Investor · Dallas, TX · Member since 2013 · 619 posts · 128 votes
I read a lot of posts on BP recommending investing in notes with your retirement funds. I see double digit returns (10-15%) being quoted as common for note investments done correctly. But when I do some simple math with an amortization calculator/chart I do not see where you get 10%+ returns for the life of the note.
Lets take a simple example.
1st position note value $60,000 @ 10% amortized for 15 years (to keep it simple do not worry about LTV, etc. again the assumption is you bought the note correctly whatever those numbers need to be for you).
So if you plug these numbers into an amortization chart you will see in the first year (months 1-12 on the chart) the interest income from the note averages $490/month; let's round up to $500/month or $6,000/year.
So Year 1 cash-on-cash return would be $6000 / $60000 = 10%
Fast forward to year 5 and the monthly interest income on the note, according to the amortization chart, averages $400/month or $4800/year.
Now in Year 5 cash-on-cash return would be $4800 / $60000 = 8%
Fast forward to year 10 and the monthly interest income on the note, according to the amortization chart, averages $250/month or $3000/year.
Now in Year 10 cash-on-cash return would be $3000 / $60000 = 5%
So it seems like the returns on your note investment are decreasing over time,
where are those double-digit returns??? What am I missing???
Well your math is wrong.
In year five your capital basis would have also been reduced by principal payments.
Apply the principal reduction to the amount invested and see where you end up in return.
Well your math is wrong.
In year five your capital basis would have also been reduced by principal payments.
Apply the principal reduction to the amount invested and see where you end up in return.
One thing not yet mentioned is that a large number of notes don't run their entire amortization term, since people refi and some sell before the term ends.
you're absolutely correct the return would be higher if I lowered the cash invested in future years to account for principal pay down. However, I was trying to relate note investing to buy-and-hold rentals which I am more familiar with where you have to maintain reserves for turnover/repairs/evictions/make ready etc. If I invested in a note I would need to maintain similar reserves should I ever need to foreclose, make repairs, re-market, re-sell, etc. So I assume that means I would keep a large chunk of the principal pay down without re-investing it until the note is paid off right? If that principal pay down monies is just sitting there wouldn't you include it, like I did, in the calculations? How do you take these risks into account when performing your calculations to see if the numbers are suitable to invest in a note?
You're making an error in calculating your return. If a note is fully amortizing then each payment includes principal and interest. If the interest rate is 10%, the interest is always 10% of the outstanding balance. The error you're making here:
Is that you don't have $60,000 invested at this point. You only have $48,000 invested, so your return remains at 10%, even though the absolute returns are lower as the loan is paid down. You even say that:
You say "if I lowered the cash invested in future years". There's no "if" here. You are lowering the cash invested in future years. You must account for that or you're just doing the math incorrectly. Garbage in, garbage out, as we say in the software business. You need to find somewhere else to invest the principal that's paid back if you want to maintain your $6,000 a year in returns.
Notes aren't like rentals in that they do get paid off. Once a loan is paid off you have your principle back, but you no longer have any returns at all.
Interest only hard money loans are different. Those loans typically don't include any principle, so the interest amount remains the same until the loan is paid off.
There are two issues that make that hard. One is that notes are "lumpy". If you have $100K to invest, and the notes available to you are $80K, its hard to get that last $20K put to work. The second is you have down time. When one loan pays off it usually takes some time to get a new loan originated or purchased. So even if the return on your notes is 10%, its impossible to get 10% on the entire amount of cash you have to invest.
And, you are correct that you must have reserves to deal with hiccups like foreclosures.
When I first started doing this I made direct loans via a broker. I received the full interest payments and we split the points. She eventually got out of this business because of increasing regulation and (I think) because she wasn't making enough off just half the points to be worthwhile. One of her helpers picked up the business. The deals shifted to him keeping all the points and 1% of the interest, but in exchange, he took over all the servicing of the loan. I did have one default with this model. I finished the rehab and sold the house, but at a loss vs. what we were owed. Its was only a small loss overall, but effectively there were 15 months with no return on a big chunk of money. Then he shifted to a pool model. All of the investors put their money into a pool and he makes the loans out of that. We get a monthly payment and then an extra payment every six months, based on overall results. I no longer deal with individual loans at all. And, while the return is nominally lower than the individual notes, my entire investment is getting paid at all times. The pool is absorbing the three issues I list above.
Notes are not real property. So you can't make them out to be the same, they are not.
I have no idea how much money you have attempted to reserve. Somehow I get the notion that it is likely more than I would. For each his own. Default risk and prepayment risks are evaluated when investing in notes. So in response to your question, how do you judge these things, the risk of having to foreclose is default risk. To some degree you always have default risk but that risk can be offset by other factors like down payment. Advances made can be recovered if there is equity.
All that said, this idea really doesn't change your return. What ever you want to do with the money is your business but that doesn't change the numbers. The yield on this note will be just shy of 10%.
Principal prepayment only impacts return if you have discounted the principal due in a purchase. In a par investment the interest is your return. You are always only getting 10% interest. When the loan prepays, the unpaid principal is paid with no interest. In that case early payoff does not elevate your return.