The past decade has seen an explosion of private investors moving from buying property to buying notes. Tired of the headaches of being a landlord, they would rather be the bank. After all, nobody calls the bank at 2 am for a lockout or stopped up toilet.
For years banks have been profiting from interest on home loans (earning back an average of 1.5 to 3 times the amount they lend over the course of a 30-year note), and private investors want their share.
Real estate notes can be great assets for self-directed retirement accounts. The benefits include:
Here’s an example of a seller-financed note purchased by my IRA a few years back in Sunrise FL. The seller sold their small condo unit to a retiree wanting to enjoy the sun and sand of sunny Florida. The seller carried back a note and after receiving a year of payments decided to sell the note for a lump sum of cash.
Sale Price $25,500
Down Payment $ 3,000
Original Balance $22,500
Terms 8.0% interest payable in180 payments of $215.02 per month
Payments Made 15 months
Remaining Balance $21,477.84
Remaining Term 165 months
My retirement account was able to purchase the unpaid balance on the note (including future interest and payments) for $15,800. That resulted in a discount of $5,677 and a yield of 13.9% to the retirement account.
If you are considering investing in mortgage notes for your IRA here are ten tips for getting started.
What type of note investor are you? Can you afford to take significant risks or are you looking for a more conservative approach to note buying? Notes come in all shapes and sizes so weigh the pros and cons of:
If you are new to note investing it is a good idea to get some performing first lien notes under your belt before considering non-performing notes, second liens and riskier deals.
Create a playbook outlining your plan of attack, processes, and approach to note buying. Set targets for Yields and Investment-To-Value (ITV) thresholds. Get to know the ABCs of note grading related to property type, occupancy, equity, seasoning, and credit rating. They’ll provide a guideline when performing your deal analysis.
After the thrill of making the deal comes the reality of validating the facts. Taking time to inventory a collateral file can be tedious, but it is also essential. In the words of one of the world’s most successful investors,
“The great moves are usually greeted by yawns.” – Warren Buffet
Looking for a place to start? Here are some of the fundamental questions to get answered:
Draw upon industry standard due diligence processes to help you establish a transaction checklist. Be consistent and use it on every single deal.
No, I’m not suggesting you consult a therapist for your deals. I’m talking about the experts you can use to help avoid making mistakes in your transaction. There are lots of resources including:
Keep your portfolio diverse. Spreading the risk out over several smaller notes instead of one large note will ward against that one deal souring your entire nest egg. I’d rather have four $50,000 notes than one $200,000 note.
Think outside the typical banker’s “box”. Look at other solutions to structure a deal creating a win-win for everyone.
Utilize the Partial Purchase, one of the most powerful wealth-building tools in the note industry. You don’t have to collect all of the payments on a note to still yield double digits. These unconventional approaches to note investing can provide strong returns while minimizing risk.
Purchase a financial calculator or software and learn how to use it. It can be your best friend in harnessing the power in The Time Value Of Money. And don’t let all those buttons scare you. You only need to understand five sets of letters to solve most note investing calculations:
N (number of payments)
I (rate of interest/return)
PV (present value)
PMT (payment amount)
FV (future value)
How are you planning to find notes? They don’t just drop on your doorstep, so you’ll need to figure out how you’re going to bring those notes to you.
Look at networking and referrals through real estate clubs, educational events, and conferences. Direct mail still works for targeting sellers who have sold property with owner financing and are collecting payments. You can also find notes online through exchanges and listing platforms like NotesDirect.
Don’t try to reinvent the wheel. Learn from others who have been right where you are now. Gain knowledge from both their home runs and mistakes made on deals gone awry.
Use the services of a self-directed retirement account custodian to buy notes tax-deferred or tax-free. The most common types of accounts are the Traditional IRA or the Roth IRA. Other options you may want to consider are the Solo 401k, SEP (Simplified Employee Pension), HSA (Health Savings Account), and ESA (Educational Savings Account.
Work closely with your Custodian to properly title the asset in the name of your IRA. Be sure to avoid prohibited transactions with any disqualified persons and setup note collections through a third party servicing company.
Tracy Z Rewey is the author of How to Calculate Cash Flows and co-owner of Diversified Investment Services, Inc. She has handled millions of dollars in real estate notes since 1988, becoming a well-known industry expert. Visit her blog online at NoteInvestor.com to read all 21 of her Note Investing Tips.
*Mainstar's role as custodian of self-directed accounts is nondiscretionary and/or administrative in nature. This information is for educational purposes only, and should not be construed as investment, legal, tax or financial advice or as a guarantee, endorsement, or certification of any investments. Mainstar encourages individuals to consult a financial or legal professional when making investment decisions.