Do loan variables affect note valuation?

Question

I understand that the value of a note is a function of the collateral, borrower profile, seasoning, etc. My question is about the structuring of the loan variables affecting the price. Specifically, a note made with a higher present value and lower interest rate vs a lower present value and higher interest rate. For example:

pv = 99k i = 4% n = 120 pmt = 1000

vs

pv = 79k i = 9% n = 120 pmt = 1000

If a note's value is reflected in the computed yield, then pv and i should not affect price. Is my thinking about this correct or am I off base?

Jay Hinrichs · Answer

@John Lowe it will simply be NPV equation for a note investorBack in my days when I bought timber land... I often sold said property after we logged it on terms... I was able to hypothecate the note with my local bank. at bank rates which was lower that the interest that I was getting on the seller carry backDion and Bill will chim in on other aspects and Dodd Frank and all of that qualified mortgage stuff that you need to be cognizant of.But if you have a good relationship with a local bank you may be able to tap equity from them.. Just a thought.In the day I was writing owner contracts for 9 to 10% and my bank charged me 7% or so.. can't recall exactly other than I remember I made a little on the interest delta.

Dion DePaoli · Answer

The example is not overly realistic for the same underlying reason Bill points out. Example 1 with the low/no down payment would carry a higher rate than example 2. Risk of loss is higher if there is less equity and vice versa. So the larger down payment would have a lower rate. While it can be relevant to have an end investor in mind when structuring a loan the risk of the loan should still lead the dance. In that yield is always relative to the risk and price is bi-product. If the risk is high and the yield low the discount will be greater than the opposite. The investor will bring the yield into their risk parameters through the price.

Bill Gulley · Answer

All other things being equal (LOL, like that would happen) the lower PV and higher rate will be more marketable, 1. the price is lower bringing more buyers to the table, 2. interest income is taxed as regular income vs a gain off discounted principal. Otherwise, the buyer is buying the payment computed to their required yield. :)

Bob E. · Answer

One thing to keep in mind, is you may need an RMLO to underwrite the loan. PM me if you would like a referral.Also, your borrower will get the tax benefits of the mortgage interest deduction this will help them make your payments.Lastly, if sold for 90,000 at 8% with 120 payments their payment would be about $1031.28. (Extending that to 180 payments drops it to $812.30 but increases the total payments you receive from $123,754.15 to $146,214.77).Selling 34 of the above payments at 10% would net you @ $30,425, getting your cash out.It will be much easier to sell some of your payments if you have clear documentation of the payment history so you will want to place it with a servicer.

Bill Gulley · Answer

What Jay is talking about is the hypothetacation of loans, borrowing against another loan and is well known by banks, the credit is extended to the note holder, based on their credit and the note is pledged as collateral, the quality of the collateralized note is also considered as well as the security pledged for the collateralized note. Everything is looked at. Allowing the note to season will make it stronger collateral and be considered as to your ability to pay. 50% is the norm and probably at a payment due the bank not exceeding 75% of the payment being paid on that note. I think I suggested above, get with a mortgage broker/RMLO to process the loan!You can't really process your own note to obtain the highest value, you have a vested interest in the note, that's like a runner showing his stop watch to prove he ran a 100 yd dash in 9 seconds, a note buyer or the bank can't really trust that documentation.Not saying you can't document the loan, but it won't carry much weight unless the matter is re-verified again through due diligence. If you find a mortgage broker that has investors for such loans, the processing may be accomplished and a partial or whole loan sale set up at the same time. I also agree with Dion, do not use Zillow, you need an appraisal. :)

Jay Hinrichs · Answer

@John Lowe some greater than others.. I will take the low rung on the great minds totem pole.but I have done a lot of owner finance deals in my day.. A lot of it not germane to todays lending environment... And in my Timber deals the timber paid for the property so I had zero basis in the collateral. So I pulled working capital out of the Note from my commercial bank.. they would give me 50% advance... so 150k note I got a 75k from the bank.. And then the people I sold to paid me off usually in 18 to 36 months.. so we retired the bank loan which cost us nothing because the payments from my buyer far exceeded my payments to the bank.. And the 75k I got was not taxed at the time it was a loan.. we paid tax when the note finally paid off. But I don't look at this as note investing.. its was just business.. And I never looked at it in the realm of rate of return... It was simply how much did I make on that deal.. and in the Timber business we did pretty well.. but its a niche that not many know or play in... And it certainly is apples to oranges from SFR's... but the concept is the same you have 1st position collateral your in the business your local commercial bank is in the business of funding their community investors.. Its not a hard concept to grasp for a banker. And you will pay far less than trying to sell these through broker networks.. The only way you will do better is to find private money that is happy with a 9% return or so.

