Partials are a great tool in a note investor’s toolbox to mitigate risk, but partials do not completely eliminate your risk.
A partial is simply a note investing strategy that enables you to reduce your risk and still get some of the upfront cash to your seller.
The dangerous side of partials is that they can give you a false sense of comfort when buying mortgage notes.
Let me share an experience with a partial investment that went sour.
Partial Mortgage Note Investment Example
We purchased a note secured by a small single-family residence in Nevada. It sold in 2007 for $60,000 with a $6,000 down payment. The balance five months later was approximately $53,276. We quoted the seller a partial of $30,000 for the next 100 of the remaining 175 payments.
- I = 9
- PV= $38,435
- PMT= $547
During due diligence the payor’s credit came back in the low 500s. When we saw this we originally were going to cancel the file. Instead we decided to see what the value of the property came in at. We were pleased to see that the value still held and actually came back closer to $70,000. This gave us a comfort level to stay in and to offset the low credit we decided to reduce the partial instead of cancelling the file altogether.
We told the seller we would have to reduce the number of payments that we were planning to purchase to 40 and the maximum we could put into the note was cut in half to $15,000. The sellers agreed and we closed on the file.
We felt comfortable that our exposure was approximately 25% of the value (or ITV calculation).
Although the note paid on time for a while, trouble eventually started. The payors stopped paying, filed bankruptcy twice, and drew out the foreclosure process for a couple of years. We had the property evaluated and when the payors left, they stripped the entire property of cabinets, bathtub, toilets etc. The property value plummeted to around $25,000.
Lessons Learned When Buying Partials On Mortgage Notes
The key take away from this investment is to avoid any low credit payors unless they have a long established pay record to review (this payor only had 5 months). The only other exception we would make is if a low credit payor had substantial equity in the house. This payor put down 10% but this was 2007 when values were decreasing by the month. When the payors knew their equity was gone, they had very little incentive to continue to pay.
As you can see, partials should not be used as a crutch to “clean up” a file. Only use them when the other characteristics of the note; payor, property note are within your buying guidelines. We took on extra risk and the time, energy and money we are out was not worth it.
We should have passed on this file, but at least now we have a story that we can share with you.
While we did not get much of a return on our investment in this note, we did receive a great education and hope you will benefit as well.
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 these additional articles by Greg on buying mortgage notes:
How to Buy Notes: Learning From My Worst Real Estate Note Investment
Real Estate Note Investing: “Wow, That Sounds Risky!”