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Mortgage Notes vs Real Estate Rentals

Comparing Secured Notes to Income Producing Properties

NotesRentals
Higher yieldLower yield
Less workMore work
Finite cash-flowIndefinite cash-flow
Foreclosure/BorrowerEviction/Tenant

A diversified portfolio should include a variety of investments in different asset classes: stocks, bonds, real estate, precious metals, cryptocurrencies and more. Within each of those categories there is even more diversification necessary!

Focusing specifically on real estate, two great long-term investments to build your passive income portfolio are performing mortgage notes and tenant-occupied rental properties.

Cash-Flowing Real Estate

There are many different types of income-producing real estate to choose from. Some require more effort, others are easier to manage passively. At the end of the day, the biggest advantage that any of these real estate options have over mortgage notes is that when you own real estate holdings, you own the asset for the long haul.

Single-Family Residential (SFR)

  • Most common type of residential real estate, abundant in virtually every US real estate market
  • Variety of options across different price-points: occupied/turn-key, vacant but ready to rent, rehab necessary, etc
  • Financing options are inexpensive and plentiful, leveraging low-interest rate debt is easy with a decent credit score

TIPS: 3+ bedroom homes in good school districts have seen ample appreciation. Rural properties should be considered very carefully – more difficult to keep rented

Multifamily Residential (MFR) and Mixed-Use

  • 2-4+ units (duplex, triplex, etc) offer investors more rental units in each building
  • Commercial lending is most likely, adjustable rate loans and short terms are possible
  • Maintenance & management is more efficient with multiple tenants under a single roof
  • “House-hacking” is an option for investors who live or work in one of their units

TIPS: Creative financing/purchase options like seller financing or lease-option agreements are more palatable to investor-sellers than private home-owners. Mixed use properties allow more flexibility for commercial purposes

Short-Term/Vacation Rentals

  • Often seasonal, short-term rentals generate more cash-flow per square foot
  • Turnovers are much more frequent, typically every few nights or weekly
  • Operating costs are much higher due to marketing, vacancy, utilities & management
  • Many platforms to assist with screening & booking: Airbnb, VRBO, etc
  • Not all properties make good short-term rentals… location, location, location!

TIPS: Prepare for a business venture closer to hospitality than passive investing, aim to achieve AirBnb Superhost status or the equivalent to maximize earnings

Garage & Self-Storage

  • Much lower overhead than residential if operated efficiently
  • Many more tenant relationships & lease contracts
  • Larger initial investment for quality asset

TIPS: Achieving scale with multiple, proximate buildings or the purchase of a large facility allows for critical economies of scale: dedicated hire for leasing, management, etc

Real Estate Investment Trust (REIT)

  • Private or publicly traded fund that invests & manages cash-flowing residential & commercial real estate
  • 100% passive, make sure you properly vet the managers 
  • Diversification is easier and options are plentiful: specialty REITs include agriculture, cell tower, etc

TIPS: No control over operations, more similar to owning stock than investing in real estate, not recommended as a large piece of your passive income portfolio as there is no long-term benefit to your personal resume

Cash-Flowing Mortgage Notes

Compared to traditional real estate investments, mortgage notes give investors a much more hands-off, higher-yield option that is still backed by the underlying real estate collateral. Income-producing mortgage notes are an amazing wealth-building asset for investors to add to their portfolios but it is important to understand the types of notes, the advantages/limitations of each and how to successfully profit from a mortgage note investment by mitigating the down-side and maximizing the advantages of owning real-estate secured assets. We’re only going to be looking at notes secured by residential real estate below (see our case studies to learn more about unsecured debt or the occasional commercial note)

Performing Mortgage Notes

In order of expected yield, from lowest to highest – performing notes are first on the list. Performing notes have never been in default, they are paying “As Agreed” per the terms of the original promissory note. It’s unlikely that you will find performing notes originated by institutional lenders on the secondary market, since most bank notes are only sold to private investors after they have been charged-off. However, private investors originate secured promissory notes that are resold to cash-flow investors. Yields are typically <10% cash-on-cash for loans that are performing

Re-Performing Mortgage Notes

Re-performing notes or RPLs (re-performing liens) give investors a stronger return on investment. These loans were in default at one point but are now paying again, most likely under the terms of a new modification agreement. You can expect more than a 10% annual yield on most RPLs, higher for junior liens – sometimes approaching 20%.

When an RPL is created through a modification agreement with a private note investor there are a few things to look out for:

  • Complete collateral files (note, mortgage, full chain of assignment & allonges)
  • Active servicing agreement with licensed servicer, consistent payment history of 6+ months
  • Complete modification package (including balloon addendum if necessary, ACH authorization and lender added to property policy as additionally insured)

Non-Performing Notes (NPN or NPLs)

Although they aren’t cash-flowing at acquisition, NPLs offer investors higher returns when they are able to create a resolution to the borrower’s default. Note investors that buy non-performers must be ready to pivot in a few different directions depending on the borrower’s ability to repay and intentions. Many NPLs resolve when the borrower signs a modification agreement but investors should be ready to take back the collateral property in some cases. A simple way to conceptualize the resolution process: the deal is either exited through the borrower or through the property.

Resolving with the Borrower

There are many types of borrower resolutions, including discounted or full payoffs, modification agreements and structured settlements. These are the exit strategies that investors utilize when the borrower wants to keep the property and pay off the loan in full or in installment payments. An investor’s due diligence process can help them determine the likelihood of these types of exits based on the borrower’s occupancy, equity and status of senior liens or tax balances. Learn more about the Due Diligence process by reading our free course.

In our experience, junior lien investors see more deals resolve with the borrower, especially when they are targeting owner-occupied, high-equity loans behind performing senior liens.

Exiting through the Property

In our experience, senior liens more often resolve through the property, especially when the owner is delinquent on their home owner’s association (HOA) dues or their property taxes. Exiting through the property is often a short sale or full payoff at the sale of the home or selling the collateral property at the end of the foreclosure process. More often, a borrower facing a foreclosure or no longer interested in keeping their property will help by executing a deed-in-lieu of foreclosure (DIL) or quit-claim deed (QCD)

The bottom line

Despite the flashy headlines and deceivingly easy gains in stocks or crypto, real estate has made more millionaires than any asset class. Getting rich slowly by investing in cash-flowing assets is a proven strategy that the wealthy have utilized since the dawn of capitalism. Cash-flowing mortgage notes secured by real estate are one of the sophisticated investor’s best income generating assets and paired with hard real estate, create a rock-solid foundation for a passive income portfolio.

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