There are various types of notes that can provide attractive returns, including longer term private mortgages or short-term loans to flippers often referred to as hard money lending. Because the loan is secured by real property, there is a certain degree of stability and security. Notes provide consistent returns, with payments coming in each month.
Non-performing notes are another facet of this asset class, and represent an opportunity with a higher risk factor, but a corresponding potential for exceptionally high returns.
What is a Non-Performing or Distressed Note?
When a borrower takes out a loan for the purchase of real estate, the lender’s capital is secured by a mortgage or deed of trust and a promissory note. If the borrower fails to repay the debt, the lender has a lien against the property and can choose to foreclose on the property to redeem their capital.
In some cases, the lender, whether a bank, investment fund or other private lender may choose to sell the note at a discount to another investor rather than go through the process of foreclosure. This can save the original lender a good bit of time and expense, and allow them to recoup an acceptable amount of their original investment.
This type of distressed note can be a good opportunity for self-directed retirement plan investors.
Finding and Buying Non-Perfuming Notes
It can be difficult as an individual investor to purchase non-performing loans directly. Most banks sell pools of notes to large institutional investors such as hedge funds and private equity groups. Such transactions typically run in the hundreds of millions of dollar ranges. There are many such large investors that choose to break apart their pools and sell individual notes to private investors, and several firms specialize in offering such notes.
There are also companies that market to homeowners in default, negotiate with the bank to purchase the note and then resell those notes. This is a marketing and time-intensive enterprise that is generally beyond the capabilities of an individual investor, but the resold notes can be a good opportunity.
Understand What you are Purchasing
The ability to purchase a note at a significant discount from its face value can be a lucrative opportunity, or it can be a total loss if done incorrectly. It is important to fully understand the nature and condition of a note being sold, so that you can minimize your risks and secure solid returns for your retirement dollars.
Notes can be in a first position, meaning the note holder has a senior position to foreclose on the property. These are the most secure types of notes, but can still have risk exposure if there are other liens such as state or local taxes or a legal judgement against the property that would have seniority over the mortgage.
A note secured by a second position lien is worth considerably less as it has less security. The 2nd position note holder would need to pay off the first position note in order to have the right to foreclose.
In either case, it is important to ensure that you conduct thorough title research to ensure the quality and standing of your position should you purchase a note. Some note brokers will provide title insurance, which guarantees that there are no unknown liens with senior rights. Another tool provided by some sellers of notes is a broker price opinion (BPO) of the subject property provided by an independent realtor or appraiser.
Making Money with Distressed Notes
Generally speaking, the borrower is not currently paying on the note, and they may not even live in the property any longer. A note with no payments being made will certainly not produce any income, so you will want to pursue one of several paths to create a profit on the note your IRA or 401k has invested in.
One option is to work with the borrower and modify the terms of the loan. If there was a reasonable amount of equity in the note, you can reduce the total amount owed and still receive solid income. You might also choose to reduce the monthly payments to something the borrower can afford, perhaps stretching the term of payment to do so.
The following example illustrates this path:
- Original loan amount: $200,000
- Interest Rate: 6.20%
- Balance owed: $180,000
- Current home value: $150,000
- Discounted note cost: $100,000
While the homeowner cannot afford the $1,225 monthly payment on the original $200,000 loan and may not see the point of paying that much when the house is worth less than the loan, they may very well be able to afford a $919 monthly payment on a new loan amount of $150,000, which represents the current value of the property.
Once payments are being made, the note is now performing and is immediately worth more than it was originally. You can choose to keep the note in your retirement plan and receive the monthly payments, or you could sell the now performing note to another investor at a higher value than your original purchase. After the borrower has paid for several months, they would qualify to refinance the loan and you would get paid off on your $150,000 note, making a $50,000 profit on your $100,000 investment.
Deed in Lieu
There are some situations where the original borrower may just want to be out from under the burden of the original debt. In these cases, you may be able to negotiate a deed in lieu, whereby the borrower signs over title to the property as remedy for the outstanding loan. If you purchased the note for less than the property is worth, this can be a good path to profit. You can choose to have your self-directed plan hold the property as a rental, or sell the property at a gain.
Another option if the borrower really wants out of the property is to allow them to execute a short sale. As the lender of a first position note, you control the transaction and can approve any negotiated sales price. If there is equity in the property relative to the amount you purchased the note for, the house can be sold for less than what is owed, and your IRA can still make a good profit.
An example follows:
- Balance owed on note: $250,000
- Current home value: $200,000
- Discounted note cost: $150,000
If the home is sold for $200,000, those proceeds will go to your IRA or 401k. You have forgiven $50,000 of debt to the borrower, but still made a hefty profit of $50,000.
This option is generally a last resort, and can take considerable time and expense to execute, depending on state laws. When researching the purchase of a note, you should be sure to understand the foreclosure process and evaluate the transaction with this in mind as a “worst case scenario”.
In a foreclosure situation, you can either let another investor purchase the property at auction at a price that still provides a return on investment to your plan, or you can take ownership of the property and hold it as a rental or fix it up and resell it.
Using a Servicer is Key
When investing in non-performing notes with your Checkbook IRA or Solo 401(k) plan, using a 3rd party loan servicing company is the best way to go. There are many note servicing companies that can help you execute any of the above strategies to turn a profit from your non-performing note investment. They will have the right legal and title infrastructure in place and be familiar with the laws of the state where the property is.
Even if you have the capacity to work the process yourself, perhaps with the guidance of your attorney, it is better to use a 3rd party servicer when investing with a self-directed plan. Doing so eliminates any concerns that you may be engaging in a prohibited transaction through providing goods or services to your plan.
While investing in a single note and negotiating with the borrower on a modification may not create any issues, committing the time and expertise required to execute a large number of such transactions, or directly handling more complex events such as the foreclosure process could very well be viewed as providing services to the plan.
As with any investment, there are details you need to understand to minimize your risks and maximize your profits. If you are willing to commit the time to learning about the distressed notes market and perform diligence on the notes themselves and the providers you choose to work with, these types of notes can be a great opportunity to grow your tax-sheltered retirement savings.