If you found a great rental property for sale but the house was burned down, would you buy it? 

Guessing not. At least I hope not.

Yet, in the world of Note investing this kind of thing can happen if you ignore essential risk mitigation strategies. 

Check out our video where I describe our essential 3 strategies for Risk Mitigation in Note Investing.

You may think of risk when you are taking a new line on your skis or hopping on a dirt bike. Or perhaps you think about risk when you are ordering extra spicy off the Thai menu. We mitigate risk in many areas of life. 

When it comes to growing your money, risk mitigation should be equally important.

Below are 3 ways we mitigate risk so that our money can work harder and we can see higher returns. Because if your money can work harder that probably means you don’t have to. 

Ready? Lets jump in!

Timeline of Risk Mitigation (Hint: It Should Be Considered From Acquisition To Sale)

We all want to mitigate risk when we’re investing. And we should do our best to look at risk from multiple perspectives. Typically, this begins with pre-acquisition due diligence.

You and I both do our due diligence for any potential investment. That could mean building a relationship with a trusted financial planner so that they can help pick your stock portfolio. Or, you may research employment and population statistics in the town that you’re looking to buy rental properties. 

However, risk doesn’t disappear when the investment is purchased. Risk should be mitigated throughout the management and sale of the investment. This is no different in Note Investing.

Note investing is different, however, because we have significant control over the risks involved, more so than many other real estate investment types. But if we stop thinking about mitigating risk after we’ve done the due diligence, then we set ourselves up for potential loss.

That would be wearing your helmet and knee pads before going skateboarding, then sending it off a building instead of a half-pipe.

Before we look at 3 strategies for risk mitigation in note investing, let’s be sure we know what it means to get your money working with a Note. Skip ahead if you’ve heard me on this.

Quick Note Investing Review

If you are new to Note investing, take a look at our video “How Note Investing Works.”  You probably understand the Note as the mortgage or deed of trust. Notes are actually the package that contains the loan terms (principal amount, interest rate, term, etc.) and the mortgage or deed of trust that attaches the real property (the house) to that loan as collateral. 

And, surprise, you can be the one who owns the note and collects those mortgage payments! (Just like the bank.)

A Note is a secured investment with the house as the collateral.

When a borrower goes into default, or stops making loan payments, the Note becomes non-performing. We here at Flow State love non-performing Notes because we can help the borrower start making payments again and “flip” the note. We are “rehabbing” the Note and flipping it to keep our money moving. That’s why we call this a velocity business model.

So, we focus on recapitalizing funds to get higher returns.

Now that we’ve reviewed notes, let’s dive into 3 of our risk mitigation strategies for investing in real estate secured notes.

Note Investing Risk Mitigation Strategy 1: Due Diligence

The first way we mitigate risk is by performing extensive due diligence before we even make an offer on the note. This involves following 3 lines of evidence: 

1. Collateral Value – Understand the Property’s Current Market Value
2. Borrower’s Ability and Desire to make Payments.
3. Quality of the Paper Trail and Documents within the Note Package. 

Collateral Value – Understand the Property’s Current Market Value

How much is the property worth as it sits right now? The answer to this question can be trickier than you think. 

Many Note investors will purchase assets without putting eyes on the property. However, without an accurate Comparative Market Analysis (CMA), we can’t know how much our collateral is worth. That is risky.

We employ local boots on the ground in the form of a realtor or other partners who are familiar with the neighborhood-level market (as well as the general market). We want photos of the property exterior, as well as notes on state of the property and the neighboring houses. 

Then, we get the CMA, or comps, from the area. We do this with local experts but we also do our own market research. By having a conservative estimate of the property value without any improvements (no After Repair Value), we can make a more educated offer for the asset that is more likely to meet our projected returns. 

Borrower’s Ability and Desire to Make Payments

The second line of evidence is doing what we can to learn more about the borrower. We can do this by looking for clues in the description of the Notes from the sellers. We can also do some of our own research through legal and ethical means.

We look for borrowers who aren’t currently making payments. But we also look for borrowers who may want to keep their home. 

Is this someone who has a track record of trying to make payments?  Or have they not made a payment in years? Have they filed for bankruptcy? Is the property owner-occupied?

Is there anything else that we can discover about that borrower that would lead us to believe that they might be willing to try to work with us to renegotiate payments and get back on track? 

Interpreting these clues comes from experience.

Ultimately, we don’t know for sure what the borrower’s intentions are until we purchase the note and leverage our team to connect (see Step 3 below). However, there is a lot we can do to pick the right assets and mitigate our risk of having to foreclose. 

Quality of the Paper Trail and Documents within the Note Package. 

The third line of evidence that we perform to mitigate risk is to understand what the paper trail looks like. 

We want to see the history of recordings in this title and understand any holes that may be present. We want to evaluate the history of loan transfer and find any gaps. We want to review loan servicing comments from previous borrower communications.

We want to be sure that someone from the history of this property is not also going to claim that they own it or have any liens on it that we didn’t see. Understanding all the liens will also factor into our offer price. 

We want to be sure that the whole title history is clean or that we can clear it up with minimal cost to ourselves. 

