The day has come when savvy entrepreneurs, investors, rehabbers, FSBOs, Realtors, and other real property owners have come to the realization that they can sell their properties faster by offering owner financing and still get to a cash position.
The advent and acceptance of what often is referred to as a “simultaneous closings” where a property is sold, and the private seller-financed note is sold to coincide with the sale of the property has become an integral way that many note deals get done these days.
I am often asked how can I structure these types of deals to provide for two things:
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A saleable note that can be easily converted into cash
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A minimal note discount from the balance owed
The following circumstances surrounding a potential note deal will come into play when a note investor, including ourselves, is looking to purchase these newly created notes. Let’s briefly explore each of these variables.
Type of property
As far as the collateral securing repayment of the note is concerned, clearly a vacant land parcel that has no improvements attributed to it would be considered far riskier than a mortgage lien on a single-family dwelling, which is generally considered to be the easiest type of real estate to finance, sell, or dispose of.
Different types of collateral warrant different levels of exposure from a funder. Residential properties are far more acceptable than commercial properties or land. Within the residential sector, there are varying degrees of acceptance over the actual type of residential property.
A mortgage lien on a single-family detached home is far more desirable than one on a condominium, town home, or mobile home, etc. We will focus on the most desirable type of collateral for an investor in paper and that is the “bread and butter” single-family home.
If you are creating paper and want to maximize the amount of cash you can receive, then a properly structured first lien mortgage on a single-family, owner occupied, detached dwelling is by far the type most note funders can price aggressively–meaning, maximizing the funding exposure and minimizing the discount on the note sale.
Occupancy
Statistically speaking, a payor who lives in his home as their primary residence is going to keep up the condition of their property better and pay more timely on a note than an investor/owner who may be struggling to collect rents, keep up with repairs, or other bills, etc.
This translates to more conservative exposure levels that are going to have to be adhered to for a non-owner occupant/investor type payor. It is wiser to sell to prospective buyers who are going to live in the home, feel that they have some emotional attachment to the home, and are more willing to pay a full “retail” sales price for the home than an investor.
New sale or seasoned note
A note that has been newly created with no discernable payment history established creates uncertainty and risk associated with this burning question: How will the note be repaid?
Often even good credit payors overextend themselves when purchasing a home, and all the extraneous expenses that go along with home ownership (taxes, insurance, repairs, upgrades, furnishings, utilities, etc.). A note that has even a few months of documentable payments associated with it can often lessen many issues.
With lesser credit payors, the note may have no alternative but to be seasoned in order to mitigate the risk and uncertainty and make it marketable for sale.
If you have marginal payors that are going to be paying you, make sure you have the ability to clearly document their payment history to you. After a period of time the risk and concern over their credit background becomes offset to a large degree by their performance on the note.
Buyer’s down payment
If you are presented with two identical notes secured by two identical homes located in the same neighborhood, with the exception that the purchasers of one home put down 10% of the purchase price in cash, and the other home purchaser puts down little or no cash–everything else being equal, in which note would you prefer to invest?
A down payment of a buyer’s hard-earned dollars creates more stability for a buyer. They often will fight, claw, and scratch their way out of a problem before jeopardizing their initial down payment they have made into a property.
Although most note funders want a minimum of 5% cash down, 10% is preferable on residential properties. Also make sure any initial earnest money deposited or down payment money is clearly and conclusively documented.
Buyer’s credit profile
Prospective buyers of a property who have demonstrated that they can pay their creditor obligations timely are going to be inherently a better risk and therefore command more aggressive pricing for a note that they are paying on than those individuals with a blemished credit past or present.
This is not to say that a so-called “scratch and dent” borrower cannot still be a good choice. Look carefully at the overall credit profile and history to see where the problems lie.
Are there major credit issues like a prior or more recent bankruptcy, repossession, foreclosure, judgment, etc.? Or are the credit problems possibly related to past medical payment problems? How long ago were these problems? Has there been any re-establishment of positive credit?
There is a tremendous amount of increased risk associated with buying a note that has no established payment history attributed to it. If you want to sell a newly created note it is advisable to seek better credit quality buyers.
As an alternative, be prepared to accept a larger discount for the note and a lower level of funding exposure or consider seasoning the note to establish a track record of timely payments.
Credit scores
Credit scoring is often referred to as a “FICO,” “Beacon,” or “Empirica” score. It is generated by analyzing the data in the major credit repositories for an individual and affixing a score that illustrates his pattern of credit use.
The higher the score, the lower the risk associated with that prospective borrower; the lower the score, the greater degree of risk. Although far from perfect, more and more funders are relying on these credit scores to ferret out potentially problematic borrowers.
As of this writing, when dealing with newly created notes or real estate mortgages, try to look for prospective buyers who have credit scores in excess of 600.
Sure you can sell one of your properties to a lower credit score buyer; however you will have to sacrifice a lower tolerance level for any funding for that particular note, or you will have to “age” or season the note obligation for a period of time to offset the lower credit scores and perceptions of risk.
Buyer’s employment and stability
What someone does for a living and for how long illustrates how stable a prospective buyer is. If an individual has been going from job to job over short periods or has relocated several times in the recent years, there is an extra risk associated with that type of borrower.
However, individuals who have some longer-term stability either in working for themselves or an employer are considered less risky.
Repayment terms of the obligation
After scrutinizing all of these variables, you should have a good feel for where a prospective buyer/borrower might fit in from a risk standpoint.
Candidates with less risk allow you to finance them at a higher starting loan to value (LTV) threshold for the mortgage, typically in the 85% LTV to perhaps as high as a 95% LTV, as opposed to the riskier candidates who you might wish to limit to somewhere in the 75% LTV to 80% LTV range.
The same is true with the actual note interest rate or “coupon” rate. Higher risk means the note should be drafted with a higher interest rate, typically in the 10% to 11% range.
Lower risk can allow for a lower note coupon rate perhaps in the 8.5% to 9.50 % range. The mortgage and note should typically contain a 30-day default clause, have acceleration remedies, contain no prepayment penalty, have a late fee provision, a due on sale clause, and nonassumability clause.
Putting it all together
It is the dynamic interrelationship of all of these variables that will dictate how you can “tweak” the proposed structure for a deal, so that it will allow you to maximize the amount of cash you can realize along with minimizing the note discount.
It makes little sense for you to try to sell a newly created 90% LTV note that is written @ a 9.5% interest rate to a note funder where the note payor has credit that is not deserving of that favorable interest rate or higher LTV exposure. You will be the one who suffers a greater discount on the sale of this type of note since its structure was not optimized.
Additionally, experienced funding source personnel or a competent master broker can save you tons of frustration, heartache, and headache in putting your deals together quickly in an optimum way. Pay attention to the above variables and above all, be realistic.
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