Buying first-lien notes has been a very successful investment strategy since the origins of the real estate sector. But there are some basic rules that must be followed if you want to succeed at this strategy.
Buy low and sell high
When you are buying a note, you are effectively also buying the potential of taking over the real estate, as well. As a result, you must always be watching what the value of the property is and looking for opportunities in which the face value of the note is significantly lower than the real estate that backs it up. You must always stay in line with the old adage “buy low and sell high” whether that’s your intention or not. Of course, if you buy a non-performing first-lien note, then it’s even more important, as the odds that you will end up with the property are even greater.
Get an above-market yield
Every moment in time has a snapshot of yields on everything from CDs to stock dividends. These are all very passive and somewhat safer and easier a route than buying a first-lien note. As a result, you will need to demand a higher yield on that note. If the going rate for “blue-chip” investment vehicles are 3%, then you need at least 6% to 10%+ to make it worth your while. Your time is worth something, and so is the lower liquidity risk of a first-lien note if you should ever need the money (or if your estate should because you passed away). Don’t get involved in notes that don’t have high yields.
Understand the cycles of interest rates
It’s a well-known fact that interest rates run in cycles. Therefore, as a note investor, it’s important that you understand where you stand in the cycle so that you can profit from it. If interest rates are going down, you can buy a first-lien note at a high yield and then sell it later at a profit simply because interest rates have come down and therefore your note is worth more. You also need to demand a higher yield when rates are rising so you don’t go upside down.
Risk vs. reward
One huge part of buying first-lien notes is understanding the concept of risk vs. reward: high risk and low reward should be avoided and low risk and high yield should be embraced. Every deal has a risk vs. reward profile that you have to be aware of – and it needs to be in the correct proportion. If you are buying a first-lien note on a property with a questionable location that concerns you, you need to get a far higher return than one that is rock solid. The same is true if the borrower is less than perfect.
Conclusion
Buying a first-lien note can be a great investment – if you properly construct the transaction. Use these tips to help you make sure you are buying a winner.