How to Practice Due Diligence with Real Estate Note Investments
Mortgage notes are one of the most popular asset choices for self-directed IRA investors.
These real-estate-backed debt instruments can provide a good mix of principal security and consistent returns. Mortgage notes also offer diversification from the volatility of market-based investments.
But to ensure good results when investing in notes, it’s important to do your homework first.
Investing in the right notes the right way can be a powerful way to grow your retirement savings. And investing in the wrong notes can be an expensive mistake.
Read on to learn how to understand 3 ways to acquire mortgage notes in your IRA, and the key factors to evaluate when considering note investments.
Understanding the Type of Note
There are many kinds of note transactions available in the marketplace, both in terms of how the notes are acquired and how the notes are secured.
Understanding the differences is important to evaluating risk. These differences also determine what areas of diligence you’ll want to focus on when evaluating a specific transaction.
There are 3 primary ways of acquiring notes:
- Originating the note yourself
- Purchasing notes from the originator
- Purchasing notes from a broker
The most common types of notes include:
- 1st Position performing notes
- Junior liens
- Non-performing notes
Types of Borrowers:
- Residential homeowners
- Individual investors
- Corporate investors
The process of originating a note yourself, perhaps as part of the sale of an IRA-held property, is very different from purchasing a discounted non-performing note from a broker.
The following are some of the key factors to evaluate when considering a real estate note investment for your IRA:
Equity in the Property
With performing 1st position notes, or some junior notes, one of the most important factors to consider is equity in the property, or loan-to-value.
If the note value is well below the current market value of the property, that provides a good backstop should the borrower fail to repay the note.
In a foreclosure process, your IRA is likely to come out whole if the loan balance is less than the property value.
If the note is close to or more than the value of a property, it’s a riskier proposition. In some cases, there could be significant equity in a property to cover both a 1st and 2nd note — meaning that equity level becomes a factor for evaluating a 2nd position lien.
In the case of a no-equity 2nd position note, the risk is higher. In this case, other factors would come into play when determining if the note is a good investment.
A property that’s in a good location will hold its value better than a property in a poor location.
Location is a diligence factor that helps you chart the “worst case scenario” risk.
If the note goes into default, will the value of the property be enough to cover the balance of the note, or create the possibility of a favorable exit strategy through deed in lieu or selling the note itself?
A higher quality property paired with a good equity position is a safer bet than a loan with a high loan-to-value ratio in a lower quality location.
Location can also affect regulatory simplicity. Some states are much more lender-friendly than others, or have longer or shorter foreclosure timelines.
Understanding the regulatory environment is important when evaluating the risk associated with a potential default by the borrower.
Borrower’s Ability to Pay
When lending on a short-term basis, like with new-construction or rehab loans, the borrower’s personal finances are usually not a big factor in the lending decision.
The project plan and borrower’s transaction history are generally weighted more heavily. The opposite is true when the borrower is living in the property.
If you’re originating a loan, or purchasing a freshly issued performing note from a broker, then detailed underwriting should be a part of your process.
It may make sense to involve a professional licensed loan originator who will have a structured process for analyzing a borrower’s overall financial situation. This can include credit scores, income, existing debt, potential judgements, etc.
When evaluating resale notes or non-performing notes, payment history is just as important as the overall creditworthiness of the borrower.
The longer someone has been successfully making payments on a loan, the more likely they are to continue paying, even if they have certain financial stresses.
This payment consistency is a positive both for payments from day one of the loan, and for situations where a borrower in arrears has started getting caught up. The longer they’ve been doing so, the higher the likelihood of success.
Making sure there is no risk of other senior liens against a property is important — especially with new loan originations.
You’ll want to be sure there are not outstanding liens associated with real estate taxes, homeowner’s association dues or insurance.
Even if there aren’t any outstanding liens, you still want to have a handle on these factors, as they could turn into senior liens of a borrower fails to pay on these items.
No matter how good the numbers and other factors related to a note purchase may be, a mortgage may be unenforceable if it’s not properly documented.
You’ll want to ensure that all necessary state regulations have been followed with respect to the underwriting of the loan, as well as the documentation and recording of the mortgage.
It’s important to work with a licensed professional familiar with the lending laws of the state, as each state has different rules.
Work with Professionals
While private lending transactions can be a great investment for your self-directed IRA or Solo 401(k), there are many considerations that go into selecting the right investment notes.
It’s important to ensure that the documentation of the loan is thorough and in compliance with state lending laws.
Working with a licensed mortgage broker, title company, or real estate attorney is the best way to protect your interests and ensure your mortgage contract is enforceable.
Contact us today to find out more about practicing due diligence with real estate note investments >
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