Factors to Consider When Making an Offer to Purchase a Real Estate Note

Factors to Consider When Making an Offer to Purchase a Real Estate Note

If you are a beginning note investor interested in purchasing notes secured by real estate, this article is written with you in mind.

Although a novice, you already understand that a note is sold for a discount from its face value because of the impact of inflation on future payments (i.e. the buying power of money decreases over time, so money today is worth less in the future).

You also know you can negotiate with the note seller and buy the entire note or do a partial purchase of the note (buy the rights to a certain number of payments or the balloon portion, interest only payments, etc.). Again, the lump sum cash price you pay is at a discount to the face value of each payment.

So if you are a note investor or buyer, how do you determine how much you would offer to pay for a seller financed real estate cash flow note?

For starters, do a quick math calculation to determine the present value of the note versus its future value . There are free calculators like the one found at www.timevalue.com/.

Of course the note appraisal process is not just math. The valuation of a promissory note requires a prudent and skillful exercise in judgment. In order to do a more in-depth analysis, here are a few questions you should ask because the answers are not included the "time value" discounting formula.

What type of real estate is it? (Residential, commercial, etc.)

How many payments have been? (Is the note "seasoned"?)

What is the note payment history? (Late payments?)

What is the payor's credit score?

Is there equity in the property?

What is the note's position (1st lien, 2nd )

For example, some investors will only look at 1st position notes. Some notes buyers only want "seasoned" notes, versus "un-seasoned". Some investors want the payor to have a certain credit score. Arrange these criteria in whatever priority order is important TO YOU!

Criterion 1: What type of real estate is it? (Residential, commercial, etc.)

What type of property is it? Condo? SFR (Single Family Residence)? Multi-Family Unit? Mobile Home? Is the property occupied or non-occupied? Occupied by owner or by tenants? Commercial real estate? Vacant land? Most beginning note investors start out with "bread and butter" properties, i.e. SFRs, occupied or unoccupied. How do you decide what type of real estate? Simple. Is it a property you would be happy to own? The property securing the note is what protects the note buyer's investment. It is what you, the note investor will get if it becomes necessary to foreclose. There are those who say that because banks are not eager to finance mobile homes, this type of property is usually sold using seller financing and buying these notes is a good investment. OK. However, if you don't want to get stuck with a mobile home, don't buy a note secured by a mobile home.

Criterion 2: How many payments have been made? (Is the note "seasoned"?)

The number of payments made on a note is also referred to as seasoning. Generally, 12 months or more, the longer the better, is the rule. It has to do with minimizing risk of default or nonpayment. The more payments made, the more credible the track record, the greater the likelihood the note contract will be honored and agreed upon payments will be received. But there are some note investors who buy un-seasoned notes, i.e. no payment history. As soon as the real estate transaction is completed, the note is flipped and assigned to a new note-holder and a payment hasn't even been made. In some cases, note buyers consider notes with 6 months payments or even 3 months payments. The investor usually attaches more weight to the payor's credit score, the property's equity or other criteria when evaluating a note without significant seasoning, and adjusts the discounting process accordingly.

Criterion 3: What is the note payment history? (Late payments?)

Delinquent note payments are a very important factor. Payment history and note seasoning are usually always viewed as a "unit" (together). Payment history or seasoning not only shows the number of payments that have been made, but also indicates if payments were received in a timely manner. There are some investors who actually want to buy non-performing real estate notes, i.e. loans that are in default or close to default, or have reached the maturity date but payment has not been made. Why? Probably because they have the wherewithal go after the property. Regardless, a history of late or missed payments lowers the value of the note and impacts the mathematical calculation resulting from the discounting formula.

Criterion 4: What is the payor's credit score?

Generally, credit scores are interpreted like grades on a school report card:

Above 700 Excellent (A+)

651 to 700 Very Good (A)

601 to 650 Good (B)

551 to 600 Average ( C )

501 to 550 Below average (D)

000 to 500 Poor credit

No Credit Payor has no credit payment history

A credit score is not a "tell all". It's just a gauge. A common standard used to evaluate how well individuals manage their credit and pay what they owe to others. You're the investor. As with all the other criteria, you decide how much weight you want to attach to a payor's credit score. Note: Check all three credit scores.

Criterion 5: Is there equity in the property?

Equity, in real estate, is the difference between what a property is worth ("market value" what it can sell for in the current market) and what the owner owes against that property (i.e. remaining mortgage or loan payments on a house). Some note investors believe equity is the deciding parameter and can make or break any note deal. Honk if you agree. Again, there is no set standard but one can not argue the impact on the market when the economy changes. The relationship between the note purchase value and equity is direct impact. Higher equity results in a higher note purchase value and vice versa. Well almost always. It is creative financing and sometimes investors can get very creative.

Criterion 6: What is the note's position (1st lien, 2nd )

Lien position is key because in most cases of a foreclosure, the party holding a first position lien will be paid first. Parties with a second lien position will be paid second. And so on and so on. Encumbrances affect title to the property. When property owners have a free and clear title, there are no encumbrances or liens. First position notes may be more secure than second position notes. But second position notes can usually be bought at a deeper discount. You're a beginning note investor. Exercise caution. Use good judgment.

Note discounting is not just math. It is affected by several factors e.g. note position, property type, note seasoning, payment history, payor credit score, etc. If you are an inexperienced or beginner note investor, a working knowledge and understanding of the note discounting process is your foundation for success.

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