Newbie questions on buying mortgage notes

[Haritha N.]

I am fairly new to the concept of buying/selling mortgage notes and I have been reading about it. From what I understand (to put in simplistic terms):

• Lenders (could be banks, financial institutions, private people) lend money to borrowers for purchasing properties. They do this in the form of recording a note between the lender and the borrower by having the property as the collateral.
• Lenders then sell the note to investors (institutional, private) online or through loan servicers, brokers and other channels. Now, the buyer of the note for a property becomes the lender as far as that property is concerned. Any P&I payments that the borrower makes go to the new buyer lender. Satisfying escrow, tax and other legal requirements of the mortgage are now the new buyer lender's responsibility.
• If the mortgage is paid as per the terms till the end of the loan term, the new buyer lender will get the P&I payments from the borrower for the remaining months of loan term from when he/she bought the note.
• If the borrower defaults on the payments, it is the new buyer lender's job to evaluate various avenues like loan restructure, deed in lieu, refinance, foreclosure and arrive at the best possible action by discussing with the borrower. If it goes to foreclosure, the buyer lender will incur additional costs for notice of default, auction, follow up, lender-own, repair, sell/rent the property.

My questions are:

For a performing note, why would anyone sell it at any cost less than unpaid balance? For example, if the unpaid balance is $150k, LTV is 45%, why would a seller want to sell it for $147k, even a difference of 3k ?

If a performing note stays performing till the end of the loan term, it is almost as if we did a CD or high yield savings account with the loan interest rate for the loan term  - of course, in a CD, you will get interest only for the term and get your principal at the term end. When we buy a note, we get interest and principal throughout the term so that principal diminishes over time. If this is the case, why don't investors flock to buy the mortgage notes instead of buying an investment property?

Assume we buy a performing note for full UPB of $150k with 6% rate for 240 remaining months, we get $899 per month of p&I throughout 240 months. It seems like a safe earning of $10k per year for $150k investment. In the worst case if the borrower defaults, we could choose to profit by helping the borrower continue to pay or foreclose.

• If I buy a house with the same $150k and assume it rents for $1500, we got to deduct about 40% of the rent (=$600) for all the repair/propmgmt/capex/vacancy expenses, we get $900 per month. If the expenses are a bit lesser, we may get $1000.
  

• If the difference is only $100, why would it make sense for someone to buy an investment property rather than buying a performing note? Performing note will be more liquid than buying the property too - we can hold the note as long as we want the cashflow. If we want to get the cash out, we can sell the note. What am I missing?
  

If I want to start buying performing notes, where do I start? FCI exchange site is not working. I could see one site paperstac, that I will register with. But, it has about 177 listings when I checked, seems less pool of notes. 

As an individual person, can I buy a note without any license? Does it vary from state to state?

If I want to buy a house, the team that I would be looking for is - buyer's agent, prop mgmt, prop inspector, prop appraiser, attorney, title company. Similarly, who are the partners that I should look for if I want to buy a note?

Do you have any platforms that you use to know the new performing/non-performing notes that are added from multiple lenders? I will do my due diligence once I come across a listing, but, where do I see these listings in the first place? 

I am sure I will have more questions as I learn more. Appreciate inputs from experience note investors.

[Don Konipol]

@Haritha N., you've come to the right place to get your questions answered and to learn about real estate and real estate type asset investing.  You've got some quality answers, so I'll just address a couple of things that were not answered.

First, this is a technical point, but someone who buys an existing note is not the lender; he is the note holder.  The lender is the entity or person that funds the note at its origination.

In answer to your question about if returns are equal, why would anyone buy real property instead of notes?  The answer is that although the immediate cash flow may be equal, real property's opportunity for additional profit that notes do not.  Real estate has historically gone up in value over time, at least at the rate of inflation.  So a property purchased this year and held for 20 years may easily be worth double what it is worth today.  Notes will only increase in value if interest rates decline, if rates rise they will decline in value.  Of course if you hold a note to maturity you won't realize this gain or loan.  But notes don't have the opportunity for appreciation that real property does.

Additionally real property can usually be fairly easily leveraged, which notes cannot.  So, if you borrow 80% of the purchase price at say 4% interest, and your return on the investment total cost is 6 %, your return on your invested dollars will be increased by approximately 8%, turning your 6% return into a 14% return.  Of course, any use of leverage entails additional downsized risk.

Also, real property ownership has tax benefits that notes do not.  Real property can be depreciated, at an amount thats greater than the real loss of value for improvements thats occurring.  In fact, most real property does not incur a loss of value if properly maintained, so depreciation allows some of the net income to be tax deferred; tax strategies are available which may lead to the elimination of having to pay the deferral.

So, as a consequence real property also acts as a store of value in times of high inflation.  As currency loses its value and purchasing power, ownership of real property can be a safe haven equaling or even exceeding loss of purchasing power.

Another point I'd like to emphasize is that their is substantial difference between various categories of notes; the note universe contains many different investment types and lends itself to many different strategies.  The first difference is between residential mortgage notes and commercial mortgage notes.  Within residential you have owner occupied notes and investor notes.  Within owner occupied you have primary residence and secondary residence.  Notes can also be classified as conforming or non conforming, Dodd Frank compliant or exception, performing or non performing.  

For individuals, buying performing notes from a lending institution is not a possibility.  These notes if conforming are sold to Fannie Mae or Freddie Mac, if non conforming are packaged and sold as mortgage backed securities.  So for performing notes this leaves notes that were done as owner financing when a property was sold.  The good ones are bid up by mortgage pools; the lesser quality ones often find their way onto the note exchanges that seem to pop up all over.  These are often reperforming notes, and while some peoples experience with these has been good, I think we will hear quite a different story after the next recession.  My advise: take any advice with a grain of salt if the person giving the advice was not an active investor prior to 2009!

As for non performing residential notes, well thats where most of the note players on BP play.  The most successful ones are able to pick through the over priced garbage out their and identify the few gems hiding in the pile.  To do this successfully takes A LOT of knowledge, experience, analytical ability, negotiating smarts and hard work.  

Lastly, you can invest in either performing or non performing, residential or commercial, either through a note broker or as a participant in a mortgage fund or pool.  The quality of these notes, as well as the mortgage funds are all over the board, good, bad and ugly.  As in any investment due diligence is a necessity.

Lastly, my observation after 40 years as an investor, broker, fund manager and syndicator of both real estate and of mortgage notes: Notes are the more difficult investment to get right.  I've seen many investors who didn't know what they were doing get bailed out of a bad situation because over time the property they purchased increased in value.  A property increasing in value 5-15% per year covers a multitude of sins.  However, people who made bad note investors don't get bailed out by capital appreciation; their mistakes are compounded by their lack of control over the property, by a court system that assumes the note holder is a bad guy and the borrower a victim; by foreclosure laws requiring a note holder to jump through loops and pay huge legal fees to repossess a property for non payment, by not obtaining title insurance and discovering that their are superior liens on the property, by note sellers who provided incomplete or misleading information, etc.  IMO, investing in notes successfully requires a lot more knowledge than investing in real property.