The Massive Potential and Pitfalls in Notes for Self-Directed Investors
2021 May Be the Best Year Yet for Private Lenders…If They Are Careful
by Tom Olson
When speaking with self-directed investors who are considering acquiring turnkey rentals in their retirement accounts, I always make sure to tell them that a slightly more “creative” option might better suit their needs. Without losing the benefit of holding a real estate-related asset, they can invest with a far greater tax advantage if they buy or originate well-considered private loans. This is also true for investors looking to diversify their portfolios. Last year was definitely a year for diversification, and many real estate investors, self-directed and otherwise, decided to expand their portfolios to include real estate-secured private loans.
There are many reasons to love having this type of loan in your self-directed IRA or 401(k). A few reasons are:
- They are extremely low maintenance.
- They are often even more secure and low risk than turnkey rentals.
- A borrower will almost always prioritize real estate-related debt over other debt obligations, making a private note extremely predictable even when the economy is volatile.
Furthermore, when you are using a self-directed retirement account to make these loans, you can be extremely creative with the terms of the loan. This represents nearly unheard-of potential for self-directed investors to buy and sell private notes. However, that creativity has led to some new pitfalls in the asset class as well.
Case Study: Why This “Great Note” Might Not (and Maybe Should Not) Sell
With more investors, self-directed and otherwise, moving into the private lending space, there are more notes available for purchase and sale. It might surprise you to learn that many investors do not originate their private loans but instead buy them from other investors. As you can imagine, this can be complicated if you are just getting started in the space.
Here is a real-life example I recently observed of a note that could have gone really wrong for someone:
The “deal” came from a Facebook post wherein the note-seller was attempting to sell an active land contract. The original note balance was $71,500, and the unpaid principal balance was $67,272.27. The note had an interest rate of 9 percent, and the estimated market value of the collateral property was $125,000. The note was “performing,” meaning the payer was paying monthly and on-time.
When the seller posted his ad along with the notice that he wanted a full, cash payment for the note and that he wanted to sell at face value ($67,000), the forum erupted with jokes and other commentary. People started “bidding” on the note, starting around $10,000 and nudging the bid upward in increments of a dollar. There was a lot of hilarity, until a local investor quite seriously posted that he wanted to buy the note and did not understand why everyone was laughing at the proposal of paying $67,700 to get 9 percent interest on that loan. At that point, I knew I had to respond before that investor potentially fell right into a pitfall with his hard-earned retirement capital.
Here is what I told him:
First, most note investors want to earn 10-12 percent a year on their investment, which means most investors probably do not want to pay face value for single-digit yields. Second, there are three things to consider when you are buying a private note if you plan to either keep the note performing or attempt to reinstate it:
1) Who is the borrower?
Vet a potential borrower the same way you would a tenant unless you want the collateral property. Too many investors vet borrowers far less than they would tenants. A good note for sale will have a credit report and other information about why the loan was made. Not all notes will have this information, and you need to decide if you are willing to take the risk on the deal even though you might end up owning the property if the borrower defaults. Once you make this decision, vet the property the same way you would any other real estate deal.
2) What is the quality of the asset?
Sometimes private lenders will take on a risky deal because they are fine with foreclosing and ultimately owning the asset. However, this process can take longer and be more expensive than you might think. Make sure your strategy will accommodate the value of the asset and the potential cost of holding it. Get an appraisal and quotes for repairs if appropriate before making
an offer.
3) How solid is the paperwork?
You can never assume that you are buying a note with good paperwork. Have an attorney review the terms of the note and confirm that it protects the lender’s interests and holds up under the Dodd-Frank Wall Street Reform and Consumer Protection Act that was passed in 2010. If the paperwork is not solid, some investors will buy the note anyway, but they tend to insist on a discounted price because weak paperwork weakens the asset.
Ultimately, I do not know for sure if the note-seller ever made a deal or not. However, I did learn several things from that post and subsequent commentary:
- There are still a lot of opportunities on social media if you can look past the political “garbage.”
- There are still a lot of people doing real estate deals on Facebook.
- Creative real estate is still alive and well.
The opportunity mindset will make or break investors in 2021. Make sure you are willing to be creative and dedicated to making sure your creativity is optimized to generate returns for your portfolio.
