This is a transcription of part four of our video series, Investing Mortgage Notes. In this video, we discuss alternatives to investing in mortgage notes and the advantages and disadvantages of those investments.
Welcome back. This is the fourth in our series of podcasts regarding investing in mortgage notes.
Today we’re going to talk a little bit about alternatives to investing in notes and the advantages or disadvantages of those investments. We’re going to talk about portfolio management costs, additional security that is provided by the homes and also owning real estate as opposed to owning a mortgage note.
Stocks, Bonds and ETFs
So let’s first talk about what it’s like to own stocks and bonds and ETFs and things like that. I think we’re all pretty familiar with what that means. You talk to your local stock broker, your portfolio manager or whomever, and you buy some stocks. You are subject to the volatility of the market. As we know, all of the gains of 2018, which was an extremely bull market, were wiped out in the last month of 2018. So a lot of people basically thought they were doing great and lost everything by December 31st. So there’s a volatility of the stock market and ETFs and anything like that that is associated with that type of purchase, as opposed to investing in a mortgage note.
Now, I would never suggest that anybody buy 100% of their portfolio and fill it with mortgage notes. It’s an alternative investment. It’s something that’s part of a bigger basket. Any financial advisor would tell you, and I have to give you a slight disclaimer here that I’m not a financial advisor and I’m not giving you advice, but any advisor would tell you that you’re better off to have a basket of investments as opposed to putting all your eggs in one basket, regardless of how good an investment that seems.
So if you can have some in real estate, you can have some in bonds and stocks and whatever you’d like. Some people like to invest in different currencies, some people invest in precious metals, whatever you want. The point is you have to have a diverse portfolio.
One of the advantages of investing in mortgage notes is that they’re stable and consistent and they are great for providing income on a tax free basis if you buy them through a self directed IRA. Now, if you have a regular IRA, you don’t pay any taxes on the investments up front, but when you cash them in at a later date, or I’m sorry, when you try to pull money out of the account at a later date, and hopefully you’re at a much lower tax bracket, then that’s the time you pay taxes. If you have what’s known as a Roth IRA, you pay taxes immediately on the amount invested, but you don’t have to pay anything on your monies that you take out at the end of the day.
So let’s talk a little bit about a Roth. A lot of people think well, gee, maybe it’s not worth it, but let’s take an extreme case. Let’s say you invest $10,000 and you pay taxes on that $10,000 up front at the 30% tax bracket. So that’s $3,000, so you have $7,000 to invest. And these are rough, very rough numbers. But you never have to pay taxes on that investment again.
Well, if you take that $7,000 and let’s say you invested in some stock, Apple or something like that, Amazon, and you get a huge return, you get 140%, 150%, 160% return, and maybe that’s $80,000, $90,000. When you take that money out of that account, you don’t have to pay any tax on it at all. That’s the advantage of a Roth.
Now some people don’t like them, they like just regular self directed IRAs or solo 401k. FOr advice about all that you need to talk to your local self directed IRA person. I could suggest several that I like that are very familiar with investor notes and real estate and things like that. So if you’d like to call me at some point, I’ll be glad to talk to you about that. But there are a number of self directed IRA companies out there that are very good at helping you with these investments.
The other thing that you have to think about his portfolio costs. If your money is with a Vanguard or some other mutual fund, somebody like that, or another pro portfolio manager, they’re probably going to be charging you point, a point and a half, maybe two points on your investments. So that means that you have to make at least 1% to 2% just to stay even. If you think about it, and if inflation is running at let’s say 2% and you’re paying your investment counselor or advisor 1%, then that means that dollar for dollar you have to make 3% before you even start to make any money.
Now, that same inflation factor applies to mortgage investments, private mortgage investments, but your management fees are far less. Most self directed IRA companies will charge you as little as an eighth of a point for a management fee. They may charge some transaction fees of $75 to $100 every time you invest or something like that, but the costs are far, far less so your hurdle rate is much lower.
The nice thing about investing in something like mortgage notes with a self directed IRA is let’s say if you get a 6% return and you’re currently in the 30% tax bracket. Well, that’s about the equivalent of about a 9% pretax return if you weren’t investing through your self directed IRA, which is a pretty handsome return when you look at it long term, be it 10, 12, 15 years or something like that. So this is pretty much what I call a steady eddy type of investment.
I don’t invest in nonperforming loans or anything like that. We’ll discuss those later. Some people like those because there are higher profit margins in them, but as with everything, there’s risk and reward.
In these cases, I think I’ve mentioned before, you have a home that let’s say it’s worth $60,000 and we have a $30,000 to $35,000 mortgage against it. There’s a lot of security in knowing that, because what that means is that you could sell that house, if you had to take it back. If the borrower went into default, it might cost you $1,500 to get it through some sort of foreclosure process and you may or may not have to fix up the property a little bit. But aside from that, you’ve got a very good chance of getting all of your money out of this investment, even if it’s a slower market.
Another thing you can do is you can always rent the property. When we do our analysis and we find out that a mortgage payment is maybe $400, we want to be sure that the market rents are at least $600, $700 or $800 a month. So there’s a potential there for you actually to get a higher return during that period of your investment and by renting out the property.
There’s always also another alternative, which is that you can sell the note at a later date. There are a number of people out there like me who liked to buy nonperforming notes. Let’s say you bought it for $30,000 and it’s amortize down to $25,000. There’s a very good chance that you would be able to sell that note for $25,000 and get out whole.
Another thing to remember is if you invest in stocks or something like that, let’s say you put in, for example, $10,000. What you want when you sell your stock is that your $10,000 back plus some sort of return on top of that, but you don’t get your $10,000 back until you sell the stock.
If you invest in a mortgage note, as with any mortgage, it amortizes during the period. So if you have a $30,000 note, you will get an increasing amount of your principal in addition to the interest paid back to you every month. So if you looked at this and it was a 10 year investment, on a $30,000 you wouldn’t have $15,000 left, but you might have $20,000 actual principal risk. So if something did happen to that investment, your exposure is far less than it would be if you had invested in the stock market.
And lastly, a lot of people like investing in notes as an alternative to investing in real estate. If you invest in real estate, you have to put up with the rental processes and everything that goes along with that. Some people call those the three t’s, tenants, toilets and turnover. And that being the case, you have to deal with that. If the toilet gets blocked, guess what? You’re stuck with it. But if you buy a note, just as you can’t call your bank and have them fix your faucet, your borrower can’t call you.
So what a lot of people do is they will, if they have a rental property, they will go ahead and sell it and take back a note to themselves, which I can help you facilitate. You don’t have to buy a note directly through me. You can actually, I can help you create a note. But that’s another way to participate in real estate and get a nice stable return.
So that’s it for today’s lesson. We learned a little bit about alternative investments as opposed to investing in private mortgage notes.
As always, if you have immediate questions, please don’t hesitate to give me a call at (510) 918-9001 or fill out our online contact form. If I don’t hear from you, I hope to see you soon for our fifth installment of this podcast series. See you then.