The Benefits and Drawbacks of Notes vs Real Estate Investments

 

Let’s compare the major differences between note investing and more traditional real estate investments.  While I think notes are a great option, no investment is perfect and risk free.  It’s important to understand what you are getting into.

Notes Investor Cash

Benefits:

 

  • No tenants – Because you do not own the property, you won’t be responsible for renting it out.  This includes finding tenants, dealing with vacancies where you won’t collect any rent, inspections and repairs on move-in/move-out, etc.
  • No toilets – The dreaded 4AM phone call that most landlords fear will also not be an issue.  Again, you don’t own the property, so the owners are responsible for their own maintenance on the home.
  • Predictable return – I have averaged about 14% return on my notes so far.  You can do even better if you are willing to take on riskier notes or do a bit of “rehab” on a non-performing note (if you don’t know what that is, don’t worry… we’ll go over it all soon!).  This is steady, (mostly) predictable income that I can plan around.
  • Mostly Passive – Once the note purchase is complete, there is very little to do on a day to day basis. I just watch direct deposits come in via my note servicer.  I do keep an eye on things so I have an idea if a noteholder is late on payments or has otherwise been in contact with my servicer, but it’s really only necessary to check in once a month or so.
  • Easy Diversification – Since I am buying notes in several different states on different types of property, with different terms, I feel I am well diversified and won’t be significantly impacted if one note goes south.  As of this writing I own 12 notes in 11 states.  They are all relatively small notes, purchased for between $10K and $40K.  While this is somewhat possible with traditional real estate investing,
  • The Kicker! – You can’t predict this one, but when it happens it’s phenomenal.  If you bought a note at a discount and at any point the borrower refinances or sells the property, you get paid back the full amount they owe all at once, not just the discounted rate you bought it at!  This can shoot your yield to a much higher than planned level.  I’ll have a full article on this phenomenon soon.

 

Drawbacks:

 

  • Inflation Risk – When you invest in a single family home, it is an inflation hedge. Your mortgage amount is fixed no matter how much inflation there is, and the home value would also likely rise with inflation.  Notes can work in reverse.  If your note is set to yield 10% per year but we suddenly enter a period of high inflation, where inflation itself goes up to 8%, then your yield after inflation drops to only 2%. That is likely to be much less than you originally planned on.  Our US inflation rate as of the time of this writing is less than 2% and it has not averaged over 4% in over 25 years.  If it stays this way, it’s not an issue…but anything is possible.
  • Opportunity Cost of tied up funds – The note market is much smaller than the real estate market as a whole.  If I want to “cash out” and recoup my funds quickly, I may find it takes more time than you want to find a buyer.
  • Significant Drop in Real Estate Value – When we buy a note, we generally need to make sure there is enough equity in the home to cover our loan.  I personally would not pay $100K for a note if the property is only worth $80K.  I’m aware, of course, that property values can fluctuate quickly…so even if I think I have a decent cushion, it’s still possible that the property value could sink below what we bought the note for.
  • Foreclosure – In a perfect world, the borrower would always make their monthly payment and everything would be fine.  Unfortunately sometimes things happen.  It’s up to you how much leeway you are willing to give.  Ultimately I need to be prepared to be the “bad guy” and take back the property to recoup your investment.  Nobody likes kicking someone out of their home, and I would like to think I’m much more understanding than a big bank would be.  At the end of the day, the borrower needs to fulfill their part of the bargain.  If they don’t, you need to take action.  Much more on how this works later.