Discounted Notes, I Think, are Today's Best-Kept Investment Secret

... But that may be changing because I've noticed, given the rapid growth of the Notes forum on this website, that more and more investors are discovering discounted notes as an attractive alternative to investing in real property. And, I think that's with good reason. After all, yields on note transactions can be extremely high as compared with other investments in today's climate, i.e., yields of 18% and higher are not uncommon. What's more-- and this is a very important characteristic to grasp-- with notes, the risk to the investor usually goes down as the rate of return goes up-- unlike other investments whereby you must up the risk to increase the rate of return.

In note transactions, the time value of money principle is at work here-- notes are almost always bought at a discount off the present value, cash in hand today being valued higher than money owed in the future. And, the steeper the discount off the present balance of the note, the greater the yield for the investor and the lower the risk (the lower the offer, the less $ the investor has in the transaction).

One of the most common "stumbling blocks" I hear from newer or beginner investors is that some have difficulty getting their offers accepted because they know of only one way to make an offer. But you can greatly increase your chances of getting an acceptance by giving the note holder more options.

Let me give you an example.

Let's say a good-quality note is available and let's use a round figure of $50,000 present value, let's say 8 percent interest-only for 15 years. It's a privately-held real estate trust deed. You actually have 2 cash flows here: the monthly payment itself of $333.33 and the one-time $50,000 balloon payment at the end of year 15.

Most beginners would employ a single strategy here: make an offer on the entire loan, i.e. if the desired yield is, say, 14 percent, the offer would be for $31,227.33.

Here's how you would perform the calculations for this on a financial calculator such as the BA2 Plus:

1. Calculate the present value of the $333.33 monthly cash flow (the figure we are solving for is in parentheses, in this case the present value):

N=180 I/Y=14% PMT=$333.33 (PV= $25,029.63)

What this means is that the value of this cash flow ($333.33 per month for 180 months) if you desired a return of 14 percent would be $25,029.63.

2. Calculate the present value of the $50,000 balloon payment.

N=180  I/Y=14%PMT=___  (PV=$6,197.70)  FV=$50,000

So we find that the present value of the $50,000 balloon 15 years from now is $6,197.70.

When you add both of the present values together, ($25,029.63 + $6,197.70) we get a total of $31,227.33.

What if the note seller does not accept?

In the real world, many note sellers would not be willing to accept a discount of 37% ($50,000 - $31,227.33 = $18,772.67).

If the offer is turned down, many uneducated note investors may just give up and walk away-- a lost opportunity due to ignorance. The fact of the matter is that there are other ways to approach this situation and the more options you have, the greater your chances of making money.

Let's reexamine the situation again. When you look at the present values of the two cash flows, you'll see that #1 ($25,029.63) has a much greater value than #2 ($6,197.70). Many beginners are astounded at how little the present value of the balloon due in 15 years is worth today.

We can apply the same concept to the monthly cash flow. The $333.33 payment received today has a value of ($333.33). But that same $333.33 payment received in month 180 has a present value of only $41.32.

I want to drive home a couple of important points here:

1. Always keep in mind that cash in hand today has a far greater value than money to be received in the future.

2. You can make attractive offers to note sellers by purchasing the more current payments and letting the seller keep the more distant payments which are further off in the future.

With this in mind, we can make an offer to purchase the $333.33 payments and let the note seller keep the right to collect the $50,000 balloon.

So, the offer would be $25,029.63.

This means the seller gets $25,029.63 immediately and them collects the $50,000 balloon payment, so he gets very close to what he would have received had he sold the entire loan, and he gets to keep the balloon payment.

In my experience, a great many sellers like this approach.

To take this one step further, you can make an offer for only a portion of the payments-- perhaps five years' worth. If we are looking for a 14% return, the offer to the note holder would be $14,325.53.

N = 60  I/Y = 14%  PMT = $333.33  (PV = $14,325.53 ) FV = ____

This way, the note seller gets $14,325.53 now and $39,999 in payments starting in year 6, and also collects the $50,000 balloon payment.

There are even more options available-- you could purchase less than 5 years or you could buy the payments plus part of the balloon.

The more options you present to the note seller, the more likely you are to come to a successful (and profitable) conclusion.

What if it turns out the seller is not motivated to sell the loan, but what he really needs is to free up some cash to accomplish some goal. Let's say the seller just needs to free up $10,000. The knowledgeable note buyer would be able to formulate an offer tailored to give the seller exactly what he needs. In this scenario, you would make an offer for only 36 payments. Here's how you'd calculate the # of payments you need to buy in order to get the seller the $10,000 and get you a yield of 14%:

N = 36  I/Y = 14%  PMT = $333.33  (PV = $9,752.87  FV = ____

So, you would buy 36 payments for $9,752.87.

Since everybody gets what they want, this is a real win-win transaction.

Also (and this is very important) when you buy only part of the loan, the transaction becomes safer for you (reduced risk) because the less cash you have in the transaction, the more equity you have for protection. So you get a high rate of return with a high degree of safety.

Also, keep in mind that the riskiest part of the above example is the balloon payment-- the borrower may or may not be able to come up with it when it is due. So, if you don't buy the balloon, you greatly increase your safety factor.

And, if you desire a lump sum profit as opposed to receiving monthly payments, you can flip the transaction.

The more you know, the more successful you will be.