An Introduction to Investing in Notes: Learn to "Be the Bank"

The general concept of investing makes perfect sense: It is the art of using money to make more money. So, how does this simple idea so often get lost on so many people?

Well, it comes down to two beliefs in nearly everyone’s core philosophy…

The first is that many people believe if someone wants to make a lot of money, then they need to work hard at their job. It’s true that a good work ethic is an honorable trait, but does money always come directly from hard work?

While this of course can be true, the fact is that most of the world’s richest people work hard in a different sense; they put their money to work for them.

Secondly, many people were and still are taught to save money rather than to invest it. They go to work all week, and every Friday, they save a certain portion of their paycheck and put it into a savings account.

Now, don’t get me wrong, reserves are important; building and maintaining them is a key to a healthy investment future. But at a certain point, a dormant savings account becomes just that, dormant. Most savings accounts offer an incredibly low interest rate, and keeping money in an account like this does very little to increase personal wealth.

In fact, the bank is the only one that is truly making any money in this scenario because they are paying you a nominal fee to lend back out your money for a much higher return.

Be the Bank

So why not think like the bank? In fact, why not be the bank? Like the bank, always keeping your money moving in a liquid investment is not only more profitable, but also just as safe as leaving your money in a near static savings account.

In any given loan situation, most people feel the banks have all the power, and in many ways, they’re right.

If a borrower pays off their loan, who wins? The bank — although the borrower gets to own their own house free and clear, it was the bank that made the financial profit.

If a borrower decides not to or can no longer afford to make payments, who wins? The bank — they have the option to take ownership of the property because it was deemed collateral in the loan contract.

So, when someone purchases a note, they have become the bank, and they’re entitled to some of the advantages and security that the bank is usually accustomed to.

Everyone is in the note business; they just don’t realize it because they’re on the wrong side of it. It’s hard to find a person who doesn’t have a credit card, car loan, student loan, or a mortgage.

The only problem is that most people are writing a check to a note owner instead of receiving one. The best way to get onto the other side of that equation is to start owning notes, rather than the other way around, and to do so, one must start by gaining a better understanding of the note business.

If you want to get clear on a few important definitions, I previously wrote an article, “Real Estate Notes: Key Concepts to Consider,” which may be helpful.

Why Invest in Notes?

The three most common asset classes that generate cash flow are: businesses, paper assets, and real estate. All of these have differing advantages and disadvantages, but notes have a number of benefits over other investment options. One of the most advantageous is the passive cash flow and synergy created between the other asset classes, which oftentimes can improve the chances of a more favorable outcome.

For example, an investor can have a note business that involves paper assets backed by real estate. Also, when a note is performing and being repaid by the original borrower, the holder of the note will receive payments every month, and more importantly, there is no work required to continue receiving these payments.

Aside from being an investment that is excluded from market fluctuation, some of the main advantages of investing in notes include the passive cash flow (as mentioned above), the level of volume and control, the collateral behind a secured lien, and the versatility regarding exit strategies for the note.

Volume and Control

As many of us do, banks also own real estate, but they would rather finance properties than own them. Sure, there’s much less, if any, property maintenance involved, and note portfolios can be managed via phone and computer from anywhere. But the main reason is that loan portfolios are more scalable and more liquid than property portfolios, and banks figured this out years ago. For example, it’s much easier to liquidate/sell a note than it is to liquidate/sell an REO.

Collateral

Unlike other paper assets (stocks, bonds, certificates of deposit, etc.), a note and mortgage is secured by real physical property. Owning a secured lien tied to a property, especially with equity, involves little or moderate risk, mainly because if the note stops paying, you have the option to foreclose on the property and recoup the initial investment. You also have the opportunity to offer foreclosure alternatives to homeowners, who would like to stay in their home. As “homeowners,” borrowers are less likely to vacate their property due to the emotional attachment (or emotional equity) to their home.

Versatility

Many investors love investing in property or hard Real Estate for all the varying opportunities it provides for making a profit. What most investors don’t know is that almost anything that can be done with a house can be done with a note.

Flip or wholesale a note (Example: selling as non-performing, as performing, or as a partial)

Rehab a note (Example: creating a loan modification or workout agreement with the borrower)

Borrow against the note (Example: Collateral assignment of note & mortgage)

Now that we’ve covered some introductory reasons to consider note investing as an option for your own portfolio, stay tuned, as we’ll be discussing how you can be successful without quitting your full-time job or necessarily having to pay a high priced guru.

Investors: Weigh in! Do you include notes as part of your portfolio? What are your questions about this form of investing?

Leave a comment below!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.