Selling Partial Owner Financed Notes for Profit
Selling partial notes is an interesting concept for real estate investors.
First and foremost, introducing owner financing opens the door for more prospects who do not qualify for regular bank financing. Because there are no bank origination fees and no points, it is an appealing concept to buyers even if they do qualify for traditional lending mechanisms. It also gives the seller more leverage in maintaining the sale price that they want for their property, because the buyer is already saving money on the deal.
Traditionally, owner financed notes are bought after they are seasoned. Seasoning occurs when a mortgagor already has established a history of payments anywhere from 10-12 months. The funding market has expanded to include “point of sale” funding, or “table funding”. This means that the real estate seller, at closing sells his interest on the note to a funding source. He/she can sell some or all of the payments on the note. For the purposes of the real estate investor we will deal with examples of partial note sales.
The reason why the real estate investor is interested in this type of funding is simple. He/she can make some additional cash to apply to current investment interests and still keep some payments that will kick in a few years down the road adding to whatever retirement income they may expect.
Below please find some interesting examples:
1. Seller has a one family house that after purchase and fixing adds to an investment of $70,000. The market value is $115,000 but he wants to sell fast because there is another property he wants to invest in. He owns the property free and clear and his sell price is $100,000.
He finds a buyer who has good credit but has recently relocated and doesn’t have a long work history in the area. The buyer puts 10% down.
A note is generated for $90,000 with an interest rate of 8% (because of credit history and low down pmt.), for 360 months. He makes arrangements to sell part of the note at closing.
If he sells 180 payments he could conceivably end up with this transaction:
Down Payment: 10,000
Sale of 180 payments: 60,878
Principal value of note after 180 pmts: 69,102
Interest on 180 pmts left: 49,768
Total value on investment $189,748
The out-of-pocket costs for this note sale is -- zero. The yield on the investment is astronomical.
2. Seller has a townhome that he put a $15,000 down payment and upgrades of $7,000. He has a first mortgage of $30,000, amortized for 12 months at 6% interest. The property appraises at $75,000 he wants to sell for $70,000. He sells his property with owner financing, 10% down and 7.5% interest rate for 240 months with a balloon of $10,000 at the end of the term.He makes arrangements to sell part of the note at closing.
If he sells 200 payments he could end up with this transaction:
Down Payment: 7,500
Sale of 200 payments: 50,362
Principal value of note after 200 pmts:26,348
Interest on 40 pmts. Left: 4,681
Total value of investment: $88,891
After paying the outstanding mortgage and recovering the initial investment, the seller walks away with an additional $4,098 in cash at closing and a future income stream of $31,029.
Structuring the note carefully is key to making sure that there is a profit at both ends of the deal.
When structuring a note with an intent to sell it, the following bears careful consideration:
• Property purchased with $1,000 or less often default. – Investors will not purchase the note.
• An amortized note is more valuable than one with a balloon, since the payor may not be able to make the balloon payment.
• The single most powerful financial aspect of determining the value of the note is the amount of the monthly payment. All things being equal, a 15 year note with a large monthly payment and no balloon at the end, is worth more than a 15 year note with a smaller monthly payment and a balloon.
• Play up the benefits that the buyer is getting by going with owner financing, (such as savings in points and origination fees, or being able to buy even though credit is not sterling). Use this as a negotiation tool with the buyer to set up the interest rate on the note that will bring a greater yield.
• A note in first lien position is more valuable that one in the 2nd position. Third lien or lower notes are worth very little.
• The value of the note depends on the economic conditions that support the value of the property. If the property is located in a depressed area, the offer for the note will reflect that.
On Sale Dean,
If the note doesn't go to term, you still have the principal on the note, and since the note is on first position, you are paid when the property goes to closing.
The key to a partial sale is to determine how many payments to sell, you are in fact selling some of the principal (very little) and a lot of the unearned interest (the bulk of it). Yes, you sell it at a discount, but since you never intended to keep the whole note, it doesn't matter. The broker who deals the note for you to sell, (someone like me), will be paid a fee from the funding source who buys the payment s and the fee is part of the discounted sale.
The discount taken on the note represents not only the fee for the broker, but the inherent risk that any investor takes when purchasing any such instrument. Their required yield reflects that risk. Again, if you didn't intend to keep the note, it is not money out of your pocket.
Theresa (FIAFA)
So, if the amount financed is 50,000 (principal) are you dicounting that amount or are you dicounting the total of payments wich includes interest, depending on the dicount rate 10,20 ,30, 40 ,50% to arrive at a net check amount?
What is the industry standard rate for this type of structure?
Talking about a seller financed note
In the car biz 50% of principal only would be cusomary on a unseasoned note and 65% of a seasoned note (prin &interest)
Big difference in a net check.
