If you’ve provided owner financing on real property that you own, often you find yourself thinking about selling that note to free up cash for other needs. You probably also wonder what your note is actually worth. You may even assume it was simply equal to the amount of principal still owed on the note. The fact is, the value of mortgage notes is based on a number of different factors, and it’s a good idea to understand the things that determine it.
Is Your Note Sellable?
Investors invest money into things because they want to earn an acceptable return. Notes are no different.
If an investor can’t make money on a note, they simply aren’t going to buy it. Believe it or not, some notes offer no return on investment at all. While most notes are sellable, it’s important to note that the two major determinants of a note’s value are the borrower and the collateral.
Collateral is the underlying physical property associated with the note. Different types of collateral have different levels of risk which is relate to their marketability. For example, single family residences are more valuable than land tracts.
Important attributes of the borrower are down payment, credit score, and ability to pay.
Did you receive a down payment from the borrower (property buyer) when you first entered into an agreement with them? The percentage of down payment received plays a big role in determining whether the note holds any value at all.
The higher the down payment, the more “skin-in-the-game” the buyer has, and the less risky the investment. An investor typically looks for a minimum 10% down payment. However, down payments of 20% and higher will increase the value of mortgage notes.
What’s the Buyer’s Credit Score?
Does your buyer have good credit? Investors use credit scores as a measure of creditworthiness and risk level. The higher the score, the less risk of default on a loan. Ideally, they look for credit scores of 580 or higher with higher scores bringing a higher mortgage note value.
What is the Buyer’s Ability to Pay?
Similar to credit score, an investor may be looking at ability to pay as a means to determine risk. Whether your buyer has a job and how long they’ve been there are important factors. The percentage of debt payments they hold versus their monthly income is also an important consideration.
Recourses Versus Non-Recourse
Sometimes the buyer of your property is not an individual, but rather a family trust or corporate entity. If this is the case, an investor will look for an individual guarantor on the loan.
Why? If the legal entity stops making payments, there will still be an individual who is legally responsible and you can pursue payment from them.
Was the Note Originated Legally?
When Dodd-Frank became law in 2010, it imposed certain restrictions on seller-financed loans while allowing for certain exemptions.
If the loan was completed prior to Dodd-Frank, or if it was completed after with exemptions from its restrictions, the note is fine. But if not, and the note was illegally originated, it won’t be worth anything to an investor. You may want to check with an attorney to ensure your note is in good standing.
What Factors Determine the Value of Mortgage Notes?
If you determine you can sell your note, the logical next question is how will an investor determine its value? The over-simplified assumption that mortgage note value is equal to the unpaid principal balance is untrue. In fact, the value of mortgage notes are highly variable and dependent on six important factors:
- down payment
- terms – the principal, interest rate, amortization, and balloon, are the major components that make up the term of a note
Seasoning refers to the borrower’s payment history.
Do they make their payments on time every month? Do they pay by check, cash, or automatic debit? The answers to these questions determine the note’s status, which has an effect on the note’s value.
A note is classified as performing if payments are timely. Sub-Performing if some payments have been late or missing. Non-Performing if payments have ceased altogether.
Expect the use of third party verification to determine the seasoning of a note and there should be sufficient proof of the borrower’s payment history.
Do you have legal documentation pertaining to the note, including the note, any deeds, and a title policy? Also, is the paperwork easily obtainable and readily available.
A title policy provides insurance to the lender against the risk of previously undiscovered tax liens on the property, unknown restrictions on the property’s use, mistakes in public recording of ownership, fraud, or forgery.
Typically, title policies cost 1% of the face value of the note. If you did not purchase a title policy when you originated the note, you will have to purchase one before you can sell the note.
Investor Yield Requirement
The investor yield requirement is how much money the investor wants to earn from the note based on the level of risk. The note’s interest rate is not equal to the yield. Most investors look for an IYR of at least 6% to 8%. Anything less may negatively affect the value of mortgage notes.
Interest Rate on the Loan
If the interest rate you’ve agreed to on the loan is too low, you may not get as much for your note. Seller-backed financing usually offers a way to complete a sale transaction when buyers are not bankable. Meaning, they are unable to secure traditional bank financing due to not meeting underwriting requirements.
A higher interest rate makes up for the risk involved with a buyer whose credit score may not be stellar or whose job may not be stable. Ideally, interest rates should be between 7.5% and as high as 12%. But, keep in mind they cannot exceed the maximum usury law of the state where the property was purchased, as that would make the note worthless.
Even though a borrower might be able to modify their loan and secure a different interest rate on their note, an investor will be purchasing a note “as is.” An investor has no guarantee that a loan modification is feasible.
What is the payback period of the note and is there a balloon payment?
The longer the term, the less valuable the note. Investors don’t typically want to be tied into a 30-year investment. Shorter term notes – 5 years – in which an investor can recoup their investment faster, are worth more making the value of mortgage notes more.
Does the Perfect Note Exist?
In short, the answer to this question is ‘no.’ If the perfect note existed, you probably wouldn’t be selling it!
Sometimes, the redeeming aspects of a note balance out the negative ones. We must accept that other negative aspects are simply an unchangeable fact of the note. Investors must make adjustments for ITV (investment to value). ITV refers to the amount an investor can prudently invested based on the “as is” value of the note.
A high down payment or excellent payment history on the loan can offset poor credit.
Obtaining title insurance and filing an affidavit of a lost note can resolve the problem of a loan with missing paperwork.
Proven re-establishment of good payment history on the part of the borrower can mitigate negative seasoning.
There are no redeeming factors, however, that can offset a small down payment, an interest rate that’s too-low, or an extended amortization.
What are Typical Note Prices?
Determined by quality and multiple factors, note pricing varies between individual investors. Investor receive a discount either way on the value of the unpaid principal to account for future payments not yet received.
Above Average Notes (Less Common)
Above average notes are less common and require the following aspects:
- first position notes
- credit scores of 700 or above
- excellent payment history
- high down payment
- payback period of less than 15 years,
Qualifying notes may expect a value of between $0.87 and $0.97 of the remaining principal owed.
Average Notes (More Common)
First position notes with less than the requirements noted above, typically sell between $0.70 and $0.85 of the remaining principal owed.
If you own real property and want to offer seller financing to a buyer it’s important to consider the many factors that determine a mortgage note’s value to ensure your buyer will meet their end of the deal.
In addition, they ensure the investment will have value if you decide to cash it in before its maturity date. If you’ve already been providing seller financing, it’s important to know what factors may determine the ultimate valuation of your note.