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“I got tired of dealing with tenants so I started lending money.” We hear this a lot from investors who were worn out being landlords, and looked for another way to be involved with real estate, now as lenders. While private lending is a great way to generate income, many self-directed IRA investors aren’t aware that an alternative strategy exists: Buying owner financed real estate notes at a discount. This article outlines how buying a real estate note (also known as a mortgage note) differs from lending money, and what investors should know before trying this strategy. Let’s start by looking at how owner financed notes are created.
How Real Estate is Bought and Sold
There are 3 ways a buyer can purchase real estate. They can use:
- Their own money (cash)
- The bank’s money (loan)
- The seller’s money (owner financing)
Owner financing isn’t a loan but instead an extension of credit by the seller. The buyer pays cash for a portion of the sales price and promises to pay the seller the rest of the money in the future by signing a Promissory Note.
By recording a Deed of Trust or Mortgage (depending on the state where the property is located), the seller is able to record a lien against the property and foreclose if the buyer doesn’t pay as promised in the Note.
Here’s a recent example:
Property: 7-unit multi-family in Los Angeles, CA
Sales price: $1,850,000
Cash down: $1,100,000
New note: $750,000 at 4% amortized for 20 years at $4,544.85 monthly
Balance: $720,743 at the time McKinley Mortgage bought the note
After receiving 12 payments, the seller found an investment property he wanted to buy and wanted to cash out his note.
The note made it through due diligence and our private investor agreed to buy the note for $570,000, or a projected 7% yield on the remaining term of the note. Keep in mind this return is based on the buyer making payments for 19 years. We’ve found most of our notes pay off within 5-7 years so there’s a very good chance the investor on this deal could earn more than 7% if it pays off early.
The 3 P’s of Note Underwriting
The advantage of buying an existing note versus originating a new one is that you have a past performance to consider. Before buying any discounted note, you should consider the three P’s of note underwriting:
Look at the amount of cash paid down, the note’s payment history and how the payors manage their credit. Most note brokers should be able to provide you with a soft pull credit report on the buyers.
Do you feel comfortable owning the property if the buyers stop paying you? It’s also important to make sure that taxes are paid and hazard insurance is sufficient. If the property is for commercial or industrial use, there could be environmental concerns that could surface later.
Owner financed notes come in all shapes and sizes. You may want your attorney to review the original documents before taking assignment to them. Make sure your note is in first position and that you have title insurance at closing to back it up. Also, some states have judicial foreclosure laws, which could take a very long time to foreclose upon. If you know these rules at the start, you may be able to prevent delays in paperwork.
Discounted real estate notes can be a great source of income inside a self-directed IRA. However, it takes a lot of work and specialized knowledge to do it right. Before you start, I would suggest building a team to include:
- Experienced real estate attorney to review the files
- Trusted note broker to find the deals for you
- Third party note servicing company to manage the payments
- Real estate professionals to be your eyes on the property
- Your Entrust IRA team to facilitate all the rest
With the right expertise on your side, note investing is not only safer, but also a lot more fun!
By: Caleb Preston, Principal - McKinley Mortgage Company
Caleb Preston has been buying notes in his IRA since the age of 12. His family owns McKinley Mortgage Company, which has purchased over 3,000 notes since 1989. For more information visit www.mckinleymortgage.com