We often get asked what is the most important factor when purchasing a note. Everyone has different hot buttons.
Some investors will tell you that the location of the property is the most important factor, perhaps focusing on something close to their home or on judicial versus non-judicial states.
Some will tell you the yield (return).
Some will tell you the seasoning (the amount of time the person has paid on the note thus far).
Some will tell you that it depends on how much the payor contributed toward the down payment when they purchased the property.
One of the best things about our industry is that, as a note investor, you get to choose what is important to you. This could be based on what you have learned in a training, picked up at an industry convention, or just learned through experience in your own notes.
Tracy and I have been in the note industry for over 30 years. During that time, we have seen many notes, and, for me, it comes down to this.
Why is Collateral So Important When Purchasing Notes?
It’s the LTV and ITV of it all, and it’s what secures your note.
LTV is the Loan-To-Value. It is the amount of equity that the payor has in the property. They get equity right out of the gate by providing a down payment. The equity gains over time as the loan is paid down (or the property increases in value). If the payor owes $75,000 for a $100,000 property, the LTV is 75%.
ITV is the Investment-To-Value. It is the amount of money the investor has in the deal…in relation to the value of the property. With the above LTV example, if the investor pays $65,000 for the $75,000 note…and the property is worth $100,000, the ITV is 65%.
LTV is the likelihood that the payments will continue to be made. ITV is the likelihood that the investor will get their money back IF they don’t pay.
Both of these are very important. And both can be verified in many ways. We have an entire closing checklist for this type of thing in the Due Diligence Master Class.
But…if I were pressed into picking JUST ONE THING? I would pick equity.
For starters, the more equity there is in the property, the less likely I will need to take the property back. If someone has equity in the property and then they have trouble affording it, they would sell the property and walk away with the equity.
If they have no equity in the property (or are underwater), they might walk away.
Securing Your Collateral with a Down Payment
Many payors on private notes have poor credit, reside in judicial states, and are self-employed.
So, how do you combat this? With a GOOD down payment.
The average down payment in 2024 was 27%. That is a significant amount of equity, dispelling the rumors that private notes are all ‘no-money-down’ deals.
If the payor enters the deal with equity from day one, the likelihood that the payments will continue is quite good. Again, if something doesn’t work out, they will try to sell to recoup some of their money. If I own the note, I get paid.
If they don’t pay…we go back to ITV.
At this point, I have not mentioned credit, seasoning, location, house size, etc. Yes, those are all essential things we look at. But, for me, it is not the first thing I look at. My priority is the collateral — what it’s worth and the amount of equity the borrower has.
What’s yours?
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