Sean
This is a very nice posting. The first real money I ever made was on such instruments
In the crazy building boom right after world war II, you remember, the war to end all wars. Well here in California everybody was a builder. No credit cards yet, so no high personal debt just did not exist. You could not get it. But your dear old Uncle Sam was doing right for his children. FHA and GI loans, buy a house with $100 down, the balance in the form of a lst Trust Deed at 4 to 4.5%. 30 year fixed. Woopy the American Dream, everybody got a house.
Then stage two set in. Families broke apart, jobs were lost people decided to go elsewhere and the houses went on the market for sale. The real estate brokers increased the price to pay for a six percent commission and away we went on round two of the great American Dream. People bought houses again. My god they had only gone up a few thousand dollars. Just enough to cover a brokers commission. Of course no cash, so the friendly brokers took their commissions back in the form of second trust deeds aka mortgages in some states.They were small notes by our standards today, The value of the dollar was still high. These seconds were between two and four thousand dollars same interest rate as the first 4.5% mostly set to run until paid $20 a month to maybe $30 a month. Some of the brokers were gougers and charged 6%. Lets face it this type of business does cause an increase in the price of real estate. All thru a broker sticking a commission in the price of the property.
Well guess what, some of these Brokers needed money so they started selling these notes average price unseasoned note ten cents on the dollar. I whipped around to all the escrow companies dropping my card, yes I will buy those notes. Even the ones where I knew the crafty brokers were fudging. At ten cents on the dollar I could absorb a few losses and if they went bad, I just came up with a hundred dollars or so, bought the deed, waved goodby to the old owners and moved the new tenants in, most soon to be buyers.
All of the knowledgeable persons said that I and a few others were nuts. The worst paper in the world. My fellow mortgage and real estate brokers openly sneered. They felt that we were suckers, fools anybody could take advantage of us. I had one nice little Mortgage Broker from Beverly HIlls tell me that I was just an overeducated stupid Goy looking to history books for answers when they were right in front of my face. Like the back row at Nat and Al's Restaurant. Lenders Hangout. My Grandmothers name was Rothchild I am only an honorary Goy. Watch it.
.
So we paid them their $200 to $400 a transaction and stacked the notes.oops there I go a buzz word, the sign of a silted mind. Stack notes is to take them into a nice bank and let them collect the payments for you and stick them into a savings account.
Guess what, the bank as is their wont only look at the face of the note and if you wanted to borrow against those notes, they would pick up their copy of the Standard Operating Procedure manuel and lend you fifty percent on the face.
The world has gone insane. I am buying notes for ten percent of the face and I can borrow fifty percent of the face. I have gone to Real Estate Heaven, where are the 71 Virgins, damn John Locke, I have the money at last, shoes and virgins all at the same time. It is the great American miracle.
Up to that time my sole transportation was my VW Beetle the right hand seat was out and replaced by a small desk with a typewriter on it and places for Deeds and of course my Notary Stamp. I now bought a real car. A Porshe. Got the funny gloves with no backs the sporty hat and the super dark glasses. God if only I could smoke cigars without throwing up.
Naturaly such experiences led to many things, for example we had to figure true interest return on notes bought at discount. We bought heavy books put out by Boston Financial Publishing Company. They had tables and with a little algerbra you could figure out true yields. Now you knew a lot of things. How to sell discount paper to big time investors who just wanted to buy paper and did not want to get involved in properties. Guys like David May and Archie Pressman scions of the rich. Soon there was a big market making and selling these kinds of notes, created at the moment of sale. Lets face it a lot of it was based on the fact that people were getting so excited about the yields they were not looking at the true repeat true value of the real estate involved. Many properties were overpriced just to creat sales that would create paper that could be easily sold. Discounting makes for high yield on investment paper.
It was fun, and in the process a constant ongoing exposure to transactions. Which is where the Broker or Investor can make money. Well looks like another repeative event.
Frankly it is not new, as far back as The John Company in England or Dutch East Indies Company, notes were being created on the estimated value of a cargo not yet arrived in a European port and notes were discounted back and forth. You could play a game by having spotters in some of the way ports to London, then by horse back ride like hell to London, hit the coffee shop where all the speculators hung out and tip the upcoming arrival of a merchant vessel coming back the hard way from the spice islands etc. etc.
What do you think the development of the semaphore system across Europe was for?
From the Cape of Good Hope to Gibralter a signaling system was set up. It worked pretty good. No I was not there. I am but a child my first big crash was only 1929.
I hope this has been helpfull. Around and around. Does nothing change? Oh yes, I was way ahead of the times I used an abacus which has been around for about three thousand years. Now I use a HP 12 Calculator. Does the Declining Balance Interest Problem, tells you proper yields on discount paper.
Get rich have fun but for God's sake do not take it seriously. I wonder what else is out there?
Retrospectively Lucius
fiafa, this is a very informative article. definite learning tool to have it spelled out as you did - so clearly. there are so many unexplained phenomenon in rei!
if this practice is fairly common, then it pains me to AGAIN realize how much i still don't even know, that i don't know. :-D