Thinking of buying real estate notes in your retirement account? These tips will get you started!
The past decade has seen an explosion of private investors moving from buying property to buying notes. Tired of the headaches of being a landlord, they would rather be the bank. After all, nobody calls the bank at 2 am for a lockout or a stopped-up toilet.
For years, banks have profited from interest on home loans (earning back an average of 1.5 to 3 times what they lend over a 30-year note), and private investors want their share. Here’s what this article will cover:
- Benefits of Owning Notes
- 10 Tips for Buying Notes in a Self-Directed IRA
- Tip #1: Know Your Note Type
- Tip #2: Have a Playbook
- Tip #3: Embrace the Boring
- Tip #4: Seek Professional Help
- Tip #5: Spread the Risk
- Tip #6: Find Creative Solutions
- Tip #7: Master the Time Value of Money
- Tip #8: Tap into Deal Flow
- Tip #9: Learn from Others
- Tip #10: Use a Self Directed IRA Custodian
Benefits of Owning Notes In A Self-Directed Retirement Account
Real estate notes can be great assets for self-directed retirement accounts. The benefits include:
- Generate interest income
- Purchase at a discount for increased yield
- Backed by real estate as security
- Less hands-on than owning property
- Licensed third-party servicers can manage payments and collections
- Ability to rework the note, take a deed in lieu, or take the property back through foreclosure in the event of non-payment
- Profits are tax-deferred (or even tax-free with a Roth IRA).
Here’s an example of a seller-financed note my IRA purchased a few years back in Sunrise, Florida. The seller sold their small condo unit to a retiree who wanted to enjoy the sun and sand in sunny Florida. The seller carried back a note and, after receiving a year of payments, decided to sell it for a lump sum of cash.
Sale Price: $25,500
Down Payment: $3,000
Original Balance: $22,500
Note Interest Rate: 8.0%
Terms: 180 payments of $215.02 per month
Payments Made: 15 months
Remaining Balance: $21,477.84
Remaining Term: 165 months
My retirement account purchased the unpaid balance on the note (including future interest and payments) for $15,800. That resulted in a $5,677 discount and a 13.9% yield for the retirement account.
10 Tips For Buying Real Estate Notes in a Self-Directed Retirement Account
If you are considering investing in mortgage notes for your IRA, here are ten tips for getting started.
#1 – Know Your Note Type
What type of note investor are you? Can you afford to take significant risks, or are you looking for a more conservative approach to note buying? Notes come in all shapes and sizes, so weigh the pros and cons of:
- First position vs. second liens
- Performing vs. Non-Performing
- Owner-occupied vs. Rental
- Loans to Investors vs. Seller-Financed
- Full or Partial Purchases
- Single Family, Multi-Family, Land, Mobile & Land or Commercial
If you are new to note investing, it is a good idea to get some performing first lien notes under your belt before considering non-performing notes, second liens, and riskier deals.
#2 – Have A Playbook
Create a playbook outlining your plan of attack, processes, and approach to note buying. Set targets for Yields and Investment-To-Value (ITV) thresholds. Learn the ABCs of note grading for property type, occupancy, equity, seasoning, and credit rating. They’ll provide a guideline when performing your deal analysis.
#3 – Embrace The Boring – Due Diligence Matters
After the thrill of making the deal comes the reality of validating the facts. Taking time to inventory a collateral file can be tedious, but it is also essential. In the words of one of the world’s most successful investors,
The great moves are usually greeted by yawns. – Warren Buffett
Looking for the fundamentals?
Start with these Questions To Answer Before Investing In Real Estate Notes
- How long has the buyer been making payments, and are they current?
- Is there a servicer collecting and validating the payments?
- Do the documents match the terms presented for sale?
- Are the real estate taxes paid current?
- Is the Property insured for fire and other hazards?
- Is there an updated title report?
- What is the lien position, and what else is owed on the property?
- Who is the current holder or seller of the note being purchased?
- Where is the original note, and will it be delivered at closing?
- What is the current value of the property?
- How much equity does the buyer/payer have?
- What is the creditworthiness of the buyer, and are there any bankruptcy filings?
Draw on industry-standard due diligence processes to build a transaction checklist. Be consistent and use it on every single deal.
#4 – Seek Professional Help
No, I’m not suggesting you consult a therapist for your deals. I’m talking about the experts you can use to help avoid making mistakes in your transaction. There are lots of resources, including:
- Servicing agents to collect payments.
- Attorneys to review documentation.
- Title companies to check lien status, real estate taxes, ownership, and transfers on both the property and the note.
- Mortgage Loan Originators (MLOs) to handle disclosures and compliance issues on newly created notes to buyers planning to live in the property.
- Property Evaluation & Inspection providers to establish current value, condition, and occupancy of the property.
#5 – Spread The Risk
Keep your portfolio diverse. Spreading risk across several smaller notes instead of one large note helps prevent one deal from souring your entire nest egg. I’d rather have four $50,000 notes than one $200,000 note.
#6 – Find Creative Solutions
Think outside the typical banker’s “box”. Look for other ways to structure a deal that create a win-win for everyone.
Utilize the Partial Purchase, one of the most powerful wealth-building tools in the note industry. You don’t have to collect all of the payments on a note to still yield double digits.
Consider having your IRA lend money backed by an existing note, like the hardworking hypothecation real deal in Utah.
These unconventional note-investing approaches can deliver strong returns while minimizing risk.
#7 – Master The Time Value Of Money
Purchase a financial calculator or software and learn how to use it. It can be your best friend in harnessing the power of the Time Value of Money. And don’t let all those buttons scare you. You only need to understand five sets of letters to solve most note investing calculations:
N (number of payments)
I (rate of interest/return)
PV (present value)
PMT (payment amount)
FV (future value)
#8 – Tap Into Deal Flow
How are you planning to find notes? They don’t just drop on your doorstep, so you’ll need to figure out how to get them to you.
Look at networking and referrals through real estate clubs, educational events, and conferences. Direct mail still works to target sellers who sold property with owner financing and are collecting payments. You can also find notes online through exchanges and listing platforms like NotesDirect.
#9 – Learn From Others
Don’t try to reinvent the wheel. Learn from others who have been where you are. Learn from both their home runs and the mistakes they made on deals that went awry.
#10 – Use A Self-Directed IRA Custodian
Use a self-directed retirement account custodian to buy notes tax-deferred or tax-free. The most common types of accounts are the Traditional IRA or the Roth IRA. Other options to consider include the Solo 401k, SEP (Simplified Employee Pension), HSA (Health Savings Account), and ESA (Educational Savings Account).
Work closely with your Custodian to properly title the asset in the name of your IRA. Avoid prohibited transactions with disqualified persons, and set up note collections through a third-party servicing company.
When I first opened a self-directed retirement account in 1999, we only had a couple of companies to choose from. Now there are dozens of great options, with a whole section dedicated to these custodians in the annual Directory of Note Buyers and Service Providers.
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