Today’s question is an interesting one. It comes from Melissa and her question generally is what are the pros and cons of investing in notes? And this came about because she saw on our website recently that we have a new opportunity and that is to invest in notes more specifically promissory notes. And for those of you that don’t understand what a note is. I’m going to explain it to you today.
Interestingly, this question has come up a few times because I’ve had this on our website for about, Oh geez, maybe three or four weeks now, and it’s not something new. I’ve actually been offering note investments on and off for many years. In fact, I think it goes as far back as 2013. And there was a three year period in there, which I believe was 2015 through 18, if I’m not mistaken where I was offering promissory notes tied to real estate. So essentially real estate notes for properties that we were buying fixing, and either flipping or buying, fixing, and holding mostly I’d say 99% of them were for properties that we were buying fixing up and then reselling either as turnkey rentals or retail sales. So this is something that has been around in my world for a while, but note investing has been around for decades. In fact, it goes back a long, long way because in its simplest form, a note is really just an IOU. It’s a loan. It’s a bond is a note, a note comes in different forms and under different names. But essentially a note is just two people coming together to lend one another money that is repaid over time.
So Melissa’s question is, can you discuss more about investing in promissory notes with the return rate you’re offering? It makes passive investing so easy and simple with good cashflow. It’s almost too good to be true with a little smiley face. What are the things that new investors like me need to watch out for to make sure it’s a legitimate transaction comparing this with investing in single-family homes? I know I’m missing the tax advantage, but what are the pros and cons of investing in notes? Thank you.
Okay, Melissa, thank you for your question. So let’s break this down and tackle it and I’ll see if I can do this within 10 minutes, cause I usually tend to run long. So first of all, what is a note? Well in its simplest form, a note also known as a promissory note is a promise to pay off a loan. So a more detailed definition would be a promissory note as a contract where one party, the borrower agrees to repay the loan to the other party, also known as the payee or the lender, and that is done within a specific time, a period of time and under specific conditions. And those conditions are some things that you hear all the time like interest rates, what’s the interest rate on that loan. And are there any fees or penalties for a delay or being late and also are there clauses to prepay that loan either with a penalty or without a penalty. And you see these all the time in mortgage loans. I mean, this is standard stuff that you see in all real estate lending or financing. And if there’s a mortgage that is attached to that note, then it’s essentially an Allstate in air quotes, a guaranteed loan. So that is really what a mortgage loan is, it’s a note, a promissory note for a loan on a property. And then it has another document called a mortgage or in some states, a deed of trust and that deed of trust or that mortgage is the security instrument that ties that loan. In other words, the promissory note to the property. So when they say you have a lien on the property, the lien on the property is the mortgage or the deed of trust. That is basically saying that, if you don’t repay that promissory note, we have the ability to go after that collateral, which is what you have pledged towards full repayment of that promissory note, and so that is why they refer to promissory notes on real estate, meaning a mortgage loan as a secured or guaranteed loan.
Okay. So let’s dive a little deeper into this. There are essentially four different kinds of notes, but really there’s only two and it’s two times two, there are performing and nonperforming notes and then there are secured and unsecured notes. So really there are four different kinds, but these overlap, because you can have a secured performing note or an unsecured performing note. And so you can mix and match these, but let’s talk about these. So a performing note is pretty straight forward and I’m sure that you have guessed what this is, a performing note is a note where at least if you’re buying a performing note, you know, that the borrower has been paying is on time and is not in default. That’s a performing note. So if you buy an existing note, not a new note, then you’re buying a cashflow. You’re buying a contract where that borrower is repaying you every month, whatever that payment is. A nonperforming note is a note where a lender at one time provided the borrower a loan under a note, an agreement to repay and has broken that contract. They are in default, they are either late or have something going on where they are not repaying per the terms of that agreement. And if that’s the case, then essentially what you have is a non-performing promissory note.
Now there are investors out there who buy nonperforming notes. Why? Because they can buy them at a deep discount, often pennies on the dollar. In fact, I knew someone who was buying promissory notes for as little as 10 cents on the dollar, meaning that if the note was for let’s make a hypothetical example, a hundred thousand dollars, they were buying it for $10,000. If it was a $10,000 note, they were buying it for $1,000 and they were buying them in bulk in batches. And so the expectation was is that a percentage of those nonperforming notes would never perform. They would essentially be trash, but a percentage of them would convert. They would be able to negotiate or renegotiate with the borrower and get them back on track and paying and get them caught up or just repaying from day one and forgive whatever was in default. And so they would convert a nonperforming note to a converting or to a performing note. And all of a sudden, now they have cashflow from this very simple paper investment. So that’s the difference between performing and nonperforming notes. Notes can be existing notes where you’re buying them as in the examples that I just gave, or they could be new notes where they’re newly issued as part of an investment.
