How to structure a good saleable note

Question

I have a house that I am getting ready to sell. I am going to "owner finance" I have no experence with note selling. Any advice on how to structure the note to make it desireable for a purchaser and also to bring top dollar?  Thanks< Doug

Marc Faulkner · Answer

Doug,
     I have written extensively about the subject of seller financing here on BP.  The keys are to find buyers that have at least 10% cash down and decent credit.  In cases where the buyer only has 10% down I suggest taking back a second position note for another 10% and a first position note for no more than 80%.  I would also suggest a 5 to 7 year balloon and make sure you write a full amortizing note and charge a rate of at least slightly more than the current rates the banks are offering.

Bill Gulley · Answer

One of the reasons that we are seeing all the financial changes, especially in seller financed notes, is that many were originated where the borrower had a slim chance of performance. I'm not going into all the reasons` as they are all over BP.  Mr. Sheth, please read some. A one year at the option of the lender is like saying one year! By the time they can qualify to use the appraised value, they are in default. A high LTV will never achieve enough equity to refinance especially if the borrower didn't qualify 11 and half months ago! A one year note is, to most seller financed borrowers I have seen, simply preditory lending and such thinking is the reason we have some new laws.

Telling someone to do a 90% LTV to get the best price on a note sale? I'd have to say 20% is much better and 25% is even better. There is no standardized formula to use for every borroer in a seller financed transaction, hwile many are very similar, they are all different. Additional collateral can make up for the lack of a down payment or a credit score, this all comes from institutional note buyers, like W.G. Wentworth or similar invetor funded brokerages. An individual note buyer may give a much better price because of several reasons, but two are: they are local and can manage their portfolio and secondly, their alternative investments may not be as high as the commercial guys. Granny who is getting 3.5% might jump at a 12% note yield, that's earning 12% after the discount, not 18, 24 or maybe 30+%. Check with a local broker, your REI club. FInd investors who are paying cash for properties, many of them will buy a note. Terms? Hardley ever, ever less than three, five is fine, seven may be a bit too long. Three years gives the borrower time to get their act together to refi, if it's a 90% LTV, move the term out longer. They should have at least 20% equity based off the appraisal when it's time to refinance. That's for residential, commercial, well that's what ever is agreed to, anyone doing a commercial deal should have enough sence to know what they are doing!  Above all, check around with several sources. Bill

Marc Faulkner · Answer

I agree-the problem with short term balloons is that they are defaults waiting to happen.  The short term will not give the borrower enough time to try to refinance and I don't see institutional lending requirements loosening up much for the next two years.  This will force you to take back the property or rewrite (possibly lowering the value) the note.  
Some of my favorite note buyers use borrowed money to buy notes with and then sit back and collect the payments for term / yield spread hanging in there for the long haul.  If you can get 10 to 15% returns from banks that is great but, I think those kind of returns are a lot easier to find and a lot less risky finding and buying notes for your own account, performing your own due diligence vs letting someone else do this for you.   If the returns are not what were expected at least you know where the blame lies......

Marc Faulkner · Answer

The 2 most important things note buyers look for is equity and credit, in that order.  The key is finding a buyer that has a decent down payment and decent credit and can show you that they have the ability to pay.  
1.  Get at least 10% down.
2.  In cases where the buyer only has 10% down, create 2 notes.  Note # one is in first position at 80% of the purchase price.  Note #2 for the remaining 10%.  This is called an 80-10-10 note and it lowers the LTV in the first position note thus making it more attractive to some buyers.  
3.  Sell of the first after you have seasoned it for at least six months.  
4,  Keep the second for long term cash flow.
5.  Rinse and repeat!!!!  This allows you to pull out some profit and go buy more properties while at the same time getting some additional, long term cash flows going.

Bryan Hancock · Answer

Here is what we advertise:
          
          Below are suggestions that you can provide to the sellers of properties on how to structure their note. This way when they decide to sell the note, they will get the least amount of discount and the highest possible pay price for a Full Purchase option. Again, they are just suggestions.  These ARE NOT minimum requirements, just what we would like to see so that we can give you the best possible price. Anything different will result in a bigger discount and a lower pay price.  We will still buy notes that are not within these suggestions but the discount will be greater.
          
