25K Note For Sale: What Would A Typical Offer Be

[John Thedford]

Hello all:
I have a man holding a note he wishes to sell. It has a face value of 25K at 6% for five years. The payments are about $480 per month and they have made six payments. Note holder wants 21K for the note but I feel that is too high. How much would you seasoned investors pay for this note? What formula would you use to calculate your offer? Thanks!

[Dion DePaoli]

You are mixing yield and total return into the same concept. The discounted principal is a capital gain until it is realized through interest in payments made by the borrower at the time the payment is made. The investment principal will be paid down in ratio to the borrower's principal pay-down so both hit zero at the same time. Although an investment manager can accelerate the capital investment pay down depending on the needs of the capital waterfall and the arbitrage between yield and coupon.

So the investor interest in period one is around $180 while the borrower interest is $125. The $55 dollars become paid interest upon the borrower's payment not before. The $55 comes from the $358.32 principal portion of the borrower's payment, which is the pro rata portion of the purchase discount. The borrower has the entire amount applied to reduce principal balance and the investor applies $303.32 to reduce the capital balance.

The loan held to maturity earns $4k in interest. So the potential income from the investment is $8k through maturity. (interest plus discount) Time is needed to aggregate the $4k of interest. This idea creates an optimal time evaluation where an investment can reap the boost to Total Return through the capital gain and also capture a counterbalancing series of interest payments stabilizing the return.

Period Discount (Gain) Interest (Yield) Total Return

P(1) 4,000 0 4,000
P(19) 3,000 3,000 6,000
P(26) 2,000 4,000 6,000
P(47) 1,000 5,000 6,000
P(60) 0 8,000 8,000
It is romantic to look at this investment and simply say "liquidate now". That will create a very high total return percentage in P(1). However, is a now liquidation the best utility of the investment? Should you try and collect all or a portion of the $4k in yield to be paid over future periods? A liquidation now does not allow the investment to realize future interest payments and thus you are looking to leave a portion of total return on the table. ($4k in interest accrual)

As you can see above, periods 19 through 47 have equal Total Returns but the contributors (discounted principal and interest yield) will have varying effects on the total return percent and yield. Thus, giving way to an Optimal Investment Horizon within those periods somewhere.

The analysis commonly conducted by many loan investors actually makes efforts to over simplify the complexity of the loan and the varying impacts of the different contributors to Total Return. Those analyses tend to be more linear which is not the best for loans. Loans, while we want to specify an investment horizon are not so nicely defined. Exits will be irregular as some are influenced by the mortgagee and some by the borrower. Further, the typical deployed analysis, as here, only tries to look at a very limited investment horizon and fails to look to see if an extended investment horizon actually optimizes the investment. If you don't hold the loan, you don't realize the interest. So is it better to get $4k or is it better to get $6k or even $8k?

My statement does not need to be retracted nor do I have gas in my brain. I made the proper statement. The yield in this loan needs to be examined and the rate at which the borrower could prepay the loan as that will affect the return. Since the borrower's prepayment will affect the interest accrual and thus the investment return. That is not the same as saying the investment will not produce a return. The ideas here, which immediately went to the shortest time is the most optimal, is not a correct analysis of these types of investments. It is more likely "Shiny Thing Syndrome". Look for the shiny big number and that must be the most optimal. Analysing and deploying an investment strategy based on that over simplification of the real world will have it's issues in utility. Ignoring the cost of capital, the cost of deploying the capital, the cost of redeploying capital and the possibility of deterioration of future total return percent in new investments would be a few risks that approach does not take into account.

Yield ends up being one of those words which tends to get used much with a variety of underlying meanings. However, yield is defined as interest income. The discount does not become interest income until such time as the payment is made converting the capital gain (potential) into yield. Understanding this and it's influences on the cash flow model you create to analyse a loan will help you be a better loan investor.

I don't know why you would purchase a note and refinance it yourself. If I bought the note, I am the mortgagee. I can modify the note. Refinancing the note will be more costly than a modification. Typically when purchasing a note and talking about refinance, it is referencing the introduction of a third party as the refinancing lender, again because the modification is the more cost effect route. A modification can cure most defects in collateral documents. In addition, a refinance is really shuffling papers not realising return if it is my capital which makes the new loan. So I bought the note, to pay myself for the note so I could own the note I already bought. Yuk. I don't see the value or purpose unless the underlying ownership structure of the asset actually changes where I own the note and refinance it into an entity which I and Tom both own.