Like most things in life, the mortgage note investing business comes with both pros and cons. There are certainly a lot of positives to this business like we discussed in last week’s blog, otherwise we wouldn’t be in this industry. However, it is important we touch on the less desirable aspects of note investing as well.
Here are 10 reasons why you should not invest in notes:
1. It can get expensive to do things right (and wrong).
When it comes to mortgage note investing, it can get quite expensive if you want to do things the right way. You need to get experienced vendors, licensing, and other requirements depending on the state your note is located in. While some states are stricter on licensing than others, it is still important to stay on top of this. This is a prime example of why you need an attorney - to make sure you know the legal requirements for the state you own the note in. The penalty for not having proper licensing varies from state to state. While some states will just give you a warning and tell you to get the license, others will fine you thousands of dollars.
I’ve known investors who have gotten in trouble for Joint Venture agreements and some who have gotten in trouble for not having licensing in the state they were doing business in. I also personally had a situation where my servicer did not respond to a letter which led to a fine for violating FDCPA. Unlike being a fix and flipper where you may get a warning and an opportunity to resolve the situation before receiving a nuisance lien, the same does not apply to note investing. Jurisdictions will not work with you and negligence is going to cost you.
2. There are many moving parts.
Mortgage note Investing can get stressful with all the different moving parts. As a note investor, you will always have a lot of paperwork to keep track of and be juggling numerous tasks at once. If you are not an excellent multi-tasker or at least up for the challenge, this may not be the business for you as you really cannot let anything slip through the cracks. Unlike other real estate strategies, note investing has what is called a statute of limitations when dealing with distressed debt. If you miss a deadline and the statute of limitations has expired, it can be fatal recovering monies for your note.
3. The value of the Asset Decreases Overtime.
When it comes to performing notes, their value decreases over time. Unlike owning real estate which typically appreciates over time, a note depreciates because the borrower has been paying you back, ultimately reducing the amount of money owed on the loan. Non-performing assets also depreciate because while your expenses continue (servicing, taxes, etc.) the property is most likely not being well kept. Although there could be some home appreciation in that area, it is typically off set by the house continuing to suffer from deferred maintenance and damage. Very rarely does a non-performing asset appreciate, and even if it does, it is usually off set by the costs you are spending.
4. It is not easy to leverage.
Unfortunately, you cannot walk into a bank or call up a mortgage loan officer and ask for a loan on a note and expect them to comply. Getting money to buy notes is a different process than obtaining a loan to invest in traditional real estate. With traditional real estate, you can either get financing from the bank, or you can get a hard money loan. For bank financing, all you need is a good credit score and proof you can pay back the loan. On the other hand, a hard money loan is solely based on your assets and experience. Getting money for notes is similar to a hard money loan as you must have a strong network of investors and significant experience. Once you get your foot in the door of the mortgage note investing space, it does get easier but getting started is the hardest part.
5. There are limited enforcement laws & regulations protecting you from bad actors.
Although there are more laws now than in the past, the mortgage note investing industry is not very regulated. This can be a major downside because there are a lot of bad actors in this industry. There are usually two different types, the ones who are unethical and intentionally shady, and the ones who are just incompetent and don’t know any better. While there are laws to protect individuals, what it comes down to is that nobody is there to enforce these regulations because of the low dollar amounts involved (under $1M). Whether it is other note investors or vendors, you really have to know who you’re working with and develop that element of trust, as it’s easy for someone who is not trustworthy to operate in this space.
6. This is a conflict-oriented business.
In the mortgage note investing space, you are usually dealing with conflict daily, especially with the non-performing notes. The main conflict you will run into with this situation is the fact that the borrower cannot pay their mortgage, but they want to stay in the property. This stirs conflict because the borrower obviously cannot keep the property if they are not going to pay, and you can’t afford to have somebody living in the home for free. Unfortunately, there is no playbook on how to resolve these situations as you just learn from experience.
Along with borrowers, you are also dealing with your servicer, attorneys and other note investors. With the all the different moving parts, there tends to be a lot of mistakes that get made, which then leads to conflict. What you want to ask yourself is ‘how do you handle that?’. If you are somebody who might be hesitant, I recommend you do not enter this business. You need to have thick skin and be active versus passive. Because of all the different people you are dealing with, conflict is inevitable. You must be okay with making tough decisions and with people not necessarily liking you. You need to stand your ground.
7. This business requires significant management skills.
Managing an asset can have a greater impact on profit than what you pay for an asset. As a note investor, not only do you have to manage your asset, but you also must manage realtors, vendors, attorneys, documents, and paperwork. The fact you are managing a majority of this remotely from afar can make it quite challenging. When you work a 9-5 in the office, you just knock on someone's door to communicate what needs to get done. While it’s great that you can run your note business from anywhere in the world, communication and task management can be challenging.
If your goal is to scale in the note business, it’s going to come down to people and systems as far as the operations of it. Whether this means you hire 10 full-time employees or primarily outsource through contractors and vendors, it still requires excessive management, and each scenario has its pros and cons. Even if you hire somebody who is organized and does their job well, you still have to manage so they know what needs to be done and how it needs to be done. No matter how you organize your note business it will still require significant management skills.
8. It is a high-risk business.
Something to take into consideration before entering the mortgage note investing space is the fact that this is a high-risk business. For starters, you do not typically get to see the inside of the property. Instead, you rely on other people to relay the information to you and usually these vendors are very low paid and inexperienced. For example, a BPO is done by an associate who probably gets paid $10-$20 to go take photos of the property. This individual then hands it to an agent who puts it in their system, (and maybe looks at the photos, but probably not), researches comparable sales in the area, and then their computer gives your property a value. While you may pay this vendor about $100-$150, you run the risk of receiving inaccurate and poorly reviewed information. I have had reports describe a property that required no work when the property had burned down and the lot was vacant land.
9. It is a “learn by doing” business.
When it comes to the mortgage note investing space, there really is no formal training that can prepare you to become a note investor. While a thorough understanding of business does help, the only way to truly learn is by applying it to the world around you and gaining real-life experience. There are a lot of weekend courses and online note investor courses out there, some are probably better than others, but I am a firm believer that you cannot truly learn something after only a weekend of studying a topic such as note investing. You must buy notes and learn from experience to get the best education.
10. There is no tax advantage when you are not using a deferred retirement account.
Since notes earn interest, it is considered ordinary income. Therefore, you do not receive any preferential tax treatment such as depreciation when investing in more traditional real estate. This is a prime example of why you see so many investors using their self-directed IRA (SDIRA) or Solo 401(k) for note investing. Let’s imagine I had two buckets of money – one bucket is cash, and one is a tax-deferred account such as a SDIRA, all the tax-deferred money may be invested in notes, and all the cash would go into more traditional real estate investments. This is because real estate with your own cash has better tax treatment than notes. However, I always advise you consult with a CPA or accountant regarding tax advice to see which option is best for you.