Real Estate Notes: Buying, Selling, Discounts, Partial Notes and More
In last week’s blog, I covered some of the main elements of creating and potentially selling a real estate note. In this segment, we’ll go over six other key areas that you should be aware of, particularly if you are considering owner financing.
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1. When I called an investor about selling my note, he had questions about the condition of the property and about the neighborhood. Why?
When a mortgage note buyer is evaluating a note, he or she always has the worst-case scenario in the back of their mind. Because the property is the only collateral for the note, the investor is thinking about what happens if the payer defaults. So, we are going to price a note collateralized by a nice house in a good neighborhood much better than a beaten-down home in a bad part of town. Somewhat related to this is that we like it better if the property is owner-occupied. We ask this to assess our risk, as owner-occupied properties on average default less often than others.
2. I don’t understand how an investor calculates the discount on a note. Is there a set percentage?
No, investors decide on a needed yield (rate of return) and then plug that into their calculator. For example, on a note of an owner-occupied single family house where the payer has good credit, the investor may decide that a 9% yield is appropriate. Conversely, for a vacant land parcel with utilities but no other improvements, the investor may demand a 12% yield. This is because vacant land is much more risky and the investor will want to be compensated for taking that risk. The investor will also want to make sure that their purchase price provides a good equity buffer.
3. Is there a minimum balance that has to be on a note for an investor to consider buying it?
Note buyers can be all over the map on this requirement, but most want a starting note balance of at least $30,000, with some having a minimum of $50,000 or more. As far as maximums, only a few large investors will accept notes with balance greater than $1 million.
4. I sold a property to my brother using owner financing. Would you buy that note?
Some investors require an arms-length transaction and will not consider buying notes in which the payer is in any way related to the seller. For others, like us, we will consider such an arrangement but might only be willing to buy part of the note.
5. What do you mean when you say that you‘ll buy part of the note? I thought that this was an all or nothing.
Actually, there are multiple ways for you to sell a mortgage note, though most note holders initially think only about selling the full note. The other most common way to sell a note is with what we call a partial.
For example, let’s assume that you have a mediocre note with 14 more years of payments due. If an investor were to buy the full note, the discount on the note might be too severe. You could have a $100,000 note on which the investor will only pay $65,000 due to risk considerations. Instead, the note buyer could offer you $30,000 for just the next 5 years’ worth of payments, with you receiving everything after that terms ends. That way, the investor feels more protected and, because you are sharing some of the risk, you won’t get hit with such a big discount. There are other advantages to partials including different treatment of capital gains and the option to sell another piece of the note at a later date.
6. I am in the process of selling my business along with the property on which it resides. How should I set up my note with the buyer?
For this situation, it is best to create two notes if you think that you might ever want to sell them. You should create one note covering only the business and its assets, and another for the real property. The primary purpose of this is because most companies that buy real estate notes don’t buy business notes and vice versa. So, a real estate note investor would put zero value on the business, meaning that you would not get a good price on a combined note. If the notes were separate, you can sell one note to the business note investor and the other to a real estate note investor, thus maximizing your proceeds.