Friday, July 5, 2013

How to Make Money Buying Real Estate Notes

If you want to make money in real estate, one way is to don a lender's hat instead of trying to be a flipper or other type of traditional real estate investor. Lenders nearly always come out pretty well. They don't particularly care about market ups and downs. They just make sure their check is there every month. 

Most people aren't in a position to offer mortgages, but there is a way to make money in real estate notes. And not just a little--a lot of money is out there in the form of seller-carry-back notes. A seller-carry-back note is one in which the seller of a property accepted a note from the buyer as all or partial payment, usually because the buyer was cash-short or couldn't get a traditional loan for one reason or another.

Here's a typical situation. A seller had his or her $150,000 house listed for sale for a very long time during the 2007-2010 crash, with no takers. The house had a $100,000 mortgage. Finally, a buyer came along but only had $100,000. The seller would take the $100,000, and carry back a note, secured by a deed of trust (or other form involving equitable title, such as a land sales contract--see below), for $50,000. The interest rate is six percent, interest-only payable monthly, with the entire note due in ten years.

Now, it's four years later. The seller has been receiving the $250 monthly interest check but would really like all his money. Maybe he needs cash for a personal emergency or just has some other need. At that point, he may begin looking for a place to sell the $50,000 note. That's where the investor comes in.

Say you bought the $50,000 note for $35,000. The monthly interest check of $250 would be a 8.5% yield--not bad in today's investment climate. But in six years, the note is due, at which point you'd receive $50,000 when the buyer pays it off. That's a whopping 43% return.

Truth be told, most notes out there that might be for sale don't have the favorable characteristics  of the above example. The seller's equity in the home isn't usually that strong. Buyers who have paid with a note instead of cash can be a little on the flaky side. Due diligence with credit analysis, property appraisals and use of a lawyer is a must. And the investor will need a collection system, whether that be the investor or an escrow collection company, and send out the tax forms at year end.

While there's no going rate on a purchase price for one of these notes, the traditional starting point has always been for half, or even less, of the principal balance. It depends on the due date of the note, the credit quality of the payer, the value of the underlying real estate in case the investor had to foreclose, economic conditions, how desperate the seller of the note is, and so-on.

Carry-back notes can be secured with a deed of trust, where a trustee acts in the event of non-payment, or a land contract, which requires the holder to sue in court in the event of non-payment. In a land sales contract, the buyer has what's called "equitable title" until the note is paid. With a trust deed, the Beneficiary has equitable title.

Every locale I've lived in has had firms or individuals who have been engaged with note purchases for a long time. The competition can be pretty fierce, and most of them are experienced at note and credit analysis and at price negotiation. But that doesn't mean there isn't room for newbies. And the notes don't have to be for $35,000, as in the above example. People carry back notes of all sizes--$2,500. $5,000, whatever. You can (and should) determine your risk and exposure before jumping in.

While it's definitely not for everyone, note purchasing offers a way to invest in real estate.