Note investing isn't new by any means. From personal IOU's to commercial paper, the concept of one party lending money to another and reducing repayment terms to paper has been around for hundreds, if not thousands of years. Most people only have familiarity with notes through the purchase of their primary residence. Even then, most are only aware of the mortgage part of the transaction. What actually takes place when an individual or couple buy a home and takes out a mortgage involves two instruments: a mortgage and a note. The mortgage is the pledging of the home as collateral for the loan. The note is simply a written & signed statement promising to repay the debt and outlining the terms & provisions of the repayment.

Recently, however, numerous facets of the commercial real estate industry have been impacted by the turmoil in the debt markets.  From the disappearance of the CMBS market to the tightening of lending guidelines by most banks, those in the business of buying real estate have certainly hit some bumps in the road.  Spurred  by continued lack of liquidity in the market, many syndicators and sponsors of Tenant-In-Common properties have been forced to turn to insurance companies, local bank & credit unions, and government agency lenders (such as Fannie Mae and Freddie Mac) for financing. Those flush with cash (or the ability to raise it quickly) are looking to profit in this environment by entering the thriving mezzanine financing market.  However, more than a few such sponsors have taken a different approach by bringing some of their financing in-house through the issuance of private, asset-backed note offerings.

 

Let's examine the benefits of issuing or investing in private secured notes (vs. unsecured).   Investing in secured notes backed by commercial real estate assets isn't really that different from the previous example of someone buying a home and getting a mortgage. Only in these commercial situations, investors are the ones doing the lending, not the bank.  The real estate companies sign a note promising to make repayment of the debt to the investors and pledge land, buildings, and/or shares of the entity that owns these as collateral.

 

So, why is raising money for commercial real estate projects through notes good for the real estate company?

Firstly, it's an easy way to reduce the dependency on traditional bank lending and a creative way to potentially cut the banks out these transactions altogether. In short, companies are able to use private investors' equity as an "in-house" line of credit.

Secondly, it provides them with much more flexibility when it comes to restrictions on the use of the money. For example, a developer could typically never finance land and development projects 100%. However, with capital from a note programs, they could.

Thirdly, it provides extraordinary control over the cost and deployment of the capital.  Commercial real estate is a certainly a business where cash is king and having access to funds to facilitate deals quickly and with certainty of closing affords buyers in this position a distinct advantage. They have the flexibility to acquire properties quickly and act fast on opportunities without waiting for loan underwriting or other lender red tape.

Finally, the costs associated with borrowing investor funds in this manner are competitive versus typical mezzanine or other sources of interim financing. Most of the note offerings we see today promise monthly or quarterly payments to the investors of anywhere between 8-10% annually. On the other hand, some mezzanine lenders are charging 13%+ in addition to the customary payment of points.

Now that we've determined potential benefits for the issuing real estate company, why can secured notes be a good investment for its investors?

Note investments can provide a predictability of income from the payments generated by rents from the underlying property/properties.  In the case of land banking or development deals, income is paid from an option contract, ground lease, or general account funded at the outset.  In addition, the notes are secured by hard assets such as real property or shares in the entity that owns the property.

Investor's most often buy into a note offering with discretionary cash. However, since there is typically no Unrelated Business Taxable Income (UBTI) generated, investors may find that notes can be suitable for qualified plans and other retirement accounts.

Generally, investment offerings of this type are short term in nature. The sponsoring real estate company usually has plans for the capital for a period of less than five years and set a maturity date accordingly. Also, the notes are usually non-callable for a period (2-3 years typically) during which time an investor should receive the stated distributions and the company is prohibited from "calling in" the note and repaying all the capital owed. Since note proceeds are treated as interim debt, they are often replaced by permanent debt a few years down the road as the project is developed, leased, or improved in some fashion to merit favorable long-term bank financing.

 

Due to the fact that the note money is only be lent to the company for a short period of time and the note itself is collateralized by real commercial property (usually of institutional quality), investors can utilize note investments as a relatively safe way to generate stable monthly income and diversify their sources of fixed income. Not to mention, in times like these, it gives a smaller investor an opportunity to participate in large-scale commercial real estate projects they would not typically have access to.

 

As for small and mid-size real estate companies in need of project funding, issuing notes makes sense as a way to fill short-term capital requirements at a fair cost. Many of us know the ability to act quickly and confidently when making commercial real estate acquisitions can mean the difference between getting a good deal and a great deal. So, in conjunction with ready capital a note offering can provide, the ability to cut significant time spent dealing with a lender(s) out of the acquisition time-line can prove invaluable. 

 

The current array of secured note offerings on the market seek is substantial. There are many ways to capitalize on the current lending environment by becoming a lender, instead of most folks usual position in the greater economic scheme as borrowers. So in the end, a potential note investor should weigh the risks and rewards of note investing against other investment vehicles such as fixed annuities, bonds, and preferred stock. One may find that once demystified, private secured notes can make an attractive way to diversify an investment portfolio and generate income.