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How to Get the Most for Your Note

So now you want the money ...

Most people who hold notes do it reluctantly. They are accidental investors. They have a note because, when they sold their home, they were unable to convert all their equity into cash. In order to make the sale, they were forced to carry seller financing.

You would still rather have cash. You would like to sell your note. You understand that notes are sold at some kind a discount but you want to make sure that you get the best possible price. If you read on, you will find out how.

What's it all about? - The Time-Value of Money ...

There is one single concept, idea, theory, factor, and common denominator – call it what you will – that underlies every type of paper transaction. It is the Discount. The Discount is the difference between the nominal  “face” value of the note and its “actual” value. The actual value is the price you or I will pay for the note. 

The Discount with respect to the purchase of income streams is mainly driven by the phenomenon known as “The Time-Value of Money.” In a way, this time-value discount is the mirror image of interest. The value of money is not static. Money, if invested, maintains or gains value (interest). It also loses value over time (inflation). The net gain is interest earned less loss through inflation.

So, what is the time-value of money? While it can be difficult to quantify, it is actually not a hard concept to grasp. To quantify time-value, you need to master some math or a financial calculator and some variables. But to grasp the concept is easy – it’s intuitive.

If I offer you a $10 bill or a $5 bill – your choice, take it now – which will you choose?  You will take the $10, obviously. But then I say, “Wait. You can have the $5 now or the $10 in ten years. Which will you choose now?” This time you have to think. But I bet you will take the $5 bill.

Why is this? It’s because you know that gas used to cost $0.30 per gallon. But now it’s close to $2.00 per gallon. You know and everyone else knows that the value of money decreases with time. You could have paid $10,000 for a house 30 years ago and now it is worth $100,000. 

Now, let’s transfer the fact that money decreases in value over time to considering the purchase of a mortgage. Look at it as if you were an investor

Assume that you have just taken out a fully amortized mortgage of $100,000 for 30 years at 8% interest. You have contracted to make 360 payments to the bank. A financial calculator will tell you that each monthly payment of principal and interest will be $733.76. Now let’s say that an investor wants to buy that mortgage from the bank. 

What the investor is buying is not the “face” $100,000 of the mortgage note. Rather, he is buying (as an investment) the future income stream of $733.76 per month, every month for 30 years.  But he knows (and the bank knows) that $733.76 in month one is not going to be worth the same amount in, say, month twenty.  

In fact, each individual monthly payment over the 30-year period is going to be worth a little less than its preceding payment. And the last payment is going to be worth a whole lot less than the first payment. The value of the payment stream is determined simply by adding up the present value of each individual future payment as it is received in the future. A financial calculator does this with no problem.

So what the investor is buying with present value dollars is the future (and diminishing) value of all of the monthly payments due under the loan. The total value of the payment stream is determined simply by adding up the present cash value of each individual future payment.

How is the present cash value calculated? By applying an appropriate "discount rate." This is nominally expressed as a percentage interest rate. We say “nominally” because aside from the rate of inflation and a rate for investment the discount rate is influenced by other factors.

Other Value Factors - The Risk & Reward Discount ...

While all other value factors are subordinated to the time-value of money, they are important. They all contribute to the overall discount. The value of a note to an investor is affected by these factors simultaneously. While the risk factors can be separately identified for the purpose of discussion and negotiation, they all work together and simultaneously in the investor’s mind to form an overall picture. These factors include:

The Value Of The Property

Value is not just a matter of price. Value has regard to the type of property. We listed above the type of property that notes are made on.  A single family home is considered the most secure because when times are hard people will abandon investment property such as farms, commercial buildings and apartment buildings.  The value of the property will also be affected by its location and its neighborhood.

A note purchaser will almost always want to see an independent appraisal on the property.

The Term (Length) Of The Loan

Because of the time-value of money one of the determining factors of value is the length of the loan. An investor needs to know how long the note runs. The seller of the note receives all of his cash immediately. However the buyer has to wait for his money to stream in over time during the remaining term of the contract. As seen in our discussion of time-value, the longer the buyer of the note has to wait for his money, the less value (buying power) the money has for him.

The Interest Rate

All other things being equal, the higher the interest rate of the note, the higher is its value. This is simply because a higher interest rate means that future payments will be higher.

The Position of The Loan

Loans on a home are generally found in first and/or second position. There may be third, fourth or even fifth position loans. The position of a loan is a risk factor. It determines the order of satisfaction in case there is a foreclosure. The first position loan is the “senior” loan. Typically a bank or Savings & Loan holds the first. The other loans are “junior” loans. 

