Mortgage Note Valuations

There are three (3) primary methods in which a buyer will purchase a private mortgage note:

  1. THE ENTIRE NOTE BALANCE:  Here the buyer will calculate the remaining balance of the mortgage note, discount it to bring the yield to his purchase parameters, and make an offer on a 100% cash out of the note.
  2. PARTIAL PURCHASE:  Here the buyer of the note will purchase just a portion of the note.  It can be calculated as a percentage, such as 50% of the remaining note balance or calculated as a purchase of a set number of future payments.  This is a powerful tool of note buyers
  3. BALLOON PURCHASE:  Here the note investor is purchasing the balloon payment due at some future date.  The balloon payment will be discounted based on the investors perceived time-value of money.

Learning to Calculate Purchase Prices

In order to purchase notes, its obvious note investors need to learn how to use a financial calculator to determine note balances and calculate discounts.  In reality, note brokers should master this skill as well if they want to be taken seriously in the industry.  Later in this series of lessons, we will show you exactly how to value notes and make all the calculations you will need using a financial calculator.

Four Ways to Sell a Home With a Mortgage

A home with a mortgage can be sold in one of four ways

  1. SUBJECT TO THE MORTGAGE:  Here the home is sold to a new owner but the previous owner remains liable for the mortgage payment
  2. REGULAR ASSUMPTION OF THE MORTGAGE:  Here the new buyer is allowed to assume the existing mortgage such as a VA loan without lender approval.
  3.  ASSUMPTION WITH NOVATION:  Here the lender approval is required for assumption and it usually involves a mortgage with a “due on sale” clause stating the mortgage must be paid off if the property is sold.
  4. CASH SALE:  The mortgage is paid off by a new mortgage or a cash payment

Valuing a Mortgage Note for Purchase

Attaching a value to a mortgage note has always been a complex investment process and a has even become more so with recent law changes such as Dodd-Frank.  Before we discuss pricing and determining a discount price with a financial calculator, here are a few considerations when it comes to pricing a note.

The Property

You underlying collateral on a mortgage note is the property so the quality and condition of the property is of paramount importance.  There is an old note buyer’s adage that says, “If you wouldn’t want to own the property, don’t buy the note!”  This is very true.  Most professional note buyers will away from an attractive note if the securing property is in poor condition or not easily resalable in the event of a foreclosure.

Note Structure and Composition

In today’s low interest rate world, note structure and composition is of paramount importance to note buyers.  By note structure and composition, we mean the note’s rate of interest (fixed or variable) and maturity and to just a slightly lesser degree, things like events of default and remedies.

The rate of note interest and its maturity is very important in today’s record low interest rates.  That is because of the inverse relationship between fixed rate investment values and general interest rates.  In short, a fixed rate note’s investment value will go up in value if interest rates in general as set by the Fed and central banks go down.  I note’s principal market value will go down as the general interest rates as set by central banks go up.

Attractive Note Characteristics

  • OWNER OCCUPIED RESIDENCES:  Owners take better care of properties than renters
  • SHORT TERM NOTES:  Because of today’s record low interest rates and the probability rates will rise over time, buyers are skeptical about locking in today’s low rates for 20 or 30 years.  Short term notes are much more attractive for investment.
  • SEASONED NOTES:  Notes that have at least a twelve month or longer history of timely payment are more desirable than those with little seasoning.
  • SENIOR LIEN MORTGAGE NOTES:  Senior lien (first in line to get paid) are much more desirable than junior (second mortgage) loans.
  • NOTES WITH A BALLOON:  Longer term notes that feature a near term balloon are much more attractive than standard fully amortized notes. (NOTE: So long as they are Dodd-Frank compliant)
  • CREDIT QUALITY OF PAYOR:  Notes that have a payor with acceptable credit quality are much more desirable than those with a payor of very poor credit quality.

Using ITV in Evaluating a Note’s Investment Merit

A calculation known as ITV (Investment-to-Value Ratio) is used to value a note’s investment merit.  ITV measures the equity in a property based on fair market value vs. the amount of financing in place (including the investment of the note buyer).  Importantly, ITV measures the cushion a note buyer has in the event of default and will allow note buyers to adjust a purchase offer based in their risk tolerance.

To calculate an equity cushion using ITV, simply divide the total amount of senior financing in place plus your tentative investment by the property’s fair market value.

EXAMPLE:  Bill is considering purchasing a $50,000 second position owner financed mortgage note at a discounted price of $40,000.  There is a $60,000 first position bank loan in place.  The home has a fair market value of $200,000.  What is the ITV?

SOLUTION:  Add the senior lien of $60,000 to your anticipated note purchase price of $40,000 for a total of $100,000.  Divide by the property’s fair market value of $200,000.  The ITV on this investment would be 50%.  Or in other words, a 50% cushion would exist in the event the note you purchase defaults.