Is it better to invest in real estate or mortgage notes or both?

The one constant of the current real estate market is its volatility. Years after the housing bubble burst and the Recession having ended, the market has not calmed down.

The collapse of the housing market in 2007 was the defining feature of the last two decades when it comes to real estate. Millions of homeowners were forced to default on their mortgages and many of them couldn’t refinance or keep their homes. The housing market was glutted with pre-owned homes that were considerably less expensive than buying or building a new home.

Although the market has stabilized, somewhat since then, at the end of 2014, there were still more than 7 million homeowners who were underwater on their mortgage. This amounts to well over 10 percent of all homeowners with a mortgage. This situation, as bad as it is, can be an opportunity for investors in real estate notes.

The difference between managing real estate and mortgage notes

There are a lot of similarities in investing in real estate and investing in mortgage notes. You, as the investor, are responsible for evaluating the collateral and working with investment companies. You need to do your own due diligence to make sure the property is valuable and worth owning or holding the mortgage note on.

The differences, however, make investing in mortgage notes very attractive to current investors. The primary difference is that you don’t own the property. If you own the mortgage note on the property and the homeowner violates the terms of the agreement then you can file a lien against the property. You won’t own the property unless it is foreclosed on and, if you are the primary lien holder, then you acquire the title.

Taking the passive route

If you own physical real estate, you are responsible for it and you have tenants. If your tenants violate the lease then you can take them to court and have them evicted. Since you don’t own the property in question, the homeowner is not a tenant and you don’t have rights to the property as long as the agreement is not violated.

Owning real estate is all about managing your investment through the people who live there. That compares to managing your investment through collecting what is owed to you in owning mortgage notes.

Owning a mortgage note is also more passive than owning property. You are only responsible for collecting the payment, paying the taxes and (perhaps) ensuring that the owner carries insurance. Homeowners don’t call their mortgage companies up in the middle of the night to fix a broken furnace or replace a balky water heater.

Financing for mortgage notes

Another advantage of investing in mortgage notes versus real estate is the financing options. All of the traditional real estate investment financing can be done with mortgage notes and there are a number of other options added to them.

Mortgage notes, although linked to a specific property, are not title to it. This allows the investor to take advantage of situations by using Other People’s Money or forming LLCs to acquire notes. Compared to investing in real estate, owning mortgage notes is simpler and less risky.

The option to refinance a mortgage, either through a bank or by using your own funds, is also a viable option for owners of mortgage notes. If the homeowner wants to remortgage, you can use seller carry-back (basically, where you act as the bank to extend or modify an existing mortgage or write a completely new own) to increase or decrease your cash flow from the property.

Final thoughts

Real estate notes are one more option in an investor’s tool box. There are times that owning a property outright can be beneficial and just as many times that being the lien holder is better for you. Until the volatility that has characterized housing markets for the last decade finally ends, protecting your assets against the market is a valid and viable strategy. In that atmosphere, owning the mortgage note can be much better than owning the property.

Prior to taking part in real estate or in mortgage notes, the savvy investor will want to get expert advice. Troy Fullwood of Pinnacle Investments has over 20 years of experience as a real estate investor.