Note investing vs Buy and hold and how they affect net worth

[Greg W.]

I am seeking perspective from the savvy note investors as well as established buy and hold (rental property) investors regarding the "best" strategy to grow net worth over time.  I am a current house flipper and looking to start converting into more passive investments and am really interested in the note investing concept.  I'm not entirely sold on the idea of note investing over buying and holding rental properties.  I understand that an advantage of note ownership is that its typically viewed as a more passive investment (no 3am toilet phone calls) and that is what attracts me to this concept.  The part that I am having trouble with is long term equity.  What I mean by this is that it seems to me that as the course of the note is paid, the equity is being reduced and more importantly, how this affects your net worth.  With rental properties (assuming your using leverage), you receive the benefits of increasing equity (forced savings via mortgage reduction), ability to lend against the asset, tax benefits, depreciation, cash flow, and possible appreciation to name a few.  With a note (while you can force appreciation by converting from non-performing to performing) you won't see any other appreciation, taxed at regular income rates, and lowered equity over the course of the payment schedule and it looks to me that you are only investing for cash flow.  Investing for cash flow in my mind is fantastic, I just want that perspective from a more seasoned person than myself as it pertains to the long term.  I do understand that there are some ways to have the equity in the note eligible for some types of lending.  This post is coming from someone who is not an expert in either field but someone who is looking to become very familiar with the core concepts of note investing before taking the plunge.  Thanks in advance for your responses.

[Don Konipol]

@Greg W., Your analysis is pretty solid.  In order to MAINTAIN equity with an amortized note, you will have to reinvest the principal part of the P & I payment you receive each month.  To INCREASE equity, you will have to reinvest both the interest and at least part of the principal payment.  What is lacking is protection from a sudden surge in inflation - or devaluation of the dollar.

What I try to do, to get the best of all worlds, is I have 50% of my portfolio in performing notes, and the other 50% in real property.  The real estate is leveraged 50%, so the total 'inflation protection' covers 100% of the total portfolio.

The notes are held in my tax deferred retirement accounts, so current income is not taxed until withdrawls begin at 70 1/2 years old.  Real property is held outside the retirement account, and while tax is paid on income/rents, depreciation will defer about 30% o the income, and the new tax law may eliminate tax on another 20%.  

So, my portfolio ends up something like this:  my notes average yield 16% (I buy some notes at discount, others I originate at 12- 18% interest), all of which is tax deferred.  Because I invest in income producing property, my net rental yield is around 8%, with yearly increases, leveraged with 4-5% loans, creating a net cash flow and debt reduction yield of about 10%.  My overall portfolio yield (exclusive of appreciation of real property of note discount at purchase) is about 14 - 15% annually.  When the capital gains are added on both notes purchased at discount and paid off at full face value, and real property appreciation, I obtain my 20% goal, on a very passive participation basis.