What Are Real Estate Notes?
A real estate note (also called a mortgage note or promissory note) is a written promise to repay a specific sum of money, secured by a piece of real property. When someone buys a house with a mortgage, they sign two key documents: the deed of trust (or mortgage) that gives the lender a security interest in the property, and the promissory note that contains the actual repayment terms -- principal amount, interest rate, payment schedule, and maturity date.
The note itself is a financial instrument that can be bought, sold, and traded independently of the property. When an investor "buys a note," they're purchasing the right to receive the remaining payments on that debt. The property serves as collateral. If the borrower stops paying, the note holder can foreclose.
Types of Real Estate Notes
| Type | Description | Typical Buyer |
|---|---|---|
| Performing note | Borrower is current on payments | Income investors seeking monthly cash flow |
| Non-performing note | Borrower has stopped paying (90+ days late) | Distressed debt investors seeking discounts |
| First lien note | Secured by first-position lien | Lower risk, lower yield |
| Second lien note | Junior position behind first mortgage | Higher risk, higher potential yield |
| Seller-financed note | Created when seller carries the financing | Often sold at discount after seasoning |
How Note Investing Works
Note investing flips the traditional real estate model. Instead of owning property and collecting rent, you own debt and collect loan payments. Here's the typical flow:
- Source notes: Banks, credit unions, hedge funds, and individual sellers sell notes, often at a discount to the unpaid principal balance (UPB). Non-performing notes sell at the deepest discounts (sometimes 30-60 cents on the dollar).
- Due diligence: Review the note terms, payment history, borrower creditworthiness, property value (is the property worth more than the debt?), title status, and lien position.
- Purchase: Buy the note via an assignment of the mortgage/deed of trust. The note and security instrument transfer to you.
- Service or resolve: For performing notes, collect payments (often through a loan servicer). For non-performing notes, work out a resolution: loan modification, short sale, deed-in-lieu, or foreclosure.
Why Investors Buy Notes at a Discount
A $100,000 note with a 6% interest rate might sell for $85,000. The buyer's yield is higher than 6% because they paid less than face value but receive the full payment stream. If the borrower pays off the note in full (at $100,000), the buyer earns $15,000 in profit on top of all the interest collected.
Example: Purchase a performing note for $80,000 (80% of $100,000 UPB). Monthly payment: $600. Annual income: $7,200. Cash-on-cash return: $7,200 / $80,000 = 9.0% (vs. the 6% coupon rate). If the borrower pays off the full $100,000 at maturity, total return is even higher.
Non-Performing Notes: Higher Risk, Higher Reward
Non-performing notes are purchased at steep discounts because the borrower has stopped paying. The investor's goal is to resolve the situation profitably:
- Loan modification: Restructure the terms so the borrower can resume payments. You may reduce the interest rate, extend the term, or forgive part of the principal.
- Short sale: The borrower sells the property for less than owed, and you accept the proceeds as satisfaction of the debt.
- Deed-in-lieu: The borrower voluntarily transfers the property to you to avoid foreclosure. You now own the property.
- Foreclosure: If no workout is possible, foreclose and take the property. Then sell it or rent it.
The key risk with non-performing notes: the property may be worth less than what you paid for the note, or the legal costs of resolution may eat into your profit.
Notes and Wholesaling
Note investing and wholesaling are different strategies, but they intersect. Wholesalers encounter properties with existing notes (mortgages) that affect deal structure. Understanding note terms helps wholesalers analyze seller motivation -- an owner with a high-interest hard money note coming due has different motivation than an owner with a low-rate fixed mortgage. Creative financing strategies like subject-to deals and seller carrybacks both involve note creation or assumption.