Mortgage Swaps Help
Investors Free Up Cash

Passing notes might have been frowned on when you were a kid in school, but it may be a good way to invest in real estate now given the current interest rates.

The notes in question are mortgages on properties. Buyers can use mortgage notes on properties they own and combine them with notes on properties they want to buy to purchase the assets without having to fork over a large amount of cash upfront. Sellers of properties can benefit from buyers using notes to purchase their properties, as well.

The Gist of It

Here's one way it works: An investor who already owns an apartment building wants to buy a shopping center that's for sale. The investor creates a mortgage note on the apartment property, using his or her equity in the property and naming the seller of the shopping center as the mortgage holder, as a down payment. The investor agrees to make monthly mortgage payments on that note to the seller, including principal and interest.

Meantime, the seller then agrees to help finance the rest of the purchase price by creating a mortgage note on the shopping center. The investor also would make monthly payments on the shopping-center note -- with interest.

More for Their Money

For the investor, this is a way to buy additional property without having to spend a lot of money all at once. This frees up cash for the buyer to invest in other things, including other properties, says Bill Mencarow, a Kerrville, Texas, mortgage-investment specialist. Another advantage for the buyer, he adds: "He gets to keep his building." The buyer will have cash flow from rental income for both properties, some of which can be used to pay the notes.

"If the buyer had just paid the seller cash for the property, there would be an opportunity cost," Mr. Mencarow adds. "He's lost the opportunity to use that cash somewhere else."

For sellers, this is a way to sell property and receive proceeds from the sale in monthly installments plus interest. While the seller doesn't get the proceeds all at once, over time he or she is getting more money from the sale because of the interest payments.

While that's good for sellers, for buyers it means they end up in the long run paying more for the property when interest is factored in. For sellers, the risk includes the buyer not making payments, which means the seller would have to foreclose on not just one property but two.

"If I was advising the seller, I'd make sure I do a credit check on the buyer before agreeing to accept the notes," says Ben Utley, a certified financial planner and owner of Utley Financial Planning Inc. in Eugene, Ore. "You want to make sure they're going to pay."

Mr. Utley also points out something sellers should take note of: that mortgage notes are generally illiquid. "They're generally hard to sell, and if you do sell there is a discount involved," he says. "There's no public market for these kinds of things. There are less buyers for them."

Negotiating Rates

Mr. Mencarow and others suggest now may be a good time for small investors to buy real estate this way because interest rates are still low -- and because they're generally not expected to remain as low too much longer. Rates for notes are typically negotiated, with current rates sometimes as a starting point or benchmark gauge. That means the rate on mortgage notes they create now could be more favorable than notes created in the future.

For sellers, the rates while low, are still higher-yielding than other investment vehicles, at least for now.

George Rosenberg, a mortgage-investment specialist in San Jacinto, Calif., believes there will be even more opportunities for passing notes when interest rates rise.

"We'll see more of these as interest rates rise and it becomes tougher for some borrowers to obtain financing from lenders and as sellers may find it harder to sell their properties," he says.

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