Real estate investing in built on leverage – the concept of obtaining debt at an average of 70% to 80% of value. While many real estate investors think about the property, other focus on investing in the debt side of the business. And the best of this debt is called “first-lien” which means that, if the debtor does not make the required payments, the note holder takes back the property. So how does this sector of real estate work?

A beginning axiom that tells the whole story

There’s an old saying in real estate that “before you can have return onprincipal, you have to have return ofprincipal”. And that’s the truth about buying a real estate note. Although it may pay out a certain interest rate, that’s all washed away if the borrower defaults and you have to sell the property at a loss. So before you would ever buy a note, you have to make sure that the property is worth at least the amount of the note if not more – and that’s with some cushion for real estate commissions and legal costs to foreclose on it.

Location, location, location

So if value of the real estate is critical, then it falls back to an another old adage “location, location, location” – that’s the real mark of a safe investment. Whether the first-lien note is for an industrial building or a mobile home park, the key is to understand what makes this type of investment valuable and then establishing a value that supports the note amount.

The credit worthiness of the debtor

Just like a bank, the buyers of a first-lien note must look to the credit-worthiness of the borrower to ascertain the odds of repayment. A borrower with a solid track record and significant amount of down payment (also known as “skin in the game”) is a much safer bet than someone who has never successfully operated real estate before and bought the property with very little down.

Performing vs. non-performing notes

There are two basic types of first-lien real estate notes: 1) performing notes and 2) non-performing notes. They are two entirely different business models. The “performing note” is all about locking on a certain interest rate while a “non-performing” note is all about taking the property back and selling it at a profit, or re-negotiating the note with the borrower for a higher yield.

Understanding risk vs. reward

In both buying a performing or a non-performing loan, the key is to understand the healthy risk vs. reward relationship that a successful investment always has. Sam Zell (America’s #1 real estate investor in three different niches: 1) office 2) apartment and 3) mobile home park) is a master of this vital attribute. His theory is that you always invest when there is little risk and high reward and you never invest when there is high risk and little reward – and everything else falls somewhere in between. The bottom line is that if you are buying a note that has a weak borrower, it needs a much higher yield, the same as a non-performing note that has a sketchy location must come at a huge discount.

Conclusion

Buying first-lien notes is another way of investing in real estate, but in a much more passive role. Some people actually prefer this sector, and there are solid returns if you know what you’re doing.