The most important thing you need to know how to do as a note buyer or investor is to properly analyze a promissory note investment when it first comes into your office so that you can either pursue the deal or pass quickly.
Let me show you an overview of my 6 step analysis that I go through on every note we look at.
How to Review and Buy Real Estate Notes
1. Property Location
The first thing we look at is property location. Our preference is for real estate notes in Nevada and Arizona because this is where we have most experience, and as such, have a much better understanding of collateral values and state laws. We will consider notes in other Western states, but if they are in the Central US or Eastern states we decline them immediately.
There is nothing wrong with notes in these states; they are just not within our area of expertise. Note investors should invest only in areas where they understand exactly where their capital is going.
2. Property Type
The second thing we look at is property type. Although we used to buy notes on vacant land, these types of notes currently do not make investment sense because there are so many non-performing land notes in our area.
Get to know one or two property types really well and stick to them. If you have no expertise in a particular property type, stay away. The other parties involved will know more than you; putting you at a disadvantage.
We tend to focus on mobile home with land notes, for example, but we consider other types of properties as long as they are in our comfort zone. You too will have property types that you are more comfortable with than others. We recommend limiting the types of property to those that you have the most experience in to limit your potential mistakes.
3. Note Payor
If the note collateral is in a geographic area that we know and property type we understand we will move on to the third consideration which is the payor. In any note investment the payor that is the engine that makes a note investment work. We find out what they do for income, since this will generate the monthly payment that we will be receiving, and we also ask how their pay history has been.
Again, the payor is the component that makes a note deal work… if they stop paying, you as the note investor become the engine because now you have to make the note deal work. (Foreclosure, fixing/rehabbing, selling, taxes, insurance, working with bankruptcy attorneys, etc.)
The payor can enable a note investment to be a passive investment, but if the payor stops paying, they can enable the investment to become very active requiring a tremendous amount of time and energy. Put in the time on the front end to analyze the payor and their pay habits as this will avoid trouble down the road.
We prefer notes with seasoning (length of payment history) where the payor has made twelve or more monthly payments. We do consider shorter seasoning if their credit is satisfactory.
4. Equity Position
The the fourth factor is analyzing the current equity. This most likely will come from a down payment and is a key to keeping a possible deal alive or passing on it quickly.
Any down payment of 5% or less is asking for trouble, so we tend to reject small down payment notes quickly. A new note with 5% or less of a down payment is passed on because buyers with 5% or less have so little skin in the game that it makes it easy for them to walk away.
We prefer current equity of at least 10% and the larger the equity the safer you will be.
5. Current Property Value
Estimating the value of the collateral is fifth step in the process. High collateral value in relation to the debt is a key incentive in keeping the payor paying you regularly so it is a very important piece to learn.
Initially we will look at the county tax records to see what value the county places on the property. Second we take a look at Zillow.com and Realquest.com (both free) for a general value estimation. Current comparable sales in the area are also good barometer.
If we still don’t feel comfortable with the information we will also look at what the subject property or neighboring properties sold for between 1995 to 2002 before the market went parabolic with the credit boom. This is a good sample baseline of value if you can find it.
6. Note Purchase Price Calculations
The sixth step is determining how much to pay for the note. While we rely on the note seller to share what their cash needs are from the note we also have our internal guidelines for investment to value (ITV). Once we have a rough idea of the value of the property we can calculate our maximum ITV which refers to the amount of cash that we will put into a deal in relation to the current value of the property.
This is the key for keeping a margin of safety in our investment or an equity cushion in case something drastically goes wrong or we miss something in our due diligence. Once you have calculated your max ITV you can come up with a range of options for the note seller.
Our maximum ITV is 50% and often times it is much lower than this. This keeps our exposure low and if the property drops dramatically as we have seen recently there is still motivation for the parties involved to keep the note paying.
For example, say we purchased a note and our investment into the note was $40,000 on a property that was valued at $100,000. Our ITV is 40%. Now say that the property dropped in value by half in the current market. In this case our ITV would have increased to $40,000/$50,000 or 80%. Even though we are more exposed, we still have a 20% equity cushion that should keep the note performing.
ITV is different for different investors. We recommend keeping your ITVs low to limit your potential losses.
When looking to price a note we do calculate yield but since yield can only be determined after the last payment has been made it is only a general parameter. We are much more concerned today about buying a percentage of the balance as this gives us room in case the note does not pay as agreed.
While this may seem like a lot of steps, the more notes you look at the easier and simpler it gets. Quickly discard bad notes and focus on good quality notes. Following the above steps will help keep you out of trouble when looking to invest in notes for yourself.
Invest wisely and have fun!
About the Author: Greg Gehlen is the Principal at Canyon Capital, which specializes in the purchase of real estate notes and deeds of trust. He can be contacted at 702.515.7416 or online at www.canyoncap.com
You may also enjoy reading these additional Note Buying articles by Greg:
How Note Buyers Protect Against Rising Interest Rates
Real Estate Note Investing: “Wow, That Sounds Risky!”
Transitioning from Note Broker to Note Investor
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