The Case for Non-Performing Notes
By Sierra Davis, Principal & Fund Manager, Essential Income Fund IPublished Last reviewed
Short answer
A non-performing note is a mortgage loan whose borrower has stopped paying, typically for 90 days or more. Investors buy them at deep discounts, often priced to the property's value rather than the loan balance, and profit by resolving the default through a modification, short payoff, deed in lieu, sale of the note, or foreclosure. Returns can be high, but timelines and costs are uncertain and the work is active, not passive.
Most people hear "the borrower stopped paying" and think the deal is over. For a non-performing note investor, that's where the deal starts.
A borrower who stops paying is a problem you can solve. The question is whether you bought the note at a price that leaves room to solve it.
Why non-performing notes exist
Banks, credit unions, and larger funds sell defaulted loans to clean up their balance sheets and avoid the cost and staffing of working them out one at a time. They sell in pools or one by one, often at prices well below the unpaid balance. That's the opportunity. A loan is priced to what it's worth to resolve, not to what the borrower owes.
The case for non-performing notes
1. You buy the property's value, not the borrower's balance
A non-performing note is usually priced against the collateral (what the property is worth, what it costs to recover, and how long that takes). That can mean a very low investment-to-value. Buy a note with a $60,000 balance on a $100,000 house for $30,000, and your money represents 30% of the property's value. See loan-to-value explained.
2. There's more than one way to win
A performing note has one main outcome. The borrower keeps paying. A non-performing note has several, and the investor's job is to find the best one for everyone involved.
- Reinstatement: the borrower catches up on what they owe.
- Loan modification: new terms the borrower can afford, turning it into a re-performing note you can hold or sell.
- Short payoff: the borrower sells or refinances and pays less than the full balance.
- Deed in lieu: the borrower hands over the property voluntarily, avoiding foreclosure.
- Sell the note: to another investor better positioned to resolve it.
- Foreclosure: the last resort, followed by selling the property.
3. You can be the reason a family keeps its home
A bank servicing thousands of loans often can't spend the time to understand one family's situation. A note investor who bought at the right price can. A modification that keeps someone in their home and gets payments flowing again is frequently the best financial outcome too.
4. Supply tends to rise when others are pulling back
When the economy weakens and defaults rise, more non-performing loans come to market. For investors with capital and a process, that's when the selection tends to improve.
What the outcomes can look like
Here's one hypothetical note run through five different endings. Balance $60,000. Property value $100,000. Purchase price $30,000. Costs include legal fees, taxes, insurance, and repairs where noted.
| Outcome | Timeline | Total cash in | Cash back | Profit | MOIC | IRR |
|---|---|---|---|---|---|---|
| Short payoff at $50,000 | 6 months | $31,500 | $50,000 | $18,500 | 1.59x | About 97% |
| Modified, then sold as re-performing for $45,000 | 16 months | $31,500 | $51,500 | $20,000 | 1.63x | About 40% |
| Non-judicial foreclosure, property sold for $80,000 net | 12 months | $44,000 | $80,000 | $36,000 | 1.82x | About 73% |
| Judicial foreclosure, 32 months, sold for $70,000 net | 32 months | $64,000 | $70,000 | $6,000 | 1.09x | About 5% |
| Bad case (damaged property, sold for $45,000 net) | 26 months | $64,200 | $45,000 | -$19,200 | 0.70x | About -28% |
Look at the IRR column. Quick resolutions on small dollars produce enormous IRRs, which is exactly why IRR alone can mislead (see IRR vs. MOIC). Look at the last two rows too. The same note, bought at the same price, can earn 1.8x or lose 30% depending on the state, the timeline, and the condition of the house.
What makes or breaks a non-performing note
I evaluate every note with the same 3P framework, Property, Payer, and Paperwork. With non-performing notes, each one carries more weight.
- Property: a current broker price opinion or appraisal, condition, whether it's occupied, and what it would actually sell for after costs.
- Payer: why they stopped paying, whether they want to stay, and whether they'll talk to you.
- Paperwork: the note, recorded mortgage or deed of trust, complete assignment chain, and a title search for senior liens and unpaid property taxes.
- State: non-judicial deed of trust states can move in months; judicial states can take years. See what happens when a borrower defaults.
- Your cost to carry: legal fees, taxes, insurance, and servicing all accrue while no payments come in.
The risks
- No income while you work it out. Capital sits idle, and costs accrue.
- Timelines run long: judicial foreclosure, bankruptcy filings, and court backlogs can add months or years.
- Property surprises: damage, vacancy, or occupants who won't leave.
- Title problems: senior liens, unpaid taxes, or missing assignments.
- Regulation: servicing and foreclosure rules protect borrowers and must be followed exactly, usually through a licensed servicer and attorney.
- Skill and time: this is an active strategy, closer to running a business than collecting a check.
Performing vs. non-performing and which strategy fits
| Performing notes | Non-performing notes | |
|---|---|---|
| Goal | Steady monthly income | Profit from resolving the default |
| Discount | Smaller | Deeper |
| Income while held | From day one | Often none until resolved |
| Return profile | Predictable, contractual | Wide range, including losses |
| Investor's role | Collect and monitor | Actively work the loan |
Both strategies are built on the same skills (valuing the property, understanding the payer, and checking the paperwork). Investors who want income generally start with performing notes. Investors who want to build a resolution business, and can absorb uneven results, look at non-performing notes.
Frequently asked questions
What is a non-performing note?
A non-performing note is a mortgage loan whose borrower has stopped making payments, typically for 90 days or more, putting the loan in default. Investors buy them at deep discounts and profit by resolving the default.
How do investors make money on non-performing notes?
Investors buy the note well below its balance and resolve it through reinstatement, a loan modification, a short payoff, a deed in lieu, selling the note, or foreclosure and sale of the property. The profit is the difference between total cost and what the resolution returns.
Are non-performing notes riskier than performing notes?
Yes. Non-performing notes pay no income until resolved, and costs, timelines, and the property's condition are uncertain, so results range from large gains to losses. Performing notes offer steadier, more predictable income.
How are non-performing notes priced?
Non-performing notes are usually priced against the property's value, the cost and time to resolve the default, and the state's foreclosure process, rather than the unpaid balance.
Does Essential Income Fund I buy non-performing notes?
Essential Income Fund I invests in performing senior-lien mortgage notes and originates short-term real estate loans, because the fund is designed to pay investors fixed monthly income.
This article is for educational purposes only and is not investment, legal, or tax advice. It describes general characteristics of real estate debt investments; individual investments differ, and all involve risk, including the possible loss of principal. Essential Investment Group, LLC is not a registered investment advisor, broker-dealer, or bank. Any offer of securities in Essential Income Fund I, LLC is made only through its Private Placement Memorandum to verified accredited investors under Rule 506(c) of Regulation D.