2nd position note - is this a good deal or not?

[Nick B.]

Hello all,

A couple of days ago I saw a 2nd position note offered for sale with the following parameters:

Property FMV: $178000
Property location: Illinois
1st mortgage balance: $138000
2nd mortgage balance: $46000
Payment on 2nd: $293
Payment left: 357
Note sales price: $22900
12 months IRR: 14.6%

At first I got excited about 14% return and equity backing the note ($178K-$138K=$40K but the price of the note is $23K, hence $17K equity) but then I did some calculations and found out that the actual ROI is slightly over 5% compounded over ~30 years. In essence, this note has the same payoff as a hypothetical 30yr bond with 5% coupon bought at par value. Not much considering that the interest rates may rise in the next 30 years.

Granted, this note may get refinanced or paid off a lot sooner than 30 years and I heard of average time being ~10 years. That brings expected ROI to 7.8%/year. Still waiting for 10 years until a payoff is a long time.

Another thing I did not like about this note is the property state. It is a judicial state and it takes 12-15 months to foreclose there.

So, here are the questions to the notes investors out there:

What do you think about this note?
Would you buy it or not and why?
Is this note priced too high, too low, or just right?
Is the note term (30 years in this case) an important or minor factor to decide if a note is a good investment?

Thanks
Nick

[Dion DePaoli]

Originally posted by @Nick B.:

@Dion DePaoli ,

I like the way you calculate returns but what if a note was purchased as a source of income? Then spending it all would leave us with no capital and no note. I guess only interest portion of a payment may be spent and principal may be reinvested.

That whole reinvestment thing only makes sense if it is possible to buy another note with similar characteristics for $280 or so. If no such note is available, one will have to wait until all initial investment is returned (6-7 years) and only then look for another note. An alternative is to buy 100 notes at once and then use monthly income ($28000) to buy 101st note and so forth. Not many people have such resources.

Now, back to the note. If another one like that comes along, would it be a good investment or not so? My main concern is 30 years term. I'd rather see a note with 5 years of payments left but all other parameters being equal.

Do such notes exist?

Nick, I am not sure what other reason you would purchase a note for if not for a source of income/return. They do not make good lawn furniture.

What portion of capital that get's allocated to reinvestment is at the hands of the owner of said capital making the investments. I think what you are asking is what if a portion of the return was needed as some type of personal income to live on. Well, as I mentioned then, the investor can allocate any portion their heart desires between 0% and 100% of the return for such things.

However, the quantification of such things only has meaning to the actual investor and is not so related to the asset. The asset delivers a 14.57% return, what you do with it is your business, in that sense.

The investor capital schedule and the borrower principal and interest schedules only align if the loan is invested in at Par. Any discount or premium applied offsets the investor from the borrower. With discounts, portion of the loan principal becomes return and with premiums portions of the loan interest becomes invested capital in terms of repayment.

Again, at the end of each year, we have $3,336 that is no longer earning return. Is it practical to find investment opportunities with that low of a capital amount around the same return rate as the primary investment? I suppose that is more a function of risk assessment. For instance a second position mortgage might trade for that type of money. Other micro finance opportunities are also out there, you just have to find them. In addition, a linear idea to return is not always practical either. You may only invest the $3,336 in a bank CD and add the entire amount each year earning say 2% until you have done so for 5 years at which time you might be able to invest the $16,680 into a higher return investment which makes up for the time the return was small.

I don't understand the another note question you are asking. A mortgagee does not have to hold the mortgage to maturity. Just as the mortgage was purchased after origination here, so too can the loan be sold prior to maturity. During the term of ownership, you still received return at 14.57% annually. When you 'cash out' will not change that idea.

Are there loans with shorter time to maturity? Yes. Some loans have been written for shorter terms which may or may not have a balloon feature. In addition, as you mention you can simply seek loans with are more seasoned in their total term and closer to the maturity to accomplish the same thing.