When it comes to building wealth through real estate, most investors think of physical properties—be it homes, apartments, or commercial buildings. However, there’s another lesser-known, yet equally powerful, investment strategy: mortgage note investing. Both approaches can be lucrative, but they differ significantly in terms of how they generate returns, the risks involved, and the level of involvement required. In this article, we will compare mortgage note investing and real estate investing to help you determine which strategy might be better suited to your financial goals.
Understanding Mortgage Note Investing
Mortgage note investing involves buying the debt attached to a property rather than the property itself. A mortgage note is a legal document that represents a borrower’s obligation to repay a loan used to purchase real estate. By purchasing these notes from banks or lenders, you become the lender and are entitled to receive the borrower’s monthly mortgage payments.
There are two primary types of mortgage notes:
Performing Notes: The borrower is making regular, timely payments, and you receive monthly income.
Non-Performing Notes (NPNs): The borrower has fallen behind on payments, but investors can buy these notes at a discount with the potential to renegotiate loan terms or foreclose on the property.
Understanding Real Estate Investing
Real estate investing, in the traditional sense, involves buying and owning physical property. Whether it’s a rental property, a fix-and-flip project, or commercial real estate, the goal is to profit from the property’s appreciation, rental income, or a successful sale. Real estate investors often deal with property management, tenant relationships, repairs, and market fluctuations.
Key Differences Between Mortgage Note Investing and Real Estate Investing
Both strategies offer a path to wealth, but they operate differently. Here are some key factors to consider when comparing the two:
1. Active vs. Passive Income
Real Estate Investing: Real estate investing can be labor-intensive, especially if you are managing properties on your own. Tasks like handling tenant issues, collecting rent, managing repairs, and ensuring the property complies with local regulations make it an active form of investment. Even with property management companies, there’s still oversight required.
Mortgage Note Investing: On the other hand, mortgage note investing is generally more passive. As the note holder, you collect monthly payments (in the case of performing notes) without managing tenants, property maintenance, or dealing with the day-to-day issues that come with property ownership. It’s akin to being the bank, which makes it a more hands-off investment once the note is purchased.
2. Risk Exposure
Real Estate Investing: Owning real estate comes with risks like property damage, vacancies, fluctuating rental demand, and market downturns. The value of real estate can rise or fall based on broader economic conditions, leaving investors exposed to depreciation, particularly during economic recessions.
Mortgage Note Investing: Mortgage notes also carry risk, but it’s a different type of exposure. With performing notes, the main risk is borrower default, while non-performing notes carry higher risk due to the potential need for foreclosure. However, note investors typically purchase notes at a discount, offering some cushion against losses. If the borrower defaults, the investor can pursue foreclosure and potentially acquire the property, often for less than its market value.
3. Cash Flow
Real Estate Investing: Rental properties can provide steady cash flow, but that depends on occupancy rates and consistent rent payments. There may be periods when properties remain vacant, and rental income halts, impacting overall returns. However, real estate also offers the potential for appreciation, which can lead to significant gains when properties are sold.
Mortgage Note Investing: With performing notes, investors enjoy consistent monthly income from the borrower’s mortgage payments. There are no tenants to worry about or unexpected vacancies, making the cash flow more predictable. In the case of non-performing notes, the cash flow might be delayed while restructuring or foreclosure takes place, but buying at a discount offers the opportunity for substantial profit once the loan is restructured or the property is sold.
4. Liquidity
Real Estate Investing: Real estate is typically less liquid, meaning it can take months (or even years) to sell a property, depending on market conditions. While real estate can appreciate over time, it isn’t a quick process to convert a property into cash.
Mortgage Note Investing: Mortgage notes are somewhat more liquid compared to real estate. Investors can sell notes on secondary markets or through brokers, though liquidity still depends on factors like note quality, borrower history, and market demand. In general, performing notes are easier to sell than non-performing ones.
5. Capital Requirements
Real Estate Investing: Purchasing a rental property or even a fix-and-flip often requires significant upfront capital. There’s not only the property price to consider but also closing costs, renovation expenses, and ongoing maintenance. Additionally, investors often take out loans, which may add financial risk in the form of interest payments and mortgage obligations.
Mortgage Note Investing: Mortgage notes can be more affordable to enter. While some notes can cost as much as a property, others (especially non-performing notes) can be purchased at significant discounts. This lower capital requirement offers investors a chance to enter the real estate market without owning the physical property, reducing overhead and financial commitment.
6. Appreciation Potential
Real Estate Investing: Real estate has the potential to appreciate over time, especially in high-growth areas. Investors can profit from long-term capital gains when property values rise. Additionally, real estate offers multiple exit strategies—such as selling the property for a profit or refinancing as property values increase.
Mortgage Note Investing: The appreciation potential in note investing lies primarily in buying non-performing notes at a discount and rehabilitating the loan. If you can get the borrower back on track with payments, the note’s value increases. While mortgage notes don’t offer the same level of property appreciation as direct real estate investments, the potential for high returns exists through discounted purchases and successful renegotiations.
7. Involvement and Expertise
Real Estate Investing: Managing real estate often requires knowledge of local housing laws, market trends, property management, and tenant relations. Real estate investing is best suited for individuals willing to actively manage properties or those who have the resources to hire professionals to handle the workload.
Mortgage Note Investing: While mortgage note investing requires a different set of skills—such as evaluating loan terms, understanding legal procedures for foreclosure, and analyzing borrower risk—it doesn’t involve the hands-on management required for physical properties. Investors should still conduct due diligence, but it is often less labor-intensive than managing real estate.
Which Investment is Right for You?
Choosing between mortgage note investing and real estate investing depends on your personal preferences, risk tolerance, and financial goals.
If you prefer a more hands-off investment with predictable cash flow and less involvement in property management, mortgage note investing may be the better option for you.
On the other hand, if you enjoy hands-on investing, want to take advantage of property appreciation, and are willing to manage tenants or properties, real estate investing could be more rewarding.
Both mortgage note investing and real estate investing offer unique opportunities for building wealth, but they cater to different types of investors. Mortgage notes provide a more passive approach with lower upfront capital requirements and consistent income, while real estate offers the potential for long-term appreciation and control over a physical asset. Understanding the risks and rewards of each will help you make an informed decision about which investment strategy aligns with your financial goals and lifestyle.