties, or a combination of both, working with financially distressed borrowers who are not paying their mortgages holds a great potential upside, but not without risk.

“Notes do offer the potential for a good rate of return on investment, but investors going into the note-buying business must go in with their eyes wide open, because not all note deals are winners. Just like buying homes in a bidding war or online auction, the best protection is doing the most thorough due diligence possible on every deal,” says Rick Sharga, executive vice president at Auction.com.

Joel Cone is a southern California-based freelance business writer who specializes in the fields of real estate, economics and law. His articles have appeared both in print and online for many publications including California Real Estate, OC Metro, GlobeSt.com and The Los Angeles Daily Journal. He is also a contributor to Auction.com.