The Price of a Note?

5 Replies

Hey, good evening BP! I was wondering if the purchase of a note was anything like the purchase of a house? Meaning is their a type of payment plan or is it paid in cash for the note. Also, is there any science to price amount when looking at a 1st or 2nd position note. With SFHs for example you can use comps, square foot, and  other things to kind of gauge what you wanna pay. How is it with notes that you can gauge what you wanna pay. Any advice or feedback would be much appreciated. The more you guys respond the more I learn. Thank you and have a wonderful night :)

When you "buy a note" you are effectively making a loan.  Actually making the loan would be "originating the note".  As the buyer of the note, you're stepping into the lender's shoes.  Typically they would be purchased in cash, just like you would hand the borrower cash if you were the one making the original loan.  But you might come up with a way to borrow the money to make the loan.  Heck, that's all banks do.  My dad used to say, borrow at 3, lend at 6, on the golf course by 3.  When the bank takes deposits (borrowing at 3%, though you won't get that these days) then loans them out, they are "financing" the loan they're making.

Valuation is a straightforward calculation.  Before starting, read the help information on the Excel functions PV, FV, PMT, NPER, and RATE.  These five functions allow you to calculate one of the five key variables, given the other four.  For instance, if you want to calculate a loan payment, you use PMT and input the rate, number of payments, present value (the amount borrowed), and future value (usually 0 - fully amortized).  Given that you know the terms of a fully amortized, 30 year fixed rate loan that was made five years ago, you can use FV to calculate the current balance.

The trick is that you would rarely buy a note for its current balance.  There's almost always a discount.  That discount can be calculated based on your desired return.  Lets do a real example.  A $100K loan was made five years ago, 15 year fixed rate, 5% rate, fully amortized.  Use PMT to calculate the payment and FV to calculate the current balance.  I get a monthly payment of $790.79 and a current balance of $74,557.09.  Now, if you buy that note for the current balance, you're getting the remaining 10 years of payments.  Its exactly as if you made a brand new loan for $74,557.09 at 5% for 10 years.

Now, I don't loan money at 5%.  Say I want a 10% return on my money.  For an existing note, the stream of payments is fixed based on the original note.  In this case, you have 120 monthly payments of $790.79 coming.  What are those worth?  Use the PV function to calculate that.  You put in the payment, the rate you want, and the number of remaining payments.  Future value is $0, because you're buying it all the way until its paid off.  I get a PV of $59,840.27.  So, that might be what I would pay for that note.  This is exactly the same as making a $59,840.27 loan at 10% for 10 years, fully amortized.  The payment on that loan is $790.79.

In this case, the key input is that 10% desired return.  That's where things get tricky.  What if the underlying security is only worth $50K?  Clearly the almost $60K I calculate is too low, even if that's a good return.  So, you also want to consider the value of your security.  This is especially important when you get into non-performing notes.  Those are notes that aren't getting paid.  In this case, you buy them expecting to foreclose and take the security.  Or maybe you want to do a modification and get the borrower back on track.  So, you want to be sure the price you pay is in like with your risk tolerance and the value of the asset.

Second mortgages are higher risk.  If the first is underwater, or even close, a second may have very little value.   If the first forecloses, your second would be completely wiped out.  So, you have to be very careful about junior liens.

@Jon Holdman

I loved your post here. But, it is driving me nuts. I found the functions you have mentioned. but, I am a goat looking at a wrist watch. I don't even know what to ask. Can you make it a little simpler on how you used them. Are they linked to another cell? How do you use them?



@Don Hines in Excel (or similar programs) you can put a value into a cell, or a formula.  Formulas do refer to other cells, using the column and row.  So, if you put "15.5" in cell A1 and then "=A1*2" in cell A2, A2 will show "31".

Excel has a bunch of built in functions.  The financial ones are just one group.  All the functions take inputs which can be hardwired value or a reference to another cell.  In the description above, I'm using references to other cells.  Here's a screenshot with those calculations:

I've put a description in column A, the calculations in column B and an explanation in column C.  

