Your Guide to Investing in Real Estate Mortgage Notes

Welcome to the exciting world of real estate note investing! While you might think that I’m being sarcastic, please note that I’m 100% serious. Investing in real estate notes is a unique alternative to hard real estate acquisitions. If you want it to, a note portfolio can generate completely hands-off income streams, putting the “passive” back in “passive income.”

If you’re fed up with the hassle of being a landlord, keep reading.

What Is a Promissory Note?

A promissory note (often just called a “note”) is a formal IOU from a borrower promising to repay a debt. The note spells out the loan terms, and the borrower signs it to indicate their consent.

A note will typically specify:

The borrower and the lender
The amount borrowed
The interest rate
The repayment schedule
The date and location of issuance
What happens in the case of default

Once the borrower issues the note, the lender holds on to it while the loan is outstanding. Anytime before the borrower makes the last payment on the loan, the lender can trade or sell the note. Once the borrower fully pays off the loan, the creditor marks the note as “paid in full” and returns it to the borrower.

Lenders and borrowers can use promissory notes to memorialize various types of loans, but since we’re all real estate investors here, I will just be discussing mortgage notes.

What Is a Mortgage Note?

Mortgage notes are associated with home loans and secured by the real estate purchased. When someone takes out a mortgage, the bank or lending institution will usually have the borrower sign both the mortgage agreement and a promissory note.

Some states use deeds of trust instead of mortgages, but for our purposes, they’re essentially the same. In short, the promissory note captures the loan terms; the mortgage or deed of trust secures it with the real estate you’re purchasing. The lender will record their lien by filing the mortgage at the county land records office, but they’ll hang on to the note.

While promissory notes and mortgages are two separate documents that serve different purposes, they have a symbiotic relationship of sorts. You won’t find one without the other. Notes and mortgages are the peanut butter and jelly of the real estate financing industry.

What Does It Mean To Invest in Mortgage Notes?

Purchasing mortgage notes is an often overlooked method of real estate investing. Unlike hard real estate purchases, you don’t own any property with a note-based strategy. Instead, you step into the bank’s shoes and become the borrower’s new creditor. When you invest in notes, you buy debt, not real estate.

Where Can I Find Mortgage Notes To Buy?

You can purchase notes on the secondary market. What that market looks like depends on whether you want to take a risk on a non-performing note or play it safe(r) with a performing one.

The Different Types of Mortgage Notes

Non-Performing Notes

Remember, investing in notes equates to buying mortgage debt. As we all probably know a little too well, some people pay their debts on time, while others do not. If the borrower is behind on their payments or in default, the loan is considered non-performing.

If you invest in a non-performing note, your ROI will likely depend on a foreclosure or collections. Due to this type of investment’s inherent risks and the work involved, banks are often willing to part with non-performing notes at a discount—and sometimes a substantial one. If you are confident in your ability to navigate the waters of foreclosure or collections successfully, non-performing notes might be the way you want to go.

Performing Notes

Purchasing notes for mortgages with a steady track record of on-time payments are generally safer and less involved investments. When the borrower makes their payments on time, and the loan is not in default, it’s considered performing.

The appeal of performing notes is that investors can start receiving payments almost immediately—minimal effort required. However, since these loans are making money, you won’t get as big of a discount as you would for a non-performing loan, so your ROI will usually be lower.

Is Buying Mortgage Notes a Good Investment?

The reasons investors are drawn to real estate notes vary, depending on their investment strategy. An appealing feature of performing real estate notes to many investors is the hands-off nature of the purchase. Since you don’t own the property, you don’t have to deal with tenants or property managers, make repairs, or worry about city codes. You just get to kick back, put up your feet, and collect the borrower’s payments.

If you invest in non-performing notes, you’re probably going to have to get a little more hands-on to get the ROI you want. Investors that take this route view non-performing notes as a way to pick up real estate on the cheap.

No matter your approach, real estate notes can be an exciting addition to your portfolio. If I’ve managed to pique your interest and you want to learn more, check out my guide on “Note Investing: How To Find and Finance Real Estate Mortgage Notes.”

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