Most people are generally familiar with the concept of investing in real estate. Many of us have rented housing or we have been landlords either accidentally or intentionally. Note investing, on the other hand, can seem a bit more nebulous. When comparing these two strategies, you may wonder which investment approach is better.
As such, I will articulate a few key differences between the two and declare a “winner” for each category. For simplicity’s sake, we will frame our discussion around renting or lending as it relates to single-family residences.
Property Control vs. Property Ownership
When you invest in a rental property, you own the physical real estate. When you buy a note, you have a lien on the physical real estate. In one scenario, you own the asset; in the other, you control it.
While determining the winner for this category could be debated incessantly, I am going to give the slight nod here to notes. The main reason for this is that, as the note investor, you still have considerable influence over the asset but you incur a lot less responsibility and potential liability.
Round 1 Winner: Notes (Scorecard: Notes: 1, Real Estate: 0)
While it is possible to obtain financing using a note as collateral, traditional financing is much more common in the world of physical real estate. When buying a rental property, you can typically obtain bank financing as long as the collateral and your credit position make sense for the lender.
The world of notes, however, can be more cash-intensive. That may mean you are using your own money or that of a joint-venture partner. Acquiring leverage from a traditional lender to purchase a note is not the norm.
Round 2 Winner: Real Estate (Scorecard: Notes 1, Real Estate: 1)
While the market has tightened in recent years for both real estate and notes, it is easier in most scenarios to source real-estate deals than it is to find notes. Note investing is very much a niche strategy. Finding notes to purchase is generally not as easy as finding hard real estate. While online note portals do exist, you really have to network with banks, hedge funds, and other note investors to have access to good deals.
Round 3 Winner: Real Estate (Scorecard: Notes 1, Real Estate: 2)
Effort and Time Required
While neither strategy is truly passive, note investing certainly requires fewer active components to manage. As a note owner, contact with the borrower is typically handled by a third-party servicer. Yes, rental-property owners can hire a property manager to interface with tenants, but let’s face it, your borrower is not calling you in the middle of the night about a leaky toilet or problems with the next-door neighbor. Managing rentals, from my experience, requires more time and hands-on attention. Note investing can be done from anywhere as long as you have a laptop with Internet access and a phone.
Round 4 Winner: Notes (Scorecard: Notes 2, Real Estate: 2)
Long-Term Value of Asset
Real estate typically appreciates in value over time. Although the value of a note can go up as well, often through forced appreciation like turning a non-performer into a performer (see Strategy #2 on this blog post), that is somewhat atypical and certainly requires patience and work. What is more common is that, as the principal balance gets paid down over time, the value of the note slowly decreases as well.
Round 5 Winner: Real Estate (Scorecard: Notes 2, Real Estate: 3)
In general (not tax advice), owning rental property comes with more tax advantages than owning notes does. With hard real estate, there are often greater expenses that can be written off, such as mortgage interest, and you can depreciate the value of the asset (typically over 27.5 years) for tax purposes. This is one of the main benefits to owning rental property, in my opinion.
When it comes to notes, there are often fewer expenses and the profit is mostly due to interest income, which is treated as ordinary income for tax purposes. There is simply not as much of a tax benefit to investing in notes. This is one reason that a lot of note investors prefer to buy notes through a self-directed IRA (be it a Roth or traditional IRA), which is very easy to establish. This way, the investment grows, whether tax-free or tax-deferred, the same way more common IRA investments do. See this excellent article for more information.
Round 6 Winner: Real Estate (Scorecard: Notes 2, Real Estate: 4)
When buying a rental property, the aim is basically to collect rent, pay down the mortgage, and hold the asset for appreciation and long-term wealth-building. With notes, there are many exit strategies at your disposal. You can add to your rental portfolio if forced to foreclose. You can flip the note. You can sell a partial, meaning a certain number of payments to another note investor. The bottom line here is that there are more options from which to profit with notes than with rentals.
Round 7 Winner: Notes (Scorecard: Notes 3, Real Estate: 4)
While I do think that providing quality, affordable housing to a renter is a socially conscious approach, helping a borrower who has fallen on hard times to remain the owner of his or her home is likely even more impactful, especially when considering the effects on the surrounding community. A borrower is often just a number to a big bank. Not so in the eyes of a conscientious note investor. Further, investing in non-performing notes can help banks and hedge funds to clean up their books. It really can be a triple-win scenario.
Round 8 Winner: Notes (Scorecard: Notes 4, Real Estate: 4)
Overall Winner: It looks like we have a tie, ladies and gentlemen. So I say, “Why not do both?”