In recent years, investing in mortgage notes has become an increasingly popular alternative investment strategy. Mortgage note investing allows investors to purchase existing mortgage loans and receive the principal and interest payments. While this can provide attractive returns, especially in a low interest rate environment, it also comes with risks that investors should fully understand. In this article, we will explore the pros and cons of investing in mortgage notes and examine whether it makes sense as part of an investment portfolio.
Mortgage note investing can provide high yields in a low rate environment
One of the main appeals of mortgage note investing is the ability to achieve relatively high yields, often 6-12%, from the interest payments on performing loans. In a low interest rate environment where yields on many fixed income assets like bonds are quite low, this high level of cash flow can be very attractive. Investors can target different types of mortgage notes based on factors like loan-to-value ratios and borrower credit to balance yield and risk.
Mortgage notes offer diversification benefits for a portfolio
Investing in mortgage notes provides diversification benefits, since the returns are not highly correlated with traditional assets like stocks and bonds. Adding mortgage notes as an alternative asset can potentially enhance risk-adjusted returns for a portfolio through this improved diversification.
Lack of liquidity is a downside risk of investing in mortgage notes
Unlike stocks and bonds which trade on liquid public exchanges, the mortgage note market lacks liquidity as there is no standardized secondary market. This makes it difficult to sell mortgage notes prior to maturity. Investors need to be prepared to hold notes to maturity.
Mortgage note investing requires extensive research and expertise
Properly evaluating mortgage note investments requires significant real estate and fixed income expertise. Each note needs to be thoroughly researched to assess factors like the property value, borrower creditworthiness, loan terms, and more. Many individual investors lack the skills or scale to perform this research sufficiently.
Default risk must be carefully managed with mortgage note investing
If a borrower defaults on their mortgage loan payments, the investor suffers a loss of interest income and principal. Compared to securities like bonds, mortgage notes generally have higher default risk. Investors must implement strategies to minimize default risk through careful research and diversification across many notes.
In summary, investing in mortgage notes can potentially provide high yields and diversification benefits which may improve a portfolio’s risk-adjusted returns. However, investors take on risks including illiquidity, research burdens, and default risk. Overall, mortgage notes can play a role in a portfolio for sophisticated investors with expertise in real estate and fixed income research.