Investing in Notes Secured by Mortgages

Physician's Money Digest, April15 2003, Volume 10, Issue 7

There's a way for physicians seeking to build their retirement fund to lock up an 8% to 16% yield on money lent to individuals or businesses for property. The money lent is secured by a mortgage on the property, giving the lender some security in the case of nonpayment by the borrower.

This type of investing is widely prevalent in the case of the Government National Mortgage Association (Ginnie Mae) certificates or funds in which large pools of mortgages secure the invested funds. Individual lenders will get a significantly higher rate of return as compensation for researching the investment and for its higher risk. When it's done right, the risk can be very small, and the rewards high.

GETTING STARTED

The first step in loaning money on notes secured by mortgages is to make your presence known. Contact attorneys in your area that predominantly handle real estate transactions and make it known that you might be a source of funds for private mortgages. Do the same with local mortgage brokers and real estate agents.

Optimally, these are people you know or may have worked with, but introducing yourself "cold" is not unreasonable. In this interaction, you should be able to delineate the terms under which you will loan money. Some aspects to consider include the following:

• Commercial vs residential property

• Primary residence vs rental homes

• Geographic location of the property

• How much you will lend

• What the terms are of the loan (eg, interest percentage, points, prepayment, interest only or amortized, and length of loan).

As an example, the conditions I like to employ include a minimum 2-year term, no primary residence loans, and the property must rest within 15 miles of my home (so that I can easily check on the property from time to time).

• Who the borrower is. This depends, but it's often someone who doesn't have the quality of credit available to borrow at a lower interest from a bank. It may be someone with a troubled credit history (eg, someone who had a bankruptcy several years ago). It might be a developer who has many complex loans already with banks, and is felt to be too complicated or stretched too thin to lend to again. It might be someone with a cash business who can't prove their ability to pay back the loan based on their tax returns. Ultimately, it doesn't really matter who is borrowing the money.

DUE DILIGENCE

The next step is to investigate a loan offered to you. If it meets the terms you put forward, it's time to do some work. The crucial point in evaluating such a loan is the net value of the underlying property. Try hard to discover the "quick sale" value of the property for cash. Assume that you will have to foreclose on the property at some point, wait 6 to 12 months with no income, pay a few thousand dollars toward attorney fees and the expenses of the sale, and yet recover all this at or before a foreclosure sale without having to worry.

It's usually better to obtain a first mortgage, but you can take a second or even third mortgage in which the senior mortgages are small enough to leave you a significant value in the property. This valuation is crucial. It's a profound mistake to rely on the credit-worthiness of the borrower. Situations change, and the reliability of an individual to pay you back is usually directly proportional to the true value of the underlying property after all indebtedness and expenses are paid.

The valuation of a property may be easy or extremely difficult. Reject proposed loans if you find it impossible to understand the property's value, or feel the property can't sell quickly in the chance of a foreclosure. You can obtain information on a property's value through realtors, tax assessments, and a general knowledge of the area you live in. This process takes some work and time, but it pays off well—in the high, steady return on your investments.

These investments are much safer and more rewarding than those in the stock market. Once you have made a valuation and have decided that the loan is safe enough for your standards, it's time to make the real estate investing move.

Steven Podnos is a practicing internist in Florida. Realizing that his enthusiasm for finance had become stronger than that for medicine, he earned his MBA degree and recently passed the Certified Financial Plannerâ„¢ practitioner boards. He has begun a transition to a full-time financial planning career and welcomes questions or comments at stevenp302@aol.com.