Much has been written about the high yields and relative safety of investing in discounted mortgages, especially second and other junior lien instruments. Furthermore, since both private mortgage investments and discounted mortgage investments are based on investments in real estate debt security instruments, i.e. mortgages or deeds of trust, these two investment opportunities do have many similarities.
Information on techniques and formulas for investing in discount mortgages can be found in numerous books and on many web sites devoted primarily or exclusively to this type of investment. However, significant differences between these two types of investment do exist.
Investing in discounted mortgages or trust deeds involves purchasing a private mortgage note or deed of trust at a discount. The amount of the discount will determine the yield The greater the amount of the discount the higher the yield. Most of these mortgages are the result of owner financing on single family homes with interest rates comparable to the going market rate at the time that the mortgage was written.
A mortgage carrying an 8% interest rate might be sold for a 30% discount from face value; a mortgage with an interest rate of 10% would carry a smaller discount all, other things being equal. Further, there are yield enhancement strategies available to the aggressive investor resulting in the potential increase in the investor’s total return. Although a discussion of the details of these yield enhancement strategies are beyond the scope of this blog, they relate to the investor’s ability to convince the mortgagor to increase payment size or to pay early by offering some type of incentive. The greater the discount from face value at the time of purchase, the easier and more numerous the incentives that can be used to convince the borrower to agree to a restructuring of the note.
Investing in private mortgage notes entails significantly less risk for the investor than investing in discounted mortgages. First of all, the investor can choose his level of comfort when investing in private mortgage notes by deciding to invest in either 1st liens or 2nd liens. The vast majority of mortgages available for purchase as discounted mortgages are 2nd or junior liens. Second, almost all discounted mortgage investment opportunities will be found in the single-family home market, making this type of investment susceptible to any downturns in the residential owner occupied real estate segment. Investing in private mortgage notes allows the investor not only to choose amongst at least 6 or 7 different real estate segments such as residential, office, warehouse, retail, etc., but also allows the investor to diversify amongst these different markets if desired. Finally, the discounted mortgage investor must accept a mortgage instrument already
written, unlike the private mortgage investor who will have an attorney representing his best interests produce the note and deed of trust documentation.
This is a lot to digest. In my next blog, I will discuss the time and knowledge required to invest in private mortgage notes and discounted mortgages.