Here is a theoretical (but quite real) scenario:

In this scenario, if the homeowner defaults on his payments and the house is sold in foreclosure, the S&L is in good shape because the $100,000 home value (equity) easily covers the $80,000 debt. Also, the original seller and the pool man are (just) covered. However, the orthodontist is wiped out. This is because in the event of a default and a foreclosure, each note holder is paid out of the sale proceeds of the house in the order in which his note was recorded.

So, how does a note investor look at this scenario? Let’s assume that the S&L is hanging on to its note but the other three $10,000 notes are available for purchase. The investor has to analyze the risk. He has to look at the underlying equity supporting each note and consider the credit of the homeowner/payor. As the equity supporting each note diminishes, the more the investor has to look at the credit of the homeowner/payor. 

This is what the investor sees:

• The second position note (the one held by the original seller) is protected by an additional $10,000 in equity in the home.
• The third position note (the one held by the pool contractor) is just barely covered by equity in the home.
• The fourth position note (the one held by the orthodontist) is not covered by equity at all.

However, let’s suppose that the homeowner/payor’s credit is excellent and that he has a flawless record paying on his obligations, including the notes in question. Now the investor has to “grade” the notes and tailor his purchase offer accordingly. In this scenario, and all other things being equal, the investor may be willing to pay $6,000 for the seller’s (second position) note, $4,000 for the pool contractor’s (third position) note and $2,000 for the orthodontist’s (fourth position) note.

In grading the notes, the investor must have regard to the overall loan to value ratio. Let’s look at that.

The Loan-to-Value Ratio

An investor needs to know the value of the property relative to the total amount of loans on it.  The lower the “loan-to-value” ratio, the higher is the value of the note.  A person who has substantial equity in the property has an investment to protect and is much more likely to continue making payment on the note(s) secured by it.  “Loan-to-value” is often seen abbreviated to LTV.

Here is how loan-to-value is calculated: 

With House A, the owner only has $10,000 in equity to protect. The owner of House B has $60,000 equity to protect. This means that the $40,000 note is an intrinsically better investment than the $90,000 note.

Following the Big House example above the loan-to-value ratio is 110%. This makes any of the notes on it relatively poor investments, regardless of their position with respect to the underlying equity and regardless of the current credit standing of the payor.

The Internal Loan Ratio

This only applies to junior position loans and is a matter of assessing proportionality of risk, especially where there is a high loan-to-value. It is always conceivable that in the event of a default on a senior loan, an investor may have to cure the default in order to protect his position in the junior loan.

 For example, in the case of a $150,000 first position loan and a $5,000 second, the holder of the second would be faced with very high payments on the first, if he had to cure a default on the first to protect his investment in the second. On the other hand, were there a $50,000 first and a $40,000 second, the holder of the second is in a much more workable position with respect to curing a default on the first.

The Credit of the Payor

An important factor in determining the value of a note is the credit of the person making the payments. The investor has to look at the employment history of the payor and the status of the payor’s credit file or FICO score.

Seasoning - The Payment History of the Note

The investor has to look at the payment history of the note he considers buying. The length of time a note has been paid on is called “seasoning.” A well-seasoned note is more valuable than a note that has just been created. The note that is created in the “simultaneous close” discussed elsewhere on this web site has zero seasoning. It is also known as a "green" note.

Balloon Payments

If a note is expressed as, say, $10,000 interest only at 10% all due in 5 years, then it is said to contain a $10,000 balloon payment payable at the end of the 5-year term. If we are considering a purchase of the note at the commencement of the term, then its value is diminished by the length of time we have to wait for the balloon payment. However, if the balloon payment is due very soon, then the value of the note may be diminished if we can see that the payor may have difficulty coming up with the $10,000 payment.

Due on Sale Clause

A Due on Sale Clause means that if the property securing the note is sold, then the note itself must be paid off.  In other words, the note is not “assumable” by the purchaser of the property.  A note with a due on sale clause is more valuable than an assumable note because the investor has control over the credit worthiness of the payor. The note investor has no such control if the note is readily assumable by the next purchaser of the property.

Yield

The yield is the amount earned by an investor on an investment expressed as a percentage. With note purchases, if the risk is perceived as high, then the investor will demand a high yield or rate of return.  The yield is that measure of return where the note investor feels that risk and reward are in balance.  The investor considers all the risk factors listed above and decides how much he should pay and be paid for assuming the risks involved with the particular note in question.

Yield is not at all the same thing as the rate of interest paid on the note itself or the prevailing rate of interest in the financial markets. However, yield is affected by both these rates of interest. The rate of interest on the note affects the value of the note itself. The prevailing rate of interest in the financial markets has a heavy bearing on what yield will be acceptable to the investor. In this respect a note is no different than a bond. If prevailing interest rates are high, then all else being equal, a proportionately high yield will be expected. This results in a lower price, a deeper discount.

