Every investment comes with risks. Usually, the higher those risks are, the higher the potential yield.
Real estate notes offer an advantage over many other types of investments in that they’re secured by a lien on the property in question. That means with the right information, you can minimize your risks and still receive an attractive rate of return—from 7-9% on longer-term loans to 12-15% on shorter-term loans.
There are many different types of real estate notes to choose from. Investors can find opportunities in seller-created notes, newly originated quality trust-deeds, investing in riskier mortgages, or buying up non-performing notes at a discount. Regardless of what type of note investment you’re considering, the key to success is to understand the asset, the borrower and the risk.
Ask these questions before investing in a real estate note:
What is the current property value?
When you’re deciding whether to invest in a real estate note, the property’s current value is one of the most important pieces of information to gather. Smart investors will take into account the value of the collateral securing the loan when deciding how much they’re willing to pay for a note.
Assessing the true value of a property can be tricky in today’s market. Some investors use the “drive-by” appraisal method, in which the appraiser takes photos of the property from the street without entering the interior. However, if there are any concerns about the property, or if you need to verify substantial improvements that will affect its value, you may need to perform a full appraisal.
What is the loan-to-value ratio?
The primary risk in a real estate note investment is that the borrower will fail to make payments, thus interrupting your cash flow. You can minimize this risk by ensuring that the size of the loan is proportioned appropriately to the value of the property. That way, if the buyer defaults you can sell the property for more than the balance of the loan.
Many investors calculate the loan-to-value ratio to determine whether a real estate note is a safe investment. Divide the amount you’re lending by the value of the property, and multiply by 100 to get a percentage.
This number addresses the underlying question: What is the likelihood I’ll get my money back if the borrower stops making payments? Typically, the higher the risk a lender poses, the lower the loan-to-value an investor will offer.
How likely is the borrower to keep making payments?
Asking this question helps you assess the risk involved in your investment. Investigating the borrower’s payment habits and history is a good starting point, but to get a clear picture you’ll need to look at more than just the person’s credit report.
Find out how much equity the borrower has in the property. The larger the down payment, the more likely it is the payments will continue—and if the borrower is unable to continue making payments, he or she will be in a better position to sell the property and pay off the note rather than allow the property to be foreclosed. Some investors recommend sticking with properties with at least 10 percent current equity.
It’s also useful to know how long the borrower has occupied the property. Someone who has lived in a home for several years will have a greater emotional investment than someone who has lived there for only a few months.
Where is the property located?
The property’s location can play a big role in the success of your note investment, so it’s important to understand collateral values and state laws in the place you’re investing. Foreclosure laws, for example, vary from state to state, and in some states foreclosure can be a long process even if the borrower stops making payments. Many seasoned note investors are highly selective about property locations, preferring to stick with regions where they have prior experience.
What is your exit plan?
Before you invest in a note, make sure you have an exit plan in case the borrower defaults. Will you take possession of the property through foreclosure, or will you sue the borrower? Will any repairs be necessary before putting the property on the market? Outline in advance the steps you’ll need to take to recover your investment—just in case.