The “Big D” doesn’t stand for the “Big Disaster.” It stands for defaults, and when it comes to defaults and note investing you’ll want to know your options.
When I talk to potential note investors, they always ask, “What if the borrower defaults?” I’m always glad when they bring up the topic of defaults (which I call the “Big D”) because it gives me the chance to explain yet another advantage of investing in notes compared to stocks.
Investing in Stocks vs Notes
First, let’s take a look at the risks involved with the stock market. There are countless factors that can decrease a stock’s value (even if the company is profitable). I’m talking about things like tax increases, foreign wars, terrorist attacks, oil spikes, bankruptcies, recessions, and on and on.
When the bottom drops out of your stock value, you have no collateral that secures your investment. You can be left with worthless pieces of paper.
Compare that to the worst-case scenario of investing in a note. Even if the borrower defaults on their payments your note is still secured by the collateral of the property!
Loan-to-Value and Real Estate Notes
Before we invest in any note, we always look closely at the loan-to-value (LTV) ratio.
It’s calculated by dividing the amount owed by the appraised value of the property, so the lower the number the better. As an example, when we buy a note that’s perhaps 50% of a house’s potential sales price and that value drops 25%, our investor still has a 25% margin of safety on top of their investment in the note. So even if the value of the property drops, your monthly payments stay the same.
Defaults and Note Investing – What are Your Options
I’ll admit that some defaults can be messy. If a borrower wants to withhold his payments and vandalize the property, it’s difficult to stop them.
That’s why we only buy notes in decent neighborhoods owned by well-qualified, hardworking people who like where they live and take pride in their homes. Before we pursue foreclosure, we make every effort to modify the note enabling them to stay in their home and investors to continue receiving their payments.
However, if they default we usually have at least three remedies:
- Foreclose and Sell the Property – If your note has a low loan-to-value ratio you should have little trouble selling the house and recouping your investment and any past due payments.
- Foreclose and Rent the Property – As part of our process of evaluating which notes to invest in, we always check the area’s rental prices to make sure they approximately double the mortgage payments. If the loan defaults, we can easily rent the house and keep money flowing in.
- Sell the Note – Starting with the first payment and with every payment thereafter, an investor’s risk decreases due to the note’s amortization. There are many note buyers who specialize in purchasing defaulted notes in hope of foreclosing and obtaining the home. The note can often be sold to such a buyer for the face value.
How Common are Defaults?
We’ve bought many notes over the years but have only had three defaults. None of our investors has ever lost any money.
In one default, the borrower had medical problems and called to say that the house was clean, and the keys were under the mat. We sold it to a local property manager and created a new mortgage with no loss. In the second instance, the borrower died with no apparent heirs. We had to track down his mom who signed the property over to us. It was sold to a local home flipper with no loss. Our third instance has yet to be decided. It’s being processed and with the COVID backlog in the court system, will take a while before an outcome is determined.
So, the “Big D” is a little like the monster under the bed. Pretty scary at first but not so bad once you get to know him. When it comes to defaults and note investing, you always have options.