Due Diligence Take-away

Notes require extra due diligence. We look into the value of the property, the willingness of the borrower to keep their home, and the quality of the documentation. 

That’s a lot. Heck, that is why most people don’t attempt this strategy. However, with systems in place and the experience to know what to look for in assets, this extra work can lead to great returns with less risk. 

We’ve always liked going where other people won’t anyway.

Note Investing Risk Mitigation Strategy 2: Equity Cushion Through Discounted Purchase Price

The second way we mitigate risk in Note investing is by purchasing the asset with a significant equity cushion right out of the gate. 

How soft the cushion is (or how large the equity we have right away) depends on how steep of a discount we get when purchasing the property as compared to the value of the house.

This means that once we understand the value of that property (through comparable analysis, market research and our local realtor) we don’t pay more than a certain percentage for that note especially if the borrower is not currently making payments. This is the discount. 

We might only pay 50 or 60 cents on the dollar for the value of that house depending upon how eager the seller is to get the notes out of their portfolio, market conditions, how many Notes we are purchasing from that seller, and more.  

Why Do Banks Sell Loans At A Discount?

Good question. Why would a bank or a note seller take an asset that we know can provide great returns and get rid of it? Here are some of the reasons notes go up for sale and how a discount may be determined.

• Banks need to reduce federal capital reserve requirements.
• Sellers need to clean up financial books. It can look bad to not have the right reserve amount or to have too much debt that isn’t performing.
• These banks aren’t in the real estate management business. They don’t want to work directly with borrowers. They especially don’t want to foreclose and own a house to then have to sell or manage. Their systems aren’t set up for that.
• Regulations drive foreclosure costs for banks sky-high. They don’t want to spend the extra money to foreclose. Better to discount it and sell the note.

So right out of the gate we could have up to 40-50% equity in our investment through that initial discount. This means that we have more options for exit strategies.

We love note investing because there are many different exit strategies that we can pursue. We go for re-performing the Note (taking it from non-performing to re-performing) but the equity cushion makes a number of other strategies work as well. In other words, we sort of plan for the worst by increasing our equity cushion and we are pretty excited when we get the best. 

Equity Cushion Take-away 

So, the discounted asset provides us immediate equity. That equity allows us the flexibility to pursue more exit strategies that can yield higher returns. In other words, it mitigates risk by giving us a lot to work with.

Note Investing Risk Mitigation Strategy 3: Working with Skilled and Licensed Team

The third and final way we mitigate risk here at Flow State Investing is by partnering with a skilled and licensed loss mitigation and servicing team. This team actually provides us 3 forms of risk mitigation:

1. Years of experience in getting borrowers to make payments
2. Legal expertise to prevent disputes and move toward exit strategies quickly.
3. Prevention of borrower’s personal drama from our greatly impacting our business decisions.

Before we look at those individually, let’s define some things.

First, loss mitigation means the prevention of foreclosure. It is the term we use for the relationship between the servicer (the person who speaks directly with the borrower) and the borrower in the mortgage-industry. This relationship is built upon the idea that we want to help homeowners from losing their homes.

Experience in Getting Borrowers to Start Paying Again

However, not all servicers are experienced in the type of loss mitigation we desire. Our team members have years of experience in getting borrowers to make payments on their loan again. They specialize in our very specific form of Note investing.

Legal Expertise

Our servicing team also has the legal framework and systems to be able to connect with borrowers to negotiate our terms. They record every second of conversation to prevent any potential disputes from the borrower. They can take legal action swiftly that moves us toward exit strategies quickly. They can handle foreclosure and bankruptcy oversight if we need to move in that direction.

They build the bridge that connects us to our borrowers and they maintain that bridge to promote long-term commitment from the homeowner.

We don’t have to learn how to build bridges or the legal requirements to make it safe.

Keep Personal Drama Removed From Our Business Decisions

While we love that our investing dollars are helping people stay in their homes, we also recognize that some people will say and do anything to get out of making payments.

By communicating our intentions and negotiations through a servicing team, our business decisions are less impacted by the personal drama of our borrowers. We seek to help our borrowers keep their homes, but sometimes they need to see that we mean business as well. 

Afterall, our number one priority is capital preservation. Otherwise we wouldn’t be able to help anyone.

What else does the loss mitigation and servicing team do?

• Pre-acquisition due diligence
• Foreclosure avoidance and loss mitigation (cost savings, reduction on timeline by years)
• Foreclosure and bankruptcy management and oversight
• Post-foreclosure eviction
• Licensing/compliance (required in some states)

Loss Mitigation Team Take-away

We leverage the experience and skills of a loss mitigation team to assist in our due diligence, prevent foreclosure, communicate legally with borrowers, maintain a business relationship with our borrowers, and more. 

How Do You Assess Risk?

These are only three ways we mitigate risk here at Flow State Investing. It goes deeper than that. Now, I invite you to think about how you assess risk in your investing.

What type of risks do you look at in your real estate investing? 

What is your risk threshold in your investing?

How do you mitigate risk in your investing?

If Note investing sounds like something that may fit into your investing strategy, hop on a call with us to chat about partnership opportunities. We’ll take the time to talk about your investing goals to see if a partnership may be right for us. 

Join our Investor Circle to schedule that call!