Rows 2-5 are a simple payment calculation.  B2 is the loan amount,  B3 in the annual rate, and B4 is the term in years.  In column C I've put PV, RATE, and NPER because that's the meaning of those values in terms of the five possible variables in these calculations.  Notice I don't have a FV value.  I'll use 0, because this is a fully amortized loan.  

The payment calculation is in B5.  I've put the formula in C5.  The arguments to this formula, in order, are rate, term, PV, FV, and type.  If you click on a cell and type "=pmt(", Excel will show you the arguments.  For the rate I put B3/12.  That's because I entered B3 as the annual rate but I want the result to be the monthly payment.  So, I need a monthly rate.  Then, for the number of periods I put B4*12.  Again, B4 is in years, so I multiple by 12 to get months.  For the PV I put the loan balance.  FV is zero because its fully amortized.  Excel defaults to 0 for this, if you don't supply a value.  Type tells whether the payment is at the end of the period or beginning.  You rarely need to supply a value for that argument.

Now B5 shows the monthly payment.  Its negative because you're paying money out to reduce the PV.

Rows 7 and 8 show the calculation of the balance after some number of payments have been made.  B7 is the input and is the number of payments made.  In this case, I've entered it in years. In B8 I use the FV function to calculate a "future value" based on these inputs.  FV has arguments of rate, number of periods, payment, present value and type.  Again I'll let type default.  Rate is same as above.  Number of periods in this case is the payments made, so that's B7*12. Payment is the payment calculated above and PV is the original loan balance.  So, this tells me the balance after five years is $74,557.09.  Don't be fooled by the negative sign.  

Then, I want to calculate what its worth to me.  I do that using the PV function to compute the present value of the loan based on the stream of payments I'll receive and my desired rate of return.  I enter my desired return in B10.  The arguments to the PV function are rate, periods, payment, future value and type.   Rate is my desired rate, B10/12.  Periods is the number of payments I'll get.  That's the original term (B4) less the payments already made (B7).  Again I have to convert to months.  The payment is from the calculation above.  If you were doing this for a loan you were buying, you would enter the payment from the loan documents.  Needs to be negative.  FV in this case is 0, which is the default.  Type again gets ignored.  So that's how I get the value I'd pay of $59,840.27.

These are really handy functions when dealing with loans.  I highly recommend @Frank Gallinelli 's book What Every Real Estate Investor Needs to Know About Cash Flow... And 36 Other Key Financial Measures. He goes into these calculations in detail.

Leave it to an engineer to explain math, LOL. I suggest using a Texas Instrument BAII financial calculator, much quicker for me. Excel has advantages as a plug and play and you don't need to understand the formulas but learning the PV math isn't that hard. When you have a balloon payment or uneven payments, Excel would be easier too.

Jon's explaining, I think, what a note may be priced at as a required yield to an investor, simply saying I want 10%. 

Notes are more involved than just the calculation of a yield, the risk must be assessed to establish a required yield that is acceptable, or something close. 

Notes are not always discounted, a few sell at PAR and more sell at a premium than at PAR or the amount owing. Interest rates, the note rate has an impact as well as loan quality, type of asset and seasoning or how long the loan has been paid. Generally, note investors try buying at a discount to increase the yield, but there can be exceptions.

When you buy a note you are not buying the property securing that note, don't go down that road, you are a note holder.

The more savvy types, like myself (khmmm) can acquire notes being financed by the old note holder, they sell at a discount, finance the sale of the note as that relieves them of credit risks, risks of foreclosure and loss, payment administration or servicing issues and slow pay issues. You can also purchase a partial interest in a note, might search for "Lead Lender" in notes as someone takes the lead position on servicing and admin. These positions can also be traded and assigned.

Simply put, the price of a note is established by considerations of alternative investments of similar risk and duration within a band of investments requiring a similar amount to invest. :)

Thanks @Jon Holdman . You have made me learn something today. I finally had enough sense to look on you tube (I require pictures).  You and @Bill Gulley  should be on the payroll around here.