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The creation and trade of real estate notes secured by their real estate is far from new. For many years, it has been a well-known investment strategy and a lucrative source of passive income. Though most of the investment activity has been with performing notes, investing in nonperforming notes has been generating a lot of buzz lately, and it’s not hard to see why.

While these niche investment tools may be risky, they seem to offer a win-win solution for practically everyone involved. Investors can secure them with big discounts and offer helpful solutions for homeowners struggling through a financial hardship. Even institutional lenders get to offload the notes that don’t fit their risk profile.

But what does it really mean to invest in nonperforming notes, and should an independent real estate investor seriously consider this strategy in the first place?

When real estate investors purchase nonperforming notes, it means they are buying into a pool of real estate loans that aren’t paying. Because nonperforming notes are bought at a discount, the investor theoretically has more flexibility than the original lender to find a resolution that can help the borrower pay once again. There are many ways to do this, for example, offering a forbearance plan or reworking the terms of the original note.

Where a resolution is not possible, the investor can either pursue a deed in lieu of foreclosure, or in the worst-case scenario, take legal action to force a foreclosure. Once the investor owns the property, then it becomes like any other real estate investment that can be fixed and rented out or sold.

Plenty of real estate investment gurus claim that it all comes down to the discount. The larger the discount in relation to the value of the property, the more potential for note investors to make a profit.

However, the biggest secret to investing in nonperforming notes is that it usually does not work this way. Realize that by the time a nonperforming note has made it to an individual real estate investor, it has already been analyzed by multiple institutions and investment funds armed with cutting edge investment tools, and they have all determined that they cannot generate even a minimal ROI on it.

That is why they want to unload it.

Foreclosures can also turn into an expensive and drawn-out process, particularly if the borrower decides to contest or files for bankruptcy.

The bottom line is that nonperforming note investing is a complex and risky process.  There are a lot of variables to consider when valuing a note, its underlying collateral, and when assessing the situation and openness of the homeowner. While in some cases it may make sense to invest in a nonperforming note, real estate investors should definitely proceed with caution.

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