There are many ways to amass great wealth as a real estate investor. The real question is which investment strategy is right for YOU. Let’s take a closer look at the the pros and cons of owning rental property vs owning the note.
Part 1: Note Investing vs Buy & Hold Real Estate
I’m often asked which strategy is better for creating on-going passive income – investing in notes or buy & hold rental property.
My answer is that both can be fantastic investments – BUT what matters most is which strategy is best for YOU based on your specific goals and unique situation. Let’s take a closer look at the the pros and cons of owning rental property vs owning a note.
Buy & Hold
This strategy entails buying a property in rent-ready condition and leasing it to a qualified tenant.
long term investing
Pros:
Potential monthly cash flow when income exceeds expenses
Tax benefits (depreciation, 1031 Exchanges and expense deductions)
Rising rents over time
Rising property values over time
The ability to get financing to increase ROI
Generational wealth – the ability to pass the cash flowing asset onto loved ones
Excellent hedge against inflation (debt decreases as income increases in value)
Cons:
Possibility of vacancies
Possibility of default / eviction
Repairs
Note Investing
This strategy entails buying a note that is secured to a property (a mortgage) and collecting monthly interest payments.
Pros:
Fixed monthly cash flow from the note based on the interest rate you charge
No repairs as you are not the owner, but rather you act like a bank
No worry about vacancies – again because you are acting like a bank
Tax deductions as a business owner (not as a landlord)
If owner defaults, you get property back along with any equity gain
Cons:
Taxed as ordinary income and fewer tax benefits than buy & hold strategy
Fixed cash flow (payments don’t increase over time as rents do on buy & hold strategy)
Set end date for cash flow (when note is paid off)
No future appreciation
Possibility of default (check state laws on foreclosure process)
Possibility of note being worth less than property in an economic downturn
No leverage
No hedge against inflation
When is Note Investing Not Preferable?
Self-Directed IRA’s: Note investing makes a lot of sense because you don’t get the normal tax benefits of owning real estate anyway when you purchase property in your IRA. All income from the note goes into your retirement account and you only pay taxes when you take the money out.
Cash Buyers: The interest earned on a note may be higher than the cash on cash return of a rental property
Passivity: Note investing can be a great choice for someone in retirement who want a more passive income and doesn’t mind that cash flow ends once the note is paid off, and doesn’t have the desire to pass a property on to his or her heirs.
When is Owning Rental Property More Preferable?
Self-Directed IRA’s: If you buy a property that you believe will be worth more than you paid, you can avoid capital gains when you sell it. All cash flow and appreciation go back into the IRA tax-free, and you only pay tax when you pull funds out in retirement.
Cash-Buyers: People who want their money tied to hard assets in an inflationary economy, and expect rents and values to increase over time.
Maximizing Leverage: If you bought a $100,000 property with 20% down, you only invest $20,000 and the bank puts up the remaining $80,000. You might only get a few hundred dollars cash flow every month after paying the debt service, which is not exciting. But it is VERY exciting once the note is paid off through the rental income, at which point your $20,000 is now worth $100,000 (or possibly double or triple that due to inflation over time).
Comparing Returns
Notes: If you had $100,000 to invest and you bought a note that pays you 8% interest over a 15 year period, you would earn $72,017.
Rental Property: If you paid $100,000 cash for a rental property and got an 8% return after all expenses were paid, you’d earn $120,017.
You may be wondering why there’s a $48,000 difference between the note and the rental income – when both were calculated with an 8% return over 15 years. The reason is that the note value decreases over time as the principal is paid down.
So for example, by year 10, you’re getting 8% on potentially 1/3rd of your initial investment. The note holder could certainly reinvest capital as it’s returned, but that can be a bit cumbersome since it’s returned in small pieces.
Even though I said the rental property would yield a $120,017 at 8% over 15 years, it could be much higher due to rising rents and rising home values over that 15 year span. Here’s what that might look like:
Additional income from rent increases over 15 years:
2% – $4,100
3% – $6,800
4% – $9,800
Potential property value increases over 15 years:
2% – $34,000
3% – $56,000
4% – $82,000
Combined rental and appreciation over 15 years:
2% – $38,100
3% – $62,800
4% – $91,800
With just a 2% increase in rents and property values, the investor would earn $38,100 more than the note holder would have. At 3%, the difference would be $62,800, and at 4%, the investor would earn $91,800 more than the note holder! Remember, this return would be in ADDITION to the $120,017 cash flow!
And we haven’t even added tax savings to the mix!
So when I hear people complaining about unexpected expenses, I often remind them of the big picture. I highly doubt their expenses will exceed ROI over time, unless they bought the wrong house in the wrong neighborhood and had it all managed by the wrong property manager.
Leveraged Real Estate is the OBVIOUS WEALTH BUILDER
These numbers may be impressive, but they can increase DRAMATICALLY with the use of leverage. A good return can become a GREAT, unbeatable, phenomenal return. And for many baby boomers who didn’t plan well for retirement, it can be their life saver.
Instead of paying $100,000 cash for one rental property, you could finance 4 properties with $25,000 down payments on each. You then have a $400,000 real estate portfolio.
Each property should yield $300/mo cash flow (if bought right), or $14,400/year. If all that cash flow were used to pay off the loans one house at a time, you could own all 4 properties free & clear in 15 years or less! You could have $400,000 in equity and approximately $40,000/yr in cash flow on going for life.
