Fund Investing vs. Passive Note Investing

People often ask me when they’re first introduced to note investing, “Which is better, being in a note fund or investing in the actual notes?”

My answer is: “I don’t really know, that’s why I do both.” But, there are advantages and disadvantages to doing either.

Not everyone wants to be an active nonperforming note investor. By that I’m referencing the working of nonperforming notes, where the investor has to play a very active role with borrowers and attorneys, and where many other skill sets are required.

If you’re a more passive investor with a limited amount of time to deploy towards the note business, then investing in a note fund or in re-performing mortgages might be for you.

Fund Investing

If you’re a high net worth individual then fund investing might be for you, as many funds require investors to be accredited.

What does it mean to be accredited?

An accredited investor is a natural person with $1 million in net worth (can be individually or joint w/spouse, doesn’t include primary residence); or a person with $200,000 income if single, $300,000 joint income if married.

There are also additional ways that an investment company, business, or charitable organization may qualify as accredited. To view the SEC’s full definition and list of qualifications, click here.

By investing in shares of an LLC, there can be less responsibility, accountability, and most importantly liability. You’re overall exposure cannot be more than your investment. I enjoy fund investing myself, and to be quite honest there’s nothing like mailbox money.

But, there are also additional advantages of fund investing:

Buying Power – by pulling money together, you can purchase in bulk instead of buying individual notes.

Professional Management and Experience – if you invest in the right fund, you can benefit from their professional management and experience in acquisitions, workouts, note management, etc. You wouldn’t need to have experience managing notes for yourself.

Sources – a fund may have sources for assets that the individual investor doesn’t have access to. For example, some funds allow investors preferred access to assets purchased by the fund. An investor could potentially redeem shares to purchase re-performing notes (upon availability).

Back Office Support – for a fund investor, there’s no need for employees. A fund can take care of any legal or accounting work.

Less Due Diligence – besides reviewing the management team you’re investing with, you wouldn’t need to know how to perform due diligence on each asset purchased by the fund, and you wouldn’t need to pay for any of the services that process entails.

Anonymity – if investing in a private placement, your personal name typically isn’t out there. For example, other than the managing member(s), the general public wouldn’t know the names of participants in the fund.

Diversification – a fund investor may have more diversification in numbers without deploying the amount of capital needed to purchase all of the fund’s assets. For example, if a note deal in the fund were to go bad, this typically wouldn’t have a large impact on the investor. It’s a great way to invest in many notes (their locations and markets), while spreading the risk amongst all the assets that are owned by the fund.

Alternately, I’d say the biggest disadvantage to fund investing would be a lack of day-to-day control for the investor.

Most private placements also provide for an orderly distribution of any remaining assets in the case where there was liquidation, and in some funds, investors don’t get to share or enjoy any upside in the fund. However, this also may be a matter of preference, as some investors prefer to receive reliable payments each month from a fund that offers a flat rate.

Passive Note Investing

Investing in the actual re-performing notes gives an investor greater control, but you’re also at the mercy of the borrower when it comes to receiving payments.

If you bought a note without a warranty, for example, you will be forced to handle any foreclosure issues yourself and at your expense if the homeowner were to re-default.

With note investing, there are also some distinct advantages:

Access – a big plus is that almost anyone can invest in a note. In other words, you don’t need to be accredited to have access to this investment.

Control – if you’re the owner of the note and something goes wrong with the deal, you can jump in and contact the homeowner or do something to turn the deal around.

Possible Higher Yield – depending on the outcome of the deal, the yield may be higher than that received from a particular fund. The good news is that you never really know when you may get cashed out (although the average mortgage only lasts 5 to 7 years), which would dramatically increase one’s yield.

Collateral – when you purchase a note and mortgage, there is an actual property tied to it. The borrower may have a vested interest in making payments if they consider that property their home. It’s a more passive way to invest in real estate as opposed to owning the property (although there is the possibility that you may end up with the property).

A Secured Asset – purchasing a note and mortgage would be purchasing a secured asset (tied to collateral), as opposed to unsecured debt (credit card, medical, student loan, etc). A secured asset protects the lender more, since it can be liquidated to satisfy the lender’s debt.

Servicing – you can utilize a mortgage servicer to perform the accounting. Some note sellers may already have their re-performing notes placed into servicing, so it could be a more seamless transition for the homeowner and the investor.

The biggest disadvantage of note investing would probably be the increased level of responsibility. For example, you have to make sure you or your mortgage servicer is compliant.

And there is less anonymity since your name (as a sole proprietor) or the name of the purchasing entity is recorded on the assignment and required to be announced to the homeowner in the RESPA letter.

So, as you can see it’s hard for me to tell you which one is better, since I actually do both.

I invest in multiple commercial real estate funds and note funds. Also, I own many notes. But, I wouldn’t want to put all of my capital in just any one of these investment vehicles, as I prefer to diversify between them.

Another reason that it’s hard for me to tell which one is better is because they have different timelines for when I will be able to exit the investment and reflect on its overall performance (for example, a 3-5 year fund vs. a 20-30 year note). Also, it’s tough to tell because I typically roll my preferred returns back into my fund investment or use the interest payments from my note to buy more notes.

So, which one do you like better?

Be sure to leave your comments below!

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