How does investing in real estate notes compare to a rental house?
First in our “Notes vs. Alternative Investments” series we’re investigating how investing in real estate notes compares with rental property. Which one keeps more money in your pocket? Which one has more risk? Read on to discover the answers.
First, we need to highlight the fact that notes are the financial or paper side of the real estate business, as explained here. The stick and brick house is the collateral we can take back in a worst-case scenario where the borrower fails to pay as promised.
Keep in mind that, thanks to the flexibility of note investing, these worst-case scenarios often turn out to be our best investment friends.
When we’re comparing investments, we’ll do our best to present a fair analysis on both sides to get the most accurate comparison between the two. It should be just the facts.
Notes Have Lower Initial Investment
Let’s compare a note and rental property with an equal market value of $120,000. Right off the bat, your average note already has an advantage.
Why? Because the note value is almost always going to be secured by a property that is more valuable than what’s owed. On top of that, investors often buy discounted notes on the secondary market. We’ll talk more about that in another article, but for now, understand that your $120,000 note is usually secured by a house with a higher value.
For The Same Income, Notes Have Fewer Expenses
Now let’s compare the income streams to see which asset keeps the most money in your pocket. To keep the comparison as close as possible were going to have both assets bring in $1,000 per month.
To simplify your experience a little, the rental property will have a property management firm that averages about 10% of the monthly income. That’s a $100 per month taken out. Similarly, you’ll want to have the note serviced by a third party, both for simplicity, compliance, and other benefits. This typically runs, at most, $50 per month.
Let’s look a little further and see what expenses take a chunk out of the monthly payment of these assets. Check out the chart below for typical expenses. A good rental investor will allow for vacancies, property taxes, insurance, maintenance, and sometimes other expenses (accounting, tax preparation, improvements, etc). The chart below uses common estimates on the conservative side of average.
|Total Expenses||-$400|| -$50
So, once you add all those conservative expenses together, the total profit on the rental side is only going to be $600 per month, at best. And that’s not counting the mortgage bill that many rental investors have to pay from that profit.
Notes Have Lower Time Investment
Notes have a big advantage in time as well, because they drop the headaches of toilets, tenants, and turnover that come along with rentals, and even more so with multifamily. It’s the homeowner’s responsibility to take care of those things.
When there’s an issue, like a backed-up sewer line, the noteholder doesn’t get billed for anything. This is a common problem with rentals because the owner must pay for repairs, and that dips into the profits. Not to mention the nuisance of having to find a new tenant when the previous one moves out in the middle of the night.
Investing in Real Estate Notes is More Profitable Than Rentals
Getting back to the numbers, our note avoids most of these expenses because all the expenses are the responsibility of the homeowner. It stays strong with a profit of $950 per month.
That’s over 50% more profit per month than rental houses! Plus the benefit of avoiding the headaches that come along with rental ownership.
Notes don’t have big expenses like rentals do, and that’s just one of the advantages notes have over rentals.
Notes May Have Lower Risk Than Rentals
What about risk? Well, first, having more cash in your pocket reduces the risk for notes. And we already mentioned that there’s more of a buffer in case of disaster. The collateral property for your note will be higher than your note, making it easier to recoup your capital. If you need to sell a rental, you’re exposed to market values depending on when you bought the property.
What’s the primary risk of note investing? Other than a borrower failing to pay (for which we have a lot of remedies that can pay off well), it’s the risk of missing out on appreciation. Appreciation can be a welcome surprise for rental investors, but too much appreciation can hurt their ability to invest for cash flow. The best rental investors don’t count on appreciation, and it actually gives them more work to do as they seek out new markets that support passive cash flow.
Extreme appreciation in housing markets won’t increase your note value—but it will significantly reduce your capital risk by giving your borrower more equity.
Then there’s liability. We’re not lawyers and can’t offer legal advice, but typically it’s the property owner (not the bank) who’s liable for what happens on their property. As a rental owner, it’s your responsibility to keep the property safe and up to code for the benefit of your tenants and your own legal protection.
Remember: as note investors we are the bank, and people don’t call the bank when something goes wrong.
Real Estate Notes Look Like The Better Investment
One of the biggest secrets to building true wealth is keeping what you’ve earned. And notes have proven they offer more profit vs. rental property. And if your goal is steady cash flow, there’s also less risk.
Catch our next article as we compare investing in real estate notes with rehab investing.
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