Now, the other two types of notes, which again, overlap, this is like a layer they’re not mutually exclusive. Those performing or nonperforming notes could be either secured or unsecured. Now a secured note is exactly what we just talked about with a mortgage loan. Some asset or collateral is securing the loan. It is basically attached to either a car or a piece of real estate or any kind of asset that is saleable, that has a value that could be used to liquidate the investment. If necessary. An unsecured note is a note or a loan that doesn’t have anything attached to it as collateral or security, what some people might refer to as a non-guaranteed or unguaranteed loan. And these are also very, very common examples. For example, student loans are unsecured loans, medical debts, and medical bills are unsecured loans, credit cards, which pretty much everybody has. Some people have way too many of them, five or 10 or more, but credit card debt or credit card loans are also unsecured loans. They’re essentially like signature loans. You’ve basically promised and agreed to repay that debt. And if you don’t, they can cancel your card and they can report late payments to your credit bureaus and damage your credit. So there is some leverage that these lenders have if you don’t repay unsecured loans, but those are not attached to collateral or security. Nobody’s going to come after you, if you buy a toaster on a credit card and you don’t repay, they’re not going to come after that toaster. So those are the differences between performing and nonperforming notes secured and unsecured notes.
Now let’s talk about the returns. The expected returns really vary, can vary tremendously actually, between performing and nonperforming notes, as well as secured and unsecured notes. The biggest variable here I think has to do with it being either secured or unsecured also the length of time. So one variable is the interest rate interest rates can be very low three, four, 5% if you want to call that very low, but essentially four to 6% for a secured note, especially if there’s a longer-term on it. The interest rates can go up to the high single digits and with unsecured promissory notes, it’s not uncommon to see eight even 10 or 12 or more percent. In fact, you can see promissory notes as high as 18% or more for unsecured notes. And there are different reasons for this it’s that whole argument of risk versus reward. Sometimes there is more risk with an unsecured note because you don’t have collateral, but sometimes it’s perceived risk because you may actually have less risk in an investment on an unsecured note than you do on a secure note with collateral that has either a car or a piece of real estate or something else behind it. And the reason for that is there’s a lot of hassle in a secure note that is attached to, let’s say a piece of real estate where you would have to go through a foreclosure process and the expense of it, it’s really the expense and the hassle. You might ultimately get the property back. But if the property is in really poor condition and you’re going to have to spend tens of thousands of dollars to rehabilitate that property, to get the value back up in order for you to resell that property, to eventually collect on the note, well, then you’re talking about a lot of time, hassle, some expense, maybe a lot of expense, et cetera, et cetera. So to me, that is kind of a worst-case scenario, but it is a high-risk scenario. Whereas an unsecured note with a high-interest rate or rate of return, that’s attached to a business or a set of businesses or a group investment or some other type of deal where there is existing collateral. That’s not attached to the note, but there’s existing assets and collateral and cash flow to serve as the note that scenario is certainly from where I sit a less concerning, less risky venture. Yes, there’s no collateral. There’s no asset tied to the note directly, but the foundation can be very solid and deep where you know, that there is a very high probability of repayment on that note.
So back to interest rates. So interest rates can vary widely from 4% to as high as 20% or more. And I’ve really seen it all over the place. Interest rates are partly due to perceived risk as well as real risk also based on the length of time. And there’s probably some other factors in there, but those are really the two basic ones. Another expected return when it comes to notes are bonuses or kickers, not all notes have this, but some do, and I’m just throwing it out there, so you’re aware of it. You could invest in a note where it has a bonus or a kicker at the end of that note period, essentially what’s the maturity date. So if you invest in a note, let’s say two-year note at the end of the note on the maturity date, you’re getting paid an extra, let’s say 2%, 5%, whatever it may be on top of what you’ve already been paid, that’s referred to as a bonus or a kicker on that note. So the interest rate might be, let’s say 8%, 10% per year, simple interest, you get paid that monthly or quarterly. And then you get a kicker at the end when the note is matured and your principal’s repaid. If it’s an amortized note where you’re getting paid, not just interest but principles, well then the principal balance will diminish each and every month or every time you get a payment. So the principal amount is being reduced just like a typical real estate mortgage loan. And so, you know, there’s different ways to structure them, but there’s not too many different ways. So it’s really interest only, or an amortized loan, an amortized note.