          Residential Property
          - 10% CASH Down Payment (non o/o 15%+)
          - 9% Interest Rate or higher
          - 30 Year Amortization
          - 7 Year Balloon
          - 650 Buyer Credit Score or higher (non o/o 675+)
          - Minimum 1 Month of Seasoning
          
          Commercial Property
          - 20-30% CASH Down Payment
          - 11% Interest Rate or higher
          - 30 Year Amortization
          - 7 Year Balloon
          - 675 Buyer Credit Score or higher
          - Minimum 1 Month of Seasoning
          
          Land Property
          - 30-50% CASH Down Payment
          - 12% Interest Rate or higher
          - 30 Year Amortization
          - 7 Year Balloon
          - 700 Buyer Credit Score or higher
          - Minimum 1 Month of Seasoning
          
          Business Notes
          Unlike property, notes on Businesses do have minimum requirements. If a business note does
          not AT LEAST meet the following requirements, donâ€™t spin your wheels.
          - 30%+ CASH Down Payment
          - 12% Interest Rate or higher
          - Fully Amortized
          - No Balloons
          - Minimum 700 Buyer Credit Score
          - Personally Signed for / Guaranteed
          - Minimum 6 Months of Seasoning
          
          Hope that helps...

Bill Gulley · Answer

Hi, seems like jawsett and Marc have contridictions about the note. Jawsett has excellant advice and Marc does have an excellant stategy here and is correct.

I would suggest you contact a broker initially and see what is most marketable in your area. Many times there are local investors who are willing to go a little extra, more than the institutional or corporate investors.

Marc has a very good point in reducing the risk associated with the first mortgage, 75% and 15% with 10% down is even better if that will work for you. A private investor who is local may be more interested so long as they know you will take them out in the event of default.

Another way is do do one note with two principal parts, a principal part of the first part and a principal part of the second part. Each parts are treated as separate notes, but have common note recitals, like events of default. You can have different rates, payments and principal amounts. By keeping the subordinate part (like a second mortgage) you are guaranteeing that your buyer receives their money before you. You can also sell the note or a portion of the note "with recourse" which means that in the event of default, the buyer can have you repay the balance...doing this, you should get top dollar. Keeping the balloon payment short will also accelerate the buyer's repayment and increase the yield. Make sure the payments are affordable and that the buyer has the capacity to meet the obligation mas it comes due, otherwise, you'll have problems. Good luck, Bill

G. F. · Answer

Find notebuyers that purchase in your area and ask them what their criteria's are. Structure the note to fit the criteria. Note's without some seasoning will need a heavy discount so you will have to factor that into the sale price of the house.

Andy J. · Answer

"In the latter case, if the buyer is unable to refinance the note within a year, you take back the property from the buyer and find another buyer. How is this different than just finding another tenant to lease the property to?"

1.  It's almost always quicker and easier to find a tenant than a buyer

2.  Moving a tenant out after the end of a lease is in most places a lot easier, cheaper, and quicker than foreclosing on an owner with equitable interest in the property.

3. As Bill mentioned, a 1 year note could be challenged as predatory lending.  There's a mess you don't want to deal with first hand.

Rushabh Sheth · Answer

Mark & Bill,
          
          Thanks for your input.  Please consider the similarities between renting out the property for $X,XXX per month and financing a seller note for the same amount per month plus a down payment.
          
          In the rental scenario, the lease will be for 1 year with the option for additional years.  In the note scenario, the note will expire at the end of the year with the seller having the option to roll over for one more year.  
          
          In the latter case, if the buyer is unable to refinance the note within a year, you take back the property from the buyer and find another buyer.  How is this different than just finding another tenant to lease the property to?  
          
          If the buyer is unable to refinance the property within a year and asks for a roll over, the seller can do that just to keep the income flowing.  Heck, you can structure a note to have unlimited rollovers at the noteholder's discretion but that kind of defeats the purpose of structuring a note in the first place.  
          
          The point of having the note is to keep it for the short term so that once it is refinanced by the buyer, you can put the proceeds into other opportunistic investments.  Remember, the situation will change within the next 3-4 years.  Inflation may become a monster.  The dollar may collapse.  Gold may reach $4,000/oz.  A lot of things can happen in the next 2-3 years.  For this reason, you want to keep the note short-term.
          
          If long-term income from a single property is your goal then you might be better off keeping/buying the property outright and generate rental income from that.  It wouldn't make any sense to structure a note with a 5-7 year term.  You are NOT a bank or a financial institution that can keep such instruments in your portfolio for the long term.  If the buyer falls behind on the payments, you have to get involved in property management - you can't just dump the note in your portfolio and forget about it.

I just don't see any advantages of a long-term note over a a long-term rental.  From the perspective of an individual investor, they're the same since you still have to engage in property management either way as far as the cash flow is concerned (although, I do admit that the level of property management will be less for the noteholder than for the landlord).

Given the above facts, it would make more sense to keep the note short term, to give the buyer a greater incentive to refinance.  It's better to let a major bank or financial institution handle the note for the long term.

Jim Wineinger · Answer

The best way to get "top dollar" is to sell your note in "partials" thus reducing the risk to the purchaser. 
          
          Marc Faulkner is one that is aware of this method. I would suggest you send him a colleague request if he does not pipe up soon.

How to structure a good saleable note

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