Again, this scenario does not include the possibility of rents or home values increasing over 15 years. Based on history, there’s a good chance values would nearly double in that timeframe if you bought in the right location.
I also haven’t included tax benefits, which could be substantial (potentially more than $15,000/yr tax deductions for those who qualify).
Add today’s historically low interest rates, in which you can lock in a fixed payment under 4.5% while increasing rents every year! No other country offers 30 year fixed rate mortgages. It’s one of the best strategies available, but too often taken for granted.
Which Investment is More Secure?
Note investors argue that rental property comes with too many “unknowns” in terms of vacancies and potential repairs. And while that’s true, a smart buy & hold investor will calculate these potential costs in advance, by setting aside vacancy and maintenance reserves. These costs must be calculated in the initial pro-forma in the expense column. We also encourage investors to put $5000 aside for surprises.
Note investors also claim that acting like a bank is much SAFER than owning a property. I beg to differ. Just ask Countrywide or IndyMac if they believe note investing is 100% secure. You can’t because they are no longer in business! They now rest in peace, along with thousands of other lenders and banks that failed during the Great Recession.
When the world economy collapsed in 2008, jobs were lost, borrowers stopped paying their loans, property values plummeted, and note investors had to foreclose on properties that were often worth far less than the note. The note holders suddenly became property owners, and many inherited severely damaged properties that they had pay to fix in order to sell. Some properties didn’t sell, so these note holders ended up in the rental business after all. If they did sell them, many were forced to take much less than was owed them in what is called a “short sale”.
Be cautious when people tell you their preferred investment is safe and secure, especially if that same person is trying to sell it to you. ALL investments come with their share of inherent risk. The key is understanding fully what you are doing before you do it, and having a mentor you can trust who will share both the pros AND the cons of what you are trying to do.
A Balanced Portfolio
I believe a balanced portfolio includes both notes and buy & hold rental property, with buy & hold investing being the clear wealth builder and note investing providing steady cash flow.
Part 2: Vendor Finance Vs Buy & Hold Real Estate
Vendor Finance
This strategy entails buying an investment property, increasing value by renovating to like-new condition, marketing it to a buyer and offering vendor financing. In this scenario, you sell the property and hold the note like a bank, collecting both interest and principal.
Ex: Buy $40,000 property, spend $15,000 in renovations, sell for $85,000. You receive $2,000 down payment, and secure a note in 1st lien position against the property for $83,000 at 8% interest.
Pros:
Tenant’s Pride of ownership (owner vs tenant mentality)
Fixed monthly cash flow from the note
Lower chance of vacancy (as long as the note stays current)
Tax deductions as a business owner (not as a landlord
Not responsible for repairs (as long as the note stays current)
If owner defaults, you get property back along with any equity gain
Cons:
Fewer tax benefits than buy & hold strategy
Fixed cash flow (payments don’t increase over time)
Set end date for cash flow (when note is paid off)
Fixed sales price at today’s values (no future appreciation)
Possibility of default / foreclosure process
When Might Vendor Financing be Preferable?
Self-Directed IRA’s: The vendor financing strategy makes a lot of sense because you don’t get the normal tax benefits of owning real estate anyway when you purchase property in your IRA. All income from the note goes into your retirement account and you only pay taxes when you take the money out.
Cash Buyers: When paying cash for a property, the cash on cash returns are generally higher with the vendor financing scenario because the owner pays for all repairs, taxes and insurance.
Passivity: Vendor financing is a great choice for someone who is near retirement, wants a more passive investment, doesn’t mind that cash flow ends once the note is paid off, and doesn’t have the desire to pass the property on to heirs (however if your note outlives you, it can be inherited.)
When Might the Buy & Hold Strategy be Preferable?
Self-Directed IRA’s: If you buy a property that you believe will be worth more than you paid, you can sell and avoid capital gains. All cash flow and appreciation go back into the IRA tax-free, and you only pay tax when you pull funds out in retirement.
Cash-Buyers: People who want their money tied to hard assets in an inflationary economy, and expect rents and values to increase over time. They also might want to pass the asset on to their heirs.
Leverage & Maximizing the Power of Good Credit: If you bought a $100,000 property using an $80,000 mortgage, you might only get a few hundred dollars cash flow every month. Not exciting, unless you bought 10. Suddenly that monthly cash flow increases to several thousand dollars every month.
If you used the cash flow from all 10 properties to pay down the loan on 1 property, the $80,000 mortgage would be paid off in approximately 3 1/2 years! With one home paid off, your cash flow increases, so you could pay off the next home in approximately 2 1/2 years. Continue this pattern, and you could pay off all 10 homes in 15 years or less.
Your down payment on those 10 homes might be approximately $250,000 ($20K – $25K each). When those homes are paid off, your equity could be over $1.5 Million – based on 3% inflation – and your cash flow over $80,000/yr and rising. (This is not including tax benefits, which could be substantial.)
This strategy takes advantage of today’s low interest rates to build wealth, and ROI increases substantially when property is leveraged.
How We Can Help You
At RealWealth, we look for emerging real estate markets that have both job and population growth, combined with affordable housing. We share this data on our Best Market pages.
In those markets, we find companies with a proven track record of sourcing good properties in solid middle-class neighborhoods near jobs and have access to highly rated renovation teams and excellent property managers.
Let us know if you’d like a referral to one of these teams, all of whom come highly recommended by our members.
