What All Investors Should Consider When Determining Projected Rate of Return
“What is my projected rate of return?”
Want more articles like this?
Create an account today to get BiggerPocket's best blog articles delivered to your inboxSign up for free
This seems to be a very common question, especially from newer investors who are just starting out.
It also seems to be an even more popular question when talking about notes.
Projected Rates of Return in Real Estate
An old-time investor once told me that you never really know what you will make or lose on a deal until you exit. To be honest, I think that he was wise beyond his years.
With real estate, you can determine purchase price, fix up cost, ARV (After Repaired Value), and projected sale price to get an idea, but you never know exactly what you'll make — or what the property is really worth — until you have a ready, willing, and able buyer to purchase it.
Sure, if it's a buy-and-hold deal, you can know what the bank will finance you, meaning loan to value, interest rate, and costs. You can even know the market rent. But some things are more difficult to determine, such as vacancies, maintenance costs, and increased operating expenses.
Since you can’t predict everything and not everything is guaranteed, this makes having money set aside all the more important. I truly believe the number one reason real estate investors fail is because of a lack of reserves.
Projected Rates of Return on a Note
Estimating your return on a note deal is similar to real estate in some ways but different in others.
For example, with a performing note, you can estimate how much return you’ll make on payments and how much of a discount you may have bought the loan for, but you really don’t know what you’ll actually make until you exit. It’s even true for hard money or private money deals. You can predict what you should make though, and you’re usually pretty close.
Now, with non-performing notes, it's usually much different until you have some track record and past data to determine more accurately what will happen, especially with the different asset classes. For example, non-performing first liens with equity are fairly predictable, but it may depend on whether you're exiting through the borrower or the property.
Exiting Through the Borrower
In many cases, your exit as the note owner is dependent upon the borrower’s situation, as the outcome is mostly impacted by the borrower’s ability and willingness to pay. Unlike the bank who originated the loan, the note owner usually purchases the note at a discount, so this would give you more flexibility to offer the homeowner the best option that suits both of your needs.
There are many different exit options when dealing with delinquent mortgages, with unlimited combinations.
- Discounted Loan Payoff: In this case, a note owner would accept less than the full payoff remaining on the loan. For example, you can offer a homeowner an opportunity to pay off their loan without incurring additional late fees and penalties that have been added.
- Reinstating the Loan: The delinquent loan is considered reinstated when the amount of money needed to bring the past due loan current has been paid. The term for this past due amount of money is also known as arrears, which can consist of missed payments, interest fees, late fees, and corporate advances (i.e. back taxes, HOA fees, legal fees, etc.). Sometimes a note owner can accept a partial reinstatement or discounted arrears plan and put it into action with the borrower.
- Payment Plan: Sometimes called a “loan modification,” there is no one-size-fits-all payment plan for borrowers. Every loan is different, as is every borrower, making for different combinations of arrears and monthly payment options. A typical situation utilizing this strategy is a payment plus arrears plan, which would typically spread the reinstatement amount over a defined number of months, along with the regular or reduced payment.
- Refinance: Another type of plan instituted with a borrower is a full or partial reinstatement and regular or reduced payments with the goal of refinancing. This option could take up to twelve months of re-performance and would usually require sufficient equity in the property.
- Seller Assistance: If the borrower can't afford to stay in the property, the note owner can assist them by helping to pay for a real estate agent, a mover, a down payment or even rent for a new place. You could also allow them to stay in the current property and buy them some time until the property sells. Or you could even pay the homeowner a commission if they find a buyer or tenant for the property.
Exiting Through the Property
When exiting through the property, an investor faces either an adversarial situation, where they are exiting through the legal process and foreclosure, or a more cooperative scenario that will involve a "deed in lieu of foreclosure" or a short sale type of transaction. Exiting through the property could happen with both first and second non-performing mortgages.
Most re-performing notes, however, whether firsts or seconds, are created when a note owner agrees towards a mutually beneficial solution with the borrower.
From a strategic standpoint, some investors may prefer to exit through the property to obtain hard real estate, which is accomplished more often with vacant properties.
- Deed in Lieu of Foreclosure: If the homeowner cannot afford to stay in the property, a note owner can offer to pay an administration fee, often referred to as “cash for keys,” if the homeowner signs over the deed in lieu of doing a foreclosure. This strategy can save the homeowner from a foreclosure that could also damage their credit.
- REO: When a homeowner is unable to make full principal and interest payments on his/her mortgage, the lender can exercise their rights to protect their interests through the foreclosure and ejectment Taking place after the foreclosure, ejectment is where the borrower is contractually obligated to vacate the premises due to non-payment, leaving the lender the ability to take title to the collateral through the sheriff’s deed. This is now known as an REO (Real Estate Owned). As the note owner, you can then resell the property as is, rent it out, fix it up and flip it, or offer owner financing to recoup as much money as possible.
As you can see, there are multiple potential outcomes, and much will depend on how good you and your team are at executing these various types of exits. Notes are no different than real estate in this regard. I think we all know folks who are great at various aspects of the business, be it wholesaling, rehabbing, or even property management.
So, what all do you consider when trying to determine your projected rate of return? And, how is this impacted by your business model?
Let me know with a comment!