And then lastly is on returns. Sometimes returns can be accrued. In other words, you might be getting paid interest or principal and interest during the life of that note, which could be anywhere from three months, six months, 12 months, two years, or even 30 years in the case of mortgage notes. But you may also have another rate of return or another payment where there’s accrued interest, meaning that you’re not actually paid that rate of interest during the life of that note, but you will get paid that at some specified period in time down the road. And that could be a specific date like two years from today or when the note matures on that maturity date. And that’s when you get paid that accrued interest.
So let’s talk about the pros and cons. The cons are kind of a few because it’s not a complicated investment. You’re investing essentially in an agreement, a contract its paper. So one of them is limited liquidity. If you invest in a note, it’s not easy to liquidate that note, you would have to essentially sell that, assuming that the terms of the note allow you to do this, but you can sell that note to another investor, either at face value or at a discount, if you need to liquidate it. So you’re basically selling your cash flows to someone else. They’re basically going to take over the cash flows that you are receiving. If you need liquidity, the other disadvantage, like everything else, every other investment, there is an element of risk. However, with all investments, the right investment in the right person’s hands with the right knowledge or experience can turn something that would be risky for one individual or one investor into something that is a very profitable investment for someone else. So there’s what I refer to as controlled risk. So if you know what you’re doing and you know how to do your due diligence, you can invest in virtually anything and make money from it. And that’s the thing with notes. It’s not for everybody, even though it is a very simple investment, but you do have the ability to control your risk, but you don’t have a lot of control in whatever those funds are being used for. You’re making an investment into a company or into a piece of real estate or a person or whoever the borrower is and that’s really where your control ends.
Now, the pros are actually pretty interesting. So number one notes are very simple to understand it’s a contract, it’s basically an agreement. It could be anywhere from one to five pages in length typically. So it’s easy to understand. It’s easy to invest in it. Notes, pay higher rates of return than many other quote-unquote type investments like a savings account, which I don’t really see as an investment or CDs certificates of deposit or for some people’s certificates of destruction. You really don’t get much, you know, you might get at a maximum 3% on these types of investment vehicles or savings accounts, so you can get higher or much, much higher rates of return from investing in promissory notes. Thirdly, notes offer the ability to choose whether you want a short term or a long term investment. So they could be as short as let’s say, a month or three months, it could be six months, 12 months, 24 months, or it could be multiple years common examples, the 30 years fixed-rate mortgage that we’re so used to here in the US that’s a note that has a 30-year term and forth and this is probably one of the biggest ones. It is a great option, a great, great option for a lot of people who have self-directed retirement accounts, like self-directed IRAs, self-directed 401ks set plans, whatever it may be. So if you have monies that are underperforming, or maybe if you’re just really heavy into the stock market, and you’re growing increasingly concerned about the volatility in the future of the overall economy, US economy, global economy, and you think that it’s time to take some chips off the table and liquidate some of your holdings in the stock market. This is a great way to essentially reposition or rebalance your investments or your portfolio into things that are what I would call a fixed income investment. So it’s very predictable and you know exactly what you’re going to get, whether you’re paid monthly or quarterly on your notes, but self-directed retirement accounts are great places to use notes as an investment vehicle.
Now, the reason this all came up is because, and I’ll just mention this very quickly, these investment opportunities that we have on our website at noradarealestate.com. These are short term investment opportunities for investments that we’re making in businesses, not in real estate. So even though it’s on our website, there are different investment opportunities that are underlying these notes as the foundation. And these are essentially big brand name brand businesses that we’re acquiring have acquired that are doing business online a hundred percent e-commerce and are very, very scalable. So there’s a lot of cash flow and liquidity that is underlying these unsecured notes, which is what we talked about before. So if you want information on that, of course, it’s on our website. You can just read up a little more about it, and then, of course, contact me and I can give you some more information. These are some pretty big companies and pretty big name brands that I don’t want to mention on this podcast, because it is a public forum, even though I can disclose it, I’d rather just keep it private at the moment, but that’s about it.
So, Melissa, this is a great question. I appreciate you writing in because I’ve had this come up multiple times this month. So that’s it. Those are the pros and cons of investing in notes. It’s great for a lot of people, especially if you’re planning to be outside of real estate at the moment, but don’t get me wrong. I am still very bullish on real estate investing and building a portfolio of income-producing real estate. But of course, it really comes down to the markets, the neighborhoods, and the team that you’re working with. You just can’t invest anywhere and expect the right results. Some markets are overpriced, inflated, unaffordable, or they may not have positive migration. There may be too much outgoing population, meaning an outward flow of migration. We call that a net loss.
Anyway, I hope that helps. I appreciate the question. And for everybody else, if you have a question about real estate investing or finance, and you want me to try and cover that on the show here, just go to passiverealestateinvesting.com or go to AskMarco.com and submit your question. I will do my best to get to it.
Thank you for listening. And I will see you on our next episode.
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