Things you should know
When expanding your investment portfolio to include real estate notes there is some basic information you should have in order to evaluate the risks and rewards of such an investment. As with any investments there are some things are unpredictable. We will concentrate on some of the more common and tangible aspects of real estate notes.
Type of Property
The type of property securing a real estate note is important. Different types of property bring different responsibilities and liabilities should the borrower stop paying. A single family residence may require repairs, marketing and sales cost, where as a gas station or dry cleaning facility may have other costly environmental issues to consider. The most critical question is “would you know what to do with the property to recoup your investment in case of default”?
Location
The location of the property is equally as important. If it sits on a desirable part of town and there is demand for the type of building or the land it sits on, then in case of default, the property could be resold in a timely manner. For example, an average single family home on a city lot in a nice neighborhood will probably be easier to sell than a dry cleaning facility on the outskirts of town. Conversely a very large elegant home that sits 30 miles away from any metropolitan area may have far fewer interested buyers.
Property Value
How much is the property worth in its present condition? Does the value adequately secure the balance on the loan? The property aesthetics do not always tell the whole story. For example, a dated little convenience store that sits on a corner lot next to a new retail mega store may worth more than outward appearances lead you to believe because of its proximity to that retail store next door. Likewise a beautiful five bedroom home that cost $300,000 to build next to the city landfill will have its value diminished by the location it is in.
Equity
How much is the balance of the loan versus the value of the property? This is called the loan to value or LTV. It is calculated by dividing the loan balance by the value of the property. The lower the LTV, the safer the investment is in case of default. Equally important is the lien position, is the note in first position or second? A 1st position lien is a much safer investment than a 2nd position lien.
Borrower
The next thing to consider is how likely the borrower is to continue paying the monthly payments. Is the borrower gainfully employed? In the case of a borrower who is a business owner, how stable is his/her business and how many assets do they own and is their loan personally secured by them or just their business?
Terms
It is also important to consider the terms of the note. The amortization period (number of years to pay off the note), the interest, and down payment all play into evaluating the value of a note. Are they escrowing for taxes and insurance? There are numerous factors that go into calculating the value of a note so the value (price) of a note will depend on each individual note and the rate of return or yield a buyer is looking for on his/her investment. However the time value of money must be taken into consideration. In short, a dollar now is worth more than a dollar ten, twenty or thirty years from now. It is because of this that no investor should ever pay the equivalent of the note balance for any note.
Conclusion
When buying real estate notes, correctly calculating the price to pay for it is probably the most important thing to do and will require considerable thought and work. Once you negotiate a price, you should find a knowledgeable attorney to help with the closing and you may also want to find a servicing company like Investor Loan Services to help with monthly and yearly servicing requirements.
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This information is intended to be used as a general guide. It is not intended to constitute legal advice and is not a substitute for the advice of an attorney. While every effort has been taken to present the information accurately, this document may not be infallible. No warranty is made that these materials are current, complete, accurate, or suitable for any particular purpose. You should seek advice from your attorney before proceeding with any real estate transaction.
