Tipping the Scales of Performing and Non-Performing Notes
Not all things are created equal — a great concept to remember when beginning to evaluate the value of a note. Knowing that, let me get right into it this week.
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Imagine a property purchased for $25,000 cash in Anytown, USA. That same property is sold on seller financed terms for $50,000 with 10% down, and monthly payments of $500 at a 10% interest rate. At this point, the note is said to be worth $45,000 ($50,000 – 10% or $5,000 = $45,000). What happens as the note gets seasoned, or as payments are made, helps determine if the note is “Performing” “Sub-Performing” or “Non-Performing”. Let’s look at each:
Performing: A performing note is one where the payments are made on time by the homeowner to the note holder. As mentioned in a previous post, the best way to keep track and prove that a note is performing is to keep a copy of the canceled checks, or at least a copy of the checks. This helps the valuation of your note. Speaking in general terms, a performing note can be sold on the secondary market for anywhere between 75%-100% of the current note value.
Sub-Performing: A step below a performing note is the sub-performing note. This consists of late payments received by the note holder from the homeowner anywhere from 15 days to 60 days late. The homeowner has to be followed-up with in order to stay within the guidelines of the agreed upon contract. At times real estate attorneys have to “remind” the homeowners of their duties, but overall the contract gets paid down. A sub-performing note can fetch between 50% – 80% of the value on the secondary market, as a rule of thumb.
Non-Performing: The most popular note right now with real estate investors. The non-performing note is essentially a note that is in default and can no longer expect repayment against the original terms of the note. What makes non-performing notes so attractive to a buyer is the opportunity to essentially purchase the asset at a deep discount. From there you, the investor can decide to re-work the note or take back the asset. In this tight credit market non-performing notes can be found for anywhere between 10% – 50% of the note value for residential properties on the secondary market.
Now that we know the three types of “ratings” to classify notes, let’s re-visit our example above. If we flash forward a year into the note’s seasoning, we can make some quick valuations of the note.
If it’s a performing note, the balance after 1 year will be approximately $43,500. That means the note could have a sales price of approximately $32,625 (75% of its current value) on the secondary market. Here’s how: Add the $6,000 in payments received for 12 months plus the original down-payment of $5,000 plus the sales price of $32,625, that equals $43,625. The $43,625 you collected over the course of that year is a 75% return on your original $25,000 investment. Not too bad!!
Compare that same performing note to a non-performing note. Assume 6 of the 12 payments over that first year are successfully collected leaving a current balance of $44,000. The note is currently uncollectible and can be sold for approximately 50% of the note value or $22,000 on the secondary market. When you combine the $3,000 in payments received for 12 months, plus the original down-payment of $5,000, plus the sales price of $22,000, you can sell the non-performing note and collect a total of $30,000 in one year for the property. That’s a 20% return on your original $25,000 investment. Not bad either, but a huge difference from a performing note.
I would love to hear your experiences with performing and non-performing notes! Please share…..