Performing Real Estate Notes v. The Stock Market

Performing real estate notes or the stock market: Which investment offers lower risk? Which investment is likely to produce greater reward? We answer these questions — and more — right here, right now!

When it comes to investing, the first issue an investor should consider is risk.

Funds which are invested in stock and mutual funds are unsecured investments. If, for example, a person were to buy stock in the ABC Widget Company, it is possible for that company to go bankrupt and for the value of that stock to go to zero.

Real estate notes, on the other hand, are — by definition — investments which are secured by real estate. It is possible, of course, for a real estate note to go into default if the borrower stops paying. When that happens, the remedy is foreclosure.

Because foreclosure can be expensive and time consuming, it is important for a real estate note investor to have plenty of what those in the note business call “protective equity.”

The term “protective equity” means the existence of “positive equity,” and is calculated as the difference between the current market value of the parcel of real property which acts as security for the defaulted note and the unpaid principal balance (UPB) then owing on the note (along with the balance of any senior loans, if the defaulted loan is not in first position).

The amount of protective equity should, at a minimum, be sufficient to pay all foreclosure and related costs, and thereafter allow the investor to recover the entire UPB on the defaulted note.

Thus, we see that in a “worst case” situation, it is possible for a stock market investor to lose the entire amount of an investment, while a real estate note investor should be able to at least recover the UPB on a defaulted note investment, after paying costs related to foreclosure.

After looking at risk, the next issue an investor is likely to address is return on investment (ROI).

Currently, it appears extremely difficult for investors to earn returns of five percent (5%) or more on stock market investments.

Although there can never be any guarantees when it comes to investing, a performing note that produces only a five percent (5%) ROI would, in the current market, probably not be viewed as one of the better note investments.

When deciding whether to purchase a performing real estate note for investment purposes, one should ask (and answer) the following questions:

1. What rate of return am I currently earning on my investable capital?

2. What rate of return would I find acceptable, given the understanding that, typically, higher rates of projected returns are usually indicative of higher rates of investment risk?

3. How long am I willing to have my investment capital deployed, given that a real estate note is an illiquid asset and likely a long-term investment? Statistically, most Americans will sell or refinance their homes in less than ten years, even though a home loan may be amortized over many more years. However, receiving payments on a note until the note’s maturity date should not be a troubling prospect for a note investor. After all, receiving a regular monthly payment, each and every month, typically in the same amount every month, is exactly what a note investor wants (and what an investor in the stock market rarely gets)! Investment of retirement account funds typically presents less of an issue in this regard, unless an investor is approaching retirement age.

4. How much investment capital can I safely deploy for a real estate note investment? As with any investment, an investor should consult with the investor’s trusted advisors prior to investing and should never invest capital that may be needed to meet the investor’s day-to-day living expenses or other reasonably foreseeable financial needs.