The Top Five Reasons Seller-Financed Real Estate Notes are Discounted

Often — very often — we are asked how much a performing seller-financed real estate note (loan) is discounted when the holder of the note (usually the homeowner or a “rehabber” who sold the property) wants to “cash out” by selling the note. Although one might think the answer to this question should be fairly straight-forward, something like, “we subtract ‘x’ percent from the unpaid principal balance (UPB) which is owed on a note to arrive at a purchase price for the note,” the actual answer is a bit more involved.

When buying a seller-financed note, determining a “correct” purchase price, that is, determining the “correct” discount from UPB, is what we refer to as part science (e.g., mathematical calculation) and part art (applying judgment and discretion to a factual situation that cannot fully be analyzed through mathematical calculations alone).

The following are the top five reasons seller-financed real estate notes are bought and sold at a discount:

1. The Time-Value of Money. Before looking at the factors to be considered when determining the amount of discount for any particular note, let us first look at why there should even be a discount. That is, let us explore why the sale price of a performing seller-financed real estate loan is not simply equal to the UPB, that is, the amount still owing on the note.

The present value of a note is usually not equal to the amount of the UPB simply because the debt which is represented by the note is not currently due; it is due over a period of time, typically payable in monthly installments for a number of years. In other words, the value of an amount of money which is due at some future point in time (or which is payable in installments over a period of time) is, all other factors being equal, worth less than that same amount of money if that entire amount is due and payable today. This concept is commonly referred to as the “time-value of money,” or simply “TVM.”

Not to complicate things too much, this is not to say, however, that the present value of a note is never worth an amount which is equal to the UPB. The factors which, when taken together as a whole, will determine the amount of the discount — if any — include:

2. Loan-to-value (LTV) of the Collateral Which Secures the Loan. Perhaps the single most-important factor when valuing a note is the ratio represented by the UPB (and any senior encumbrances) to the value of the collateral. Note investors want to minimize risk. The best way to minimize risk, arguably, is to have ample equity to protect a note investment, should the note go into default status.

3. Creditworthiness of the Borrower. The next most important factor is probably the Borrower’s ability to repay the loan and the Borrower’s past record of repaying debts. Some note investors, particularly those who invest in “seconds” or other junior liens, might even opine that a Borrower’s creditworthiness is more important than LTV. Certainly, all note investors would likely agree that a Borrower’s creditworthiness becomes paramount if there is little or no protective equity securing a particular note.

4. The Number of Remaining Payments. When talking about maximizing the value of a note, the ideal number of remaining payments will vary from investor-to-investor. Some investors will prefer a comparatively small number remaining payments, while others will prefer a comparatively larger number of remaining payments. All note investors would probably agree that there should not be too few remaining payments and that there should not be too many remaining payments. In today’s market, 10 years — 120 remaining payments — is usually regarded as desirable.

5. Desired Yield (Return on Investment). The “yield” which is produced by a note investment is different than the interest rate stated in the promissory note, unless the note is purchased for an amount equal to the UPB. Notes are often attractive investments precisely because they can generate annual percentage yields which are higher than the interest rate on the promissory notes which are purchased. The greater the difference between the desired yield and note interest rate, the larger the discount.