The Discount in Perspective ...

Remember when you were actually selling your home. You sold By Owner. Recall the decision you made to carry seller financing and the reason you made it. Now look at the proposed discount on the note in the context of the original transaction. The seemingly large discount on your note actually translates into a relatively small effective discount on the sale price of your home. This is how it looks.

Say you sold your home for $100,000 but, in order to make the sale, you carried back a $20,000 note. This was because the buyer could only qualify at the bank for a 60% loan-to-value bank loan and only had $20,000 cash to put down on the home. So the terms were:

You are holding the $20,000 note but now you want to sell it for cash. Say, you are offered $14,000 for it. This is $6,000 less than the face value of the note and amounts to a 30% discount. Thus: (6,000/20,000 = 0.30 = 30%).

But, because of the $100,000 sale price of your home, the effective discount is much less. Thus: 6,000/100,000 = 0.06 = 6%.

So the relatively small 6% effective discount you took on the sale of your home was just one of the costs of making the sale. You also had to provide title insurance and a termite inspection, etc. But at least you saved the realtor's commission.

Having Your Cake and Eating It Too - The "Partial"...

One of the things you have learned here is that, when you sell a note, you are in fact selling a series of individual payments, each of which is to be made at some point in the future. 

You also know that the present value of each individual payment to be received in the future diminishes. The further into the future a cash payment is to be received, the less valuable it is today.

However, thinking of a note as simply the sum of its individual component payments brings us to a concept that can put a new complexion on the idea of selling a note.

When you sell the entire note, you sell all of the payments that will be made under the note contract. But what if you could sell just some of the payments, or just part of the note? Well you can. It is called selling a "partial." And there a big advantages to you.

Assuming that you do not need a total cash-out liquidation of your note, the concept of the "partial" allows you to minimize the effect of the discount and keep a high residual value in the note. There is no magic to this. It is all about turning the time-value of money concept to your advantage.

Let's go back to the $100,000 note example we used above. Only this time suppose you own the note, not the bank. It is  $100,000 for 30 years at 8% interest. You are about to receive 360 payments of $733.76 per month.

Now, say an investor offers you $71,335 cash for the entire note. This is an almost 30% discount. This sounds like a steep discount but in fact, depending on all the possible circumstances we outlined above, this price could be very fair. It translates into a 12% yield for the investor. In other words, by paying $71,335 for all 360 payments, the investor is getting a 12% return on the money he pays you. 

But what if you didn't need $71,335. Say that you only needed to realize $25,000 from your note for whatever project you had in mind. Well, if you explain this, the investor could make a different offer. He gets out his financial calculator and enters these values:

• $25,000 as the Present Value (which is the sum you want)
• 12% as the Interest Rate (which is the yield he wants)
• $733.76 as the Monthly Payment (which is what the note pays)

Then he gets the calculator to "solve" for the number of monthly payments he will need to purchase in order to pay you $25,000 and for him to get a 12% return on the $25,000 he is paying. The calculator returns 41.87. 

The investor rounds the result and tells you he will pay you $25,000 for the first 42 payments to be made by the note. This amounts to only 3 1/2 of the first years of the note, after which the payments revert to you. You get to keep the other 318 payments or 26 1/2 years of the note!

But it gets better! At the end of 42 months the principal balance still owing on the note is $96,760. This is because during the early years of an amortized loan most of the payment goes to interest and very little to reducing the principal balance.

Look what happens. You receive $25,000 for your project plus you retain the remaining value of your note after 42 months, thus:

Another way of looking at this is to break out the note into the monthly payments of principal and interest you will receive, thus:

Now, say you wanted to maximize your income over the next 42 months. There's another way to structure the partial. In this scenario, you decide to keep the income from the note for the first 42 months and sell the last 318. The investor agrees to this and calculates the amount he will pay using the same 12% yield. His method for establishing the the value of the the last 318 payments is to establish the present value of all 360 payments and deduct from that the present value of the first 42 of the payments.

This is what you will receive:

A completely different way to structure a partial would be, say, for the investor to purchase two thirds of each payment for the full 360 months. This would have the effect of giving the note seller a large lump sum payment plus a residual income for the full 30 years. We won't do the math here, but you get the idea.

So the "time-value of money" phenomenon offers the investor many ways to satisfy the needs of the note holder. In fact, establishing the needs of the note seller is the starting point in every note purchase transaction.

And now you know how (and why) to get the most for your note and have your cake and eat it too!.

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