Posted by John Behle on March 18, 2000 at 12:37:17:
A note as we use the term here refers to some kind of cash flow or obligation. Note as in I.O.U.
When it comes to real estate notes, they are called “discounted mortgages”, “Paper”, “Seller financing”, “Contracts” and other names.
They are usually created in a private transaction between a buyer and seller of a property during the sale. The buyer then pays the seller (who just played “bank”) on the note for whatever term, amount and rate they negotiate.
The market for these notes is what is termed an “In-efficient” market. You don’t open the paper in the morning and scan the column to see what your note is worth. It is a “bid” market. There are local and national buyers throughout the country that bid to buy the notes - usually at a discount.
You can create a note on a property you own, but the number of potential buyers diminishes fast. Most buyers want a third party transaction where a sale was involved. Some local buyers may consider buying a note you create against a property, but don’t count on it.
Since the rates on the notes are usually not enough to interest the local and national buyers they are discounted similar to how a bond is discounted. A buyer might discount an 8% note to “yield” 11-18% depending on the terms and risk factors.
Since the investor can’t go to the “payor” and say “8% isn’t good enough for me - please pay me 12% now”, the way the investor raises their rate of return is to discount the amount they pay for a note. So, a $10,000 note may end up selling at as much as a 15-40% discount depending on terms, LTV ratios, seasoning, type of property, credit, etc.