Why sell a note for less than face value?

Question

Chad U. · Answer

@Joshua Durrin

Most seller originated loans are generally not because the lender is loaning $100K of his hard earned cash in this instance.  They typically are creating a Seller Financed loan based on the perceived value of the property which is the sale price.  Say the property was purchased for $50K, and he put $20K into so all in for $70K.  Say the terms were 8% with 10 yr amortization, so the payment is $1213/mth and after 12 months you've collected $14,556 and outstanding loan balance is $93,195.  So it is seasoned and you resell it at 10% discount at $83,876 which is an additional $13,876 after subtracting your $70,000 investment.  Therefore your total profit is $28,432 and the IRR is over 40%.

Joshua Durrin · Answer

@Chad Urbshott

This is a great example but I’m not following it all the way. You mentioned that say I “purchased it for $50k” but then had a total outstanding balance in the $90k’s. You lost me there.

In the original hypothetical I used a loan amount of $100k.

Can you help me follow your analysis if I’m the original lender and funded $100k of purchase mortgage for a buyer?

Sorry for confusion.

Frank Chin · Answer

I studied finance for my masters and unfortunately when it was time to invest, I thought as you, I forgot you don't pay or collect the face value of debt instruments.

At one time, I save quite a bit, and wanted put invest some money, build up my portfolio till the time I'm ready to invest in some real estate. I opened my account at Dean Witter, and a friendly fast talking broker talked me into putting money into Ginnie Maes unit trusts. I didn't know what they were at first, got some reading materials on them. Told me there's nothing to worry about, after all, they're mortgage backed, better then bonds, and you'll never lose money. This was in the early eighties, mortgage rates for a few years range from 12% to 18%. So I bought them at 13%, put in $5,000 at first, see what happens, then put more in later.

So for all intents and purposes, I put my money into something like notes, with a rate of 13%.

Well, in about a year, I was ready to do something with the money, found something to invest in, called my broker up to sell the Ginnie Maes. I was told the $5,000 was now $4,000 something, I was so shocked that I don't recall the exact number. I stammered and said to the broker, it was a sure fire thing, mortgage backed, how could I lose money on it.

I turns out the market value, not face value, of fixed rate instruments is dependent on interest rate. Market interest rates rose after I bought by about 2%. Thus, the market value of my Ginnie Maes dropped.

I remember from my finance classes, they told me, when interest rates rise, market value of bonds go down, and when interest rates drops, the market value of bonds go up. Here, I'm a guy with a degree in finance forgot this basic principal, there's a face value, and there's a market value for all debt instruments.

For private investments, you similarly have a face value versus market value. But you have to add to it the credit worthiness of the borrower.

I once bought a condo for my sister, in her name and mine, because she's unable to get a mortgage, she lived in section 8 housing. I put the down payment down for her, and then had her sign a note for it, which I recorded. The note was for $8,000. Some investor going through the public records called me and offered to buy the note. I told him it's not worth it for him and me due to the lack of credit worthiness of my sister. I told the guy is only to put on the record she owes me money, but for any one else, you have to buy it at a big discount to make up for the risk.

Freddy Garfano · Answer

Few possibilities:

--Could be the note seller has information about the borrower that makes default likely, so they are eager to cash out quickly;

--I read in the DVH Note Investing book that seller-originated notes typically trade at lower values than institutionally originated ones, so the 10% discount could reflect this market expectation if the note is seller originated;

--Could be the property declined significantly in value (natural disaster like flooding, for example), so if it's a first, that could lower its value.

That's all I can think of. Doesn't make a ton of sense to me, either, to be honest.  What I've seen on FCIExchange.com and LoanMLS.com is that performing firsts are typically asking the value of the outstanding balance, or very close to. Whether they sell for that is, of course, another story.

Why sell a note for less than face value?

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