Dion DePaoli · Answer

@John Lowe Do not rely on Zillow for real property value. You should obtain a proper full appraisal. In most cases we would assume Zillow has an inflated value due to the nature of their automation. I suppose with $5k to use toward down payment and closing costs they have some viability. The reverse engineering of the payment is leaving out what their debt service is capable of supporting. As implied renting and owning are different animals. An obligation of $1,400 with a borrower who earns $3k per month is not a strong loan. I guess before I ramble on too much, I would say pause and approach this in a different manner. Get to the bottom of what the 'real' market value of the property actually is. Once you understand that, you can negotiate with the buyer better on details of the transaction. If the property is really only worth $50k then obviously lots of details here change. That is not a bad thing. Once you know the FMV then you can gain an understanding of how much of their $5k will be allocated to down payment. Once you know down payment you know loan amount. Once you know loan amount you have a characteristic of risk related to the down payment. Higher LTVs are more risky than less. So now meaning comes into the rate selection, we are not just picking a number out of a hat. Generally private loans will be in the 8% to 10% range. If you can get to 7.5% you are doing just fine in terms of market rates. These numbers could be examined with your real net return from rent for a little further relevance. For the sake of easy example lets assume the entire $5k applies to a $50k sale price. At 8% with a 10 year term the borrower is paying in the range of $550. Your net rental return is pretty high so it is going to be tough to compete with that since the FMV to rental rate is imbalanced like it is. However, technically speaking, every dollar of principal balance above your cost basis into the real property ($30k) is really being amplified since you don't have a cost basis for it. So you are earning 8% interest on $15k you never capitalized per se. As such your net return is higher than the rate on the note. The more the property is 'truly' worth (not from Zillow) the more principal will be in the loan which you didn't capitalize putting your return on steroids. You get the idea.There is a notion by many in your shoes to max out PITI based on rental performance and that is not always the best way to make a good loan. Often times it is bad idea. The less impact the buyer's down payment does, the stronger you want the borrower to be in capacity to pay. Delinquency and default are costly bi-products of poorly structured loans. Further, well structured loans, with fair market price of real property and good debt service coverage from the borrower market themselves. Although, working with the borrower to simply refinance you in a year or two will sky rocket your return too. In this setting I am not a fan of trying to sell a partial. If you need to do that you might as well just make a good loan and sell the whole thing. The $30k target you have is a barrier and you may not be considering prepayment as much as you need to.

Jay Hinrichs · Answer

Bill Gulley I am honored that my 3000 th post in 11 months is in response to your post.You will notice up in the thread I mentioned that what I did was a Hypothecation and I have done many many of them when most folks don't know what they are.. of course you would know.and to be fair and balanced most of my notes were on bare land so they were commercial not that it made a lot of difference back in the 70's, 80, 90s when I was doing hundreds of these.. And your correct my Hypothecation was under written by the bank just like a new loan.. Bank had to order their own appraisal etc etc.. we had to PG the loan.. But I was able to carve it out of my other business LOC's that I had with the bank and have them be stand alone loans. Worked pretty neat really...Now again with Owner occ and in todays day and age not sure if this is even remotely possible.. It was just a suggestion. But if the OP has some wherewithal and a good local community bank this would be something I would be asking them.

John Lowe · Answer

I will contact a local bank about hypothecation. I'm not hopeful, but it certainly won't hurt to ask. I wouldn't think of doing this on my own. A RE attorney will draw up the contracts and the mortgage (or contract for deed) will be processed by a LMO.

Bill Gulley · Answer

Jay, I missed you mentioning the method, I was simply adding to your lead. Yes, this can be done today, I assisted a large contractor up in SF sales and then pledging the notes for additional financing, years ago, they are still doing the same thing, but in compliance with DF, I'm sure. The issue of the day will be in the origination, so you really need a third party RMLO. Congrats on your 3000th post! :)