Re: creating note for max resale - Posted by David Butler ANN
Posted by David Butler ANN on November 08, 2000 at 20:39:53:
Looks like Mike pretty much covered all the good ground on this… but it’s an awful lot of ground to cover - and the issue comes up so much, I thought I could add a little more clarification to what Mike has reviewed.
First, pull up ANN’s FREE report, NOTE GRADING/PRICING Guidelines at: http://notenetwork.com/at.cgi?a=118510&e=Reports/Note.Pricing.Guidelines.html and study that information inside and out. Once you internalize that, you’ll have a pretty good feel for your note pricing and structuring decisions.
Also, you might benefit greatly from reviewing ANN’s FREE report, HOW TO BEAT THE FLOOR PLAN MAN, at:
Although written primarily for MH dealers, the discussion on how to create good notes is readily transferrable to real estate notes as well, and covers a lot of ground.
Other basics in creating notes…
include a substantial late payment penalty provision subject to whatever your state law allows.
include a prepayment penalty, subject to whatever your state law allows.
use a balloon payment structure when possible, to cut the long-term discount on the backend of the payment schedule. Here, you want to be careful to structure it to make sense. Always be sure to have a clearly defined exit strategy documented in your package… for example - a fellow with a 575
FICO, showing a 45%/50% DTI, isn’t really a valid candidate for a three year balloon, or even a five year balloon in my book. That doesn’t mean some investor wouldn’t take it, but you are looking for the highest probabilities of maximizing your price on selling the note - so stick to what makes the most sense, right?
So… if you write a balloon note on a buyer like that, you pretty much want to have some solid evidence in file that would indicate that the probability of timely balloon payment is high, despite this Payors poor current financial condition.
Otherwise, if I took a note like that, knowing that the probability of timely balloon payoff is remote, I am going to want a deep discount - knowing I am either going to have to extend the note past the balloon date (voluntarily - or possibly involuntarily in the case of Payor’s bankruptcy), which diminishes my yield spread; or alternatively, I am going to be faced with foreclosing on the property - in which case, I definitely want to be paid handsomely for my time and trouble
Annual payment increases (interest rate increases can work in some instances, but the laws on these are pretty sticky) are another good alternative, but again, only if it makes sense with regard to your Payor.
Assignment of Rents clause - you should always include that in the security agreement.
Military Personnel - I am pretty sure that the Soldier & Sailors Civil Relief Act is still in full force, and Jon Richards is too. This Act provides that no property owned by a serviceman can be foreclosed upon without the consent of the court if the serviceman: (1) incurred the obligation
BEFORE he entered the military, AND (2) foreclosure is attempted while he is on “active duty”, or within three months after discharge from the military. Honestly, this exemption rarely affects too many foreclosure actions - on the other hand, seems like we have seen a lot of “active duty” firefights going on around the globe since 1990. Title companies and foreclosure attorneys (or trustees) don’t always get it right.
So, I like to have the Payors sign a Declaration of NonMilitary Service with clauses that stipulate that the note was created AFTER the Payor entered into military service, or that each of the debtor parties to the note is not now, now was he/she at any time in the three months prior to the creation of the note, a person in military service as defined in the ACT.
All of the above items help reduce negative factors from the note, and help protect the risk rates assigned by an investor.
Remember this too - HARD equity (down payment) is always king. 5% is poor, 10% is fair, 15% good, 20% is much, much better. But as Mike mentioned, credit profile and debt-to-income ratio are often equally or more important than pure credit score. As a note buyer, I would rather see a 5% down on a 650 Fico Payor who has a DTI below 40% with a good income history - than I would with a 600 Fico Payor with 10% down, sitting at a 45% DTI with some sketchy income history. Can you see the trade-offs?
Too much discussion to go into here… but, don’t get confused by ITV vs. yield either. Many buyers indicate that they will pay up to 90%/95% ITV of the note balance. They very well may, if all the clauses above are included, the term is five years or less, AND it still hits their yield requirements. The lower between their risk rate, and their ITV comfort zone will ultimately dictate the price they are willing to pay!
And keep in mind that private notes are very similar to subprime loans in many respects. On a loan amount under $100k, with an A grade subprime buyer, he’s looking at approximate 10.49% at best, with 4 to 6 points in origination fees… borrowing from you, he doesn’t have those fees - so you want to scrape some of that off for yourself if possible, either by getting full purchase price or slightly higher, or getting a higher rate on the note to offset the discount you are going to take when you sell the note.
Also, in another issue I have addressed very extensively the last few months… the markets are changing. Related to that - simultanteous closings, and notes with less than 12 months seasoning have been an area that is rife with fraud, especially in the rehab sector. Investors who got their feathers burnt are becoming much more wary, and smartening up a great deal in their underwriting criteria.
Again… study our NOTE GRADING/PRICING GUIDELINES at:
Learn those to the tee, and you should be able to figure out the most everything very quickly on your own.
Best of luck, and have a profitable day!
David P. Butler