HI, let's go a little deeper. There is a basic economic concept referred to as an "opportunity cost". If you have have two (or more) opportunities to invest, the difference bewteen the two (or more) investments in selecting the investment with the lower return is the "cost" of selecting that lower return investment. Now, why might an investor choose a lower return on any investment? There may be many reasons, but two main considerations are the degree of risk and the use of funds. Private notes are rarely underwritten by any consistant guideline. A farmer who sells 50 acres to his neighbor usually makes the deal out of marketing and personal considerations, not from a risk management analysis. While the farmer may know his neighbor, his decission to finance the deal could be purely subjective. Investors don't know the borrower and therefore must use more objective and calculated analysis to assess the risk involved. SInce money, for everyone is a limited commodity an investor will also choose an investment that provides the highest return or the best use of their funds. Books have been written on both of these aspects.
A balance between acceptable risk and the highest return can be a daunting decission. I would have to say that most individuals, based on my personal experience in dealing in the paper business for over 15 years, lack the knowledge required to assess a fair value of a privatley originated note. Further, even if they do have a knowledge of real estate and finance, and after trying to assess a fair market value, they will soon find that a generalized rule of thumb usually meets their personal investment goals. What ever they then determine to be the highest yield requirement usually becomes their target yield on any note. Going at it from this simplified approach, with perhaps a quick check of the property and limited due diligence, becomes their standard assessment and basis for making an offer.
Institutional investors, companys that leverage or borrow money to purchase privately held notes are much more sophisticated in their analysis. Considerations include actual underwriting guielines and requirements which must be met due to the requirements made on them by their lenders or investors. Again, since most privately held notes or debt contracts have been made on a subjective basis, the task at hand for the institutional investor is to underwrite the deal under these guidelines. Even at this level of a more sophisticated financial assessment, a target yield will be identified. Interest rate risk for a large institutional investor is a consideration. A move in interest rates will effect their cost of borrowing money to acquire notes in the future. Inflationary periods are really of a lesser concern than for a bank since privately originated obligations are for shorter terms. Most notes require a balloon payment in five years or less. Since institutional investors deal in a volume of these obligations, they "block" loans or consolidate many loans in groups based on a maturity distribution (when a note becomes due) providing a weighted average yield. I won't go beyond that, but again, all of this will effect the expected return and therefore the present value of an obligation to them.
As with anything, the market will dictate a price as well, if someone has a note for sale, where do they go to sell it. You can't go to your local bank and do this deal with the teller. In the scope of things, buyers are really limited for these obligations. They are more marketable these days than they were say 15 years ago as more investors enter the paper market and most deals are leveraged as opposed to simply being purchased by an individual from his bank account. So, if you have a limited secondary market for anything the price will be lower for a seller and profit higher for any buyer. Simply a suppl and demand function. It's a buyer's market. In the beginning of the private real estate note market, there were only private investors. When the word gets out about potential money to be made in any market others (and larger entities) enter the market. Historically yields have been high for investors in this market due to these factors. As more have entered the market more competiton for a quality note has been seen and "prices" have decreased for the buyer, but not to a level of conventional loans. While there are billions in the private papaer market it is still a small portion of the financial sector.
When I purchased and brokered these obligations I always suggested that the seller search the market. I was usually offering the best deal for properties that I could reach out and touch and expecially where I could assess financial aspects. When I appraised for the market values of privately held financial contracts for state government, I found many notes that were so poorly written or constructed that they simply were not marketable, especially notes made between related parties.
Privataely originated notes are almost viwed as collateral loans, like auto title loans. A buyer of such an obligation may not be able to obtain a credit report since no authorization to do so was ever given. So, the price for a note is what the market will bear under these conditions. It arises from economic, financial and market conditions at the time the obligation is presented into the market. I'm sorry this is so long, but hope you have a better understanding of the paper game now. Good Luck, Bill
