Today’s investors have a plethora of choices when it comes to finding a place to put their cash. These can run the gamut from the totally safe, like savings accounts and CDs to the highly speculative, such as penny stocks. In between are tax-free municipal bonds, precious metals, commodities and a range of choices based on real estate.
This latter group can be divided into totally passive vehicles like REITs (Real Estate Investment Trusts) and syndications to very active techniques like fix and flips, wholesaling and holding as a landlord for long-term rentals. Somewhere in here are real estate-backed promissory notes and mortgages.
Notes have been around forever, but even most of my real estate professional friends have very little idea what they are, how they work and why someone might choose to invest in them.
First of all, there are two broad categories of notes: performing and non-performing. Today we will only discuss the former, since they are lower risk, but can still provide a nice return for the investor.
A performing note is one in which the borrower who signed the note to pay for his house has a good record of regular payments. He may be late occasionally, or even miss a month now and again, but generally gets in 12 payments a year to the lender.
When we purchase a note, we always pay a discount compared to the current face value, or Unpaid Balance (UPB).
We need to buy at a discount for a couple of reasons. The first one is because of what’s called the Time Value of Money.
Here’s an example. Let’s say the payment on the note is $500 a month. Imagine going to Costco or Walmart with that amount of spend. How many shopping carts could you fill up? Now imagine how many you could have filled up ten years ago. How about 30 years ago? No doubt you could have bought a lot more in 1986 than you can now in 2016. So the 1986 dollars were worth more than today’s dollars.
Looking forward another 30 years to 2046, I think we can safely assume that our $500 will buy even less than it does today. So if we buy a note that has 25 years to go before it’s paid off, we need to buy at a discount to compensate for the smaller value of the future payments.
The other reason to buy at a discount is because of the uncertainty going forward. What if the borrower loses her job, or gets injured or sick and can’t pay for several months? What if she dies? We can deal with these events if we have to, but we need to compensate for the risk.
The next logical question is, “Why would a lender sell a performing note for a discount? They’re already getting a steady cash flow and wasn’t that why they lent the money in the first place?”
Good question! And actually most note holders will hold on to the ones that provide a regular income.
However, some folks get to the point where the $500 a month isn’t providing much of an upgrade to their lifestyle. They expect their bank account to be $6,000 larger every year, but of course the money has been spent and they can’t even tell you where most of it went.
They may start thinking about cashing out their equity in the note to finally take that dream vacation. Maybe it’s time to pay off other debts or buy that motorhome and cruise into the sunset. Perhaps they’d like to help a grandchild go to college. Whatever the reason, getting a big chunk of change now can change their life in a way the $500 a month can’t.