“If you were starting out in notes today, what would you do differently?”
This is probably one of the most frequently asked questions I hear from folks interested in the note business. And the answer isn’t simple. In fact, there are four main components to getting started:
- Knowing what kind of investor you are
- Investing in what you know
- Managing risk
- Always be learning
What Kind of Investor Are You?
Whenever I meet someone who is interested in note investing, I usually start with this question because the answer will help me know what information I could give them that would help them the most. These are all good questions we could ask ourselves regardless of the investment vehicle or asset class we’re considering. For example:
- How familiar and educated are you in the space or what’s your experience level?
- What do you currently invest in?
- How much capital do you have to invest?
- What are your strengths or skill sets?
- How much time do you have available to learn or devote to the business?
- What is your risk tolerance?
Depending on the responses, the path one could go down might vary dramatically. Perhaps you’re a business owner or high-income earner who doesn’t have much time. Well, investing in performing notes or a note fund may make the most sense. Or perhaps you’re an experienced real estate investor who rehabs and flips and you see investing in vacant first liens as a unique strategy to acquire more deals. Maybe you’re someone who has time but limited capital and are willing to work non-performing notes in order to modify the loans for future cash flow, a strategy that tends to require a higher risk tolerance and certain skill sets (like “collections” abilities). All of these can be viable avenues in the note business, but it’s all about figuring out which ones are best for you and your situation.
Investing in What You Know
This is a concept that can catch people off guard. I’ll often say to folks that, “We’re all in the note business—some of us just might be on the other end of it.” What I mean is that the note business is all around us. Many of us have encountered some form of notes throughout our lives, whether it’s credit cards, student loans, auto debt, or mortgages. Most of us just never considered investing in things like that.
I don’t necessarily recommend to people that they should do what I do. I rather suggest you should just invest in what you know and are familiar with.
Many years ago, I went to an IRA conference in Orlando, and I met a gentleman who had become very wealthy through investing in auto debt. It started when his brother-in-law had a used car lot and the bank had just cut off his business line of credit that he had been using to buy used cars to sell on the lot. He knew his brother-in-law’s business intimately and trusted this family member, so he personally lent him money out of his retirement account to keep the business going. He charged an acceptable interest rate, but he also charged a processing transaction fee for every car that was purchased and sold on the lot.
As his brother-in-law’s business grew, so did this gentleman’s retirement account. And the next thing he knew, other used car dealers all over Ohio were asking him for similar loans (with similar transaction fees). That’s when things really started to take off. In this case, he was just investing in what he knew.
I’ve seen this similar scenario where it doesn’t even have to be with what we think of as traditional note investments. Sometimes it’s investing in yourself or your business. I knew an HVAC contractor who began financing heater installations—it’s really just an extension of his current business. The same goes for a dentist friend of mine who was financing dental work for his patients. You see, the note business has unlimited possibilities and avenues since it’s really just a form of leverage. My expertise just happens to be in real estate-backed assets, but if I were doing notes all over again, I would absolutely invest in other avenues that I know (such as construction or renovation financing).
This is probably the area that newer investors should consider the most but probably gets talked about the least. You have to first consider this: Are you going to be an investor or do you plan to run a business? You might be like me when I first started with my partners. We didn’t really know—we were just trying to figure out if we could actually do the business and manage to make a profit. But going in blind or without a plan isn’t something I recommend.
If you do know what you want to get out of note investing, it could make your planning much easier. In my case, today, as a note investor, I’m pretty conservative. I do some private money deals to some local rehabbers’ LLCs (avoiding the majority of Dodd-Frank and Usury laws, since it’s considered a commercial note), and my LLC invests in some performing notes that are placed with a servicer. I also invest in note funds that provide me with a wide array of diversification and limited liability. Although I’m an owner of a note company that buys non-performing notes, I personally do not—and don’t plan to—start working them myself. I’ve come to believe that there is more risk, effort, and time required to be a successful individual NPN investor than I’m willing to commit to.
That leads me to my next point, which is one of the biggest risks in the note business: compliance and regulation. Since the last major real estate and mortgage collapse, regulatory oversight has increased dramatically, especially with the creation of the CFPB and the passage of the Dodd-Frank – Wall Street Reform and Protection Consumer Act 2010. Both of which now oversee the laws that protect consumers. There is obviously way too much to explain in any one article about this subject since it’s state specific but ACAInternational.org and the local department of banking has more information on how these laws can affect your investing.
Other resources include the CFPB examination manuals, and sites like INREV, ISGN Solutions, and ALLREGS.
Before entering any investment, it’s wise to know what cycle you’re in. When I started in the institutional NPN business we were in an up market with real estate (keep in mind note values are in direct correlation to real estate values) and the regulatory environment for non-banks was almost non-existent or just not being enforced. Suddenly, things changed dramatically with a market downturn and the passage of laws holding companies and individuals to similar standards as banks and regulations are being much more strictly enforced. And of course, the market has swung back up since then as well, so obviously it’s important to act accordingly to whatever your current market is.
Licensing will depend where you want to geographically set up shop and what kind of assets (and their availability) that you’d like to invest in. Some states have buy/hold/sell licenses with some restrictions revolving around collections and whether or not you’ll be trying to collect on your own debt, hire a service to collect on your debt, or act as the servicer and collect on other people’s debt. It doesn’t take long to see how vast this trillion-dollar industry truly is. It’s one thing to think you know what it means, but it’s another for the state’s regulator to tell you what it means, so be sure to get the appropriate legal advice from the appropriate type of legal counsel.
We all utilize mortgage servicers to relieve some of the licensing and operational compliance burdens, but the stark truth is that they may not relieve it all. There’s also a lot of oversight and auditing that needs to take place, especially with all third-party vendors as the debt owners bear this liability. Yes, you heard me correctly: You could be on the hook for a vendor, servicer, or even an attorney who violates a regulation, so just because you outsource doesn’t mean you’re free of all responsibility. Just like you have to manage your property managers, you have to manage your servicers and vendors, monitoring that they do everything by the book.
Although this is a big subject, I didn’t want to end without at least planting the seed of incorporating what’s known as corporate governance into your business—especially if you’re investing happens to grow into a much larger enterprise like mine did. This is something you should consider regardless of what type of real estate fund or syndication you may end up with some day. It’s really just a guideline of best practices for any fund manager—simply put, policies and procedures to follow for your business. Today, we follow INREV guidelines for small balance real estate funds.
Always Be Learning
If you’re reading this article, then you’re off to a good start! I always say that to be successful in this business, you need to always be learning, can be a valuable resource to start. Whether it’s podcasts, blog articles, books, or forums, there’s a wealth of information and networking opportunities offered by the site.
It may sound obvious, but it’s worth reiterating that you should always be learning if you want to stay ahead of the curve on things like the market, regulatory risks, and overall innovation in your business. This is also why I suggest attending note conferences and connecting with other note investors both at your level and above to see what their issues and successes are like in the industry at any given moment. Joining note investor groups as well as considering a mentor or JV partner who you can shadow until you’re ready can be great ways to learn until you’re ready to pull the trigger on your first note deal.
So, circling back to the initial question as to how to get started in the note business, it really comes down to looking at who you are today, who you want to be, and how you plan to get there—and doing so while considering all the risks and benefits along the way.
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