Let’s face it, some people like to buy at a discount and notes are no exception.
One of the reasons mortgage notes are so attractive from an investment standpoint is that, in addition to being backed by real estate, the investor gets to set the buying terms.
The investor decides which type of property they like as security (residential, commercial, land), what area they want to invest in, and even what yield they want.
Setting your Discount as a Note Investor
As an investor, let’s say you want to get an 11% return on your money.
You put the cash flow in the financial calculator, and it TELLS YOU exactly how much you can pay for the cash flow to receive an 11% return.
You will want to pay attention to LTV and ITV, but try walking into your local bank and telling them you would like to leave a deposit and receive 11% on your investment.
So what is a ‘minimum note discount,’ and why is it important?
Minimum Discounts and Real Estate Notes
Let’s keep with the theme that, as an investor, you would like to receive an 11% return.
Here is the note presented to you.
- 120 – Payments Remaining
- 12% – Note Rate
- $932.56 – Payment Amount
- $65,000 – Principal Balance
If you were to pay $65,000 for the right to receive 120 payments of $932.56, you would receive a 12% return (IRR). Paying an equal amount to the balance ($65K for a $65K balance) is considered Par Pricing.
However, as with all note deals, there are some costs associated with closing the deal.
The Costs of Closing for Real Estate Notes
The amount it costs to close a deal depends on a particular deal, but let’s say $1,000 in this case.
That would mean I would fund $65,000 for the note and pay another $1,000 in closing costs, so I would actually have $66,000 in the deal. It’s not a significant change, but if I put all that into the calculator, it looks like this…
- 120 – Payments Remaining
- 11.62% – Yield
- $932.56 – Payment Amount
- $66,000 – Pay Price
It’s still far above our desired 11% yield, so no problems there. But what if a third party services the note at $27 monthly?
To calculate our ‘true yield’, we would factor in our upfront costs ($1,000) AND our ongoing costs ($27/mo).
The easiest way to do that would be to take $27 off the payment each month (knowing that that amount will go towards servicing costs).
Now, from the investor side, the calculation looks like this…
- 120 – Payments Remaining
- $905.56 – Payment Amount ($27 lower)
- $66,000 – Pay Price
- 10.90% – Yield
Again, it was not a big move, but our yield did go down to 10.90%. Frankly, if your requirement were 11%, I would say this is ‘close enough.’ But, there is ONE MORE THING that you will want to do.
This is something that protects you against an early payoff.
Early Payoff – What Happens to My Return?
Early payoffs are not common out of the gate, but they do happen, and if a note does pay off early, you want to be on the right side of the cash register.
Let’s go back to the original note…
- 120 – Payments Remaining
- 12% – Note Rate
- $932.56 – Payment Amount
- $65,000 – Balance
Let’s say that right after you purchase the note, the PAYOR decides to pay it off.
Maybe they refinanced the property, maybe they had the cash, or maybe they won the lottery. Whatever the reason, if they go to pay off the property right away, they will only have to pay $65,000.
But you invested $66,000 (purchase price plus closing costs). You would lose money if the note paid off this fast (early payoff).
Not a lot of money, mind you, but a slight loss.
So, how do we protect ourselves and use the ‘Minimum Discount’ strategy?
The Minimum Discount Strategy for Note Investors
Never pay 100 cents on the dollar – regardless of the yield.
There are many note sellers out there who assume investors are solely focused on yield. They offer notes at 100 cents on the dollar—no discount.
Good for them, but you will want a minimum discount.
Buying at a discount is paying less than the unpaid principal balance. The discount amount is the difference between the balance less the purchase price.
If you figure your ‘costs’ are close to $1,000, then there is nothing wrong with making sure your offer provides at least $1,000 in discount (or maybe a little more for your time and effort).
Of course, this assumes all your other requirements have been met (Yield, Seasoning, Payor Quality, LTV, and ITV being big ones).
Knowing Your Bottomline and Goals
Never solely chase the yield; always ask yourself, “How much would they owe me if they paid it off tomorrow?”
Chances are, if you built in a minimum discount, you will be more than thrilled at your return.
Hey Fred is getting back into the note business. Your information is really valuable thanks again, tom
Welcome back! – Let’s us know if we can help!
Thank you for this enlightening and detailed article.
You are very welcome!