Re: Question for note buyers - Posted by David Butler
Posted by David Butler on February 17, 2001 at 16:05:01:
I was going to suggest that, and I’m glad you found things to answer most of your questions…
And, you have already answered your own question to a degree… it use of the second mortgage is a function of downpayment, although it won’t always be a requirement - depends on several circumstances… and sometimes, it’s a reflection of what would be better in the overall picture for the note seller.
Here’s a couple of points you’ll want to consider:
In the conventional lending markets, lenders have access to (and are required by FNMA/FHLMC guidelines as well) obtaining mortgage insurance (PMI, MMI, VA Guarantee, etc) any time a mortgage exceeds 80% LTV. There is a three tiered premium structure for this insurance, depending on how high the LTV goes (85%/90%/95% etc.). The borrower pays this premium as part of his loan charges, and it adds anywhere from about 1% to 1.5% to the overall APR on such loans.
Of course, there is a reason for this insurance requirement… and it is directly related to risk. Contrary to what most folks believe, on average, lenders LOSE MONEY when they have to take a property back. That’s one of primary reasons CREI’s shoot for an average discount of 30% below market when structuring their real estate purchases!
Although a few subprime programs utilize a form of PMI too, their mechanism is more generally to use risk rating premiums instead. Rate brackets are credit driven, with even the best rate available generally 1.5% to 2% higher than conventional rates, and much stiffer point charges are incorporated at closing.
Note buyers really don’t have either of these options, so they have to build in deeper discounts when purchasing existing notes, and they must maintain an acceptable ITV (Investment-To-Value) ratio, which most buyers calculate against the value of the note… rather than than the value of the property.
The combination of these two factors is what ultimately determines the price an investor is willing to expose on a given note deal. That amount is then adjusted according to the “time value of money” (which will be affected by the actual rate and terms of the note itself).
Note investors are generally credit driven as well, so the yield rate they require, and the ITV exposure they are willing to absorb, will vary by Payor credit.
As a quick example, using a generalized rate schedule for a table funding buyer… with a 650+ credit score, some buyers will live with a 5% down payment, and a 95% first note. They then might agree to purchase up to 93% of the remaining balance on that note, subject to earning, say 12.50% yield on the note. The lower of the 93% ITV limit, or the yield, will determine the price, which in turn is determined by the rate and term of the note itself.
Say we have a $100,000 property sale, 5% down, $95,000 seller carryback at 9% interest, amortized over 30 years, $764.39 per month. Note buyer will fund maximum 93% of remaining balance, which sets his total dollar exposure at $88,350 for this note. But the note buyer also requires 12.50% yield on the note purchase. That sets his maximum price for this note, at $71,620.
The note buyer can only pay the lower amount, to meet both his ITV, and his yield, requirements.
Now, let’s take the same 650+ Payor, putting down 10%, and the seller carries back a 90% new 1st mortgage, same terms, paying $724.16 per month. Due to the higher down payment, the seller is willing to accept an 11% yield.
This time, still using his 93% ITV factor, allows total exposure of $83,700, and his yield requirement limits the total dollar investment to $76,841 - over $5,000 more dollars for the note, plus the seller received $5,000 more cash at close - a $10,000 swing in the deal, in the seller’s favor.
If you were able to follow along through that mishmash, you can see some function of risk and terms being played out here - along with the all important function of “time value of money”.
Lets’ take the last scenario, and put a seven year balloon, or stop, on the note, i.e. 30/7 payment schedule. In this instance, the note buyer is purchasing 84 monthly payments of $724.16 per month, plus a balloon payment of $84,276.41 to be received in seven years. In this instance, due to the accelerated receipt of the backend payments, the buyer can pay up to $81,451, and still earn 11% yield on his investment - even though he is paying $4,600 MORE for the note, than in the previous example. Why? Because he is getting the money back faster, so time is not eroding the value of the principal balance.
But, again we have to look at the ITV parameter… our investor is using 93% as his maximum ITV limit… and, we see that that total amount is only $83,700…
So, to meet both of the investors requirements (for yield and ITV protection), the note seller would still have to leave almost $2,300 on the table.
To preserve this $2,300, the seller can sell only a partial purchase of his note. But, a better way would most likely have been to take back a small second for $5,000, at the time he created the deal. And the effect would be much more dramatic on a deal where the buyer only came in with a 5% down payment.
Let’s look at this last deal structured this way - Now, with an 85/5/10 structure, the property sells for $100,000, with 10% down, an 85% seller carry 1st mortgage and a $5,000 seller carryback 2nd mortgage.
Terms are 9% on both notes, with 30/7 payoffs. The first pays at $683.93 per month, and the 2nd at $40.23.
Now the note buyer is only paying $76,926 for the first note, so we are netting $4,525 less cash at close. On the other hand, we create a “forced savings account” of $5,000, earning 9% interest, which means we just saved $475 in discounted dollars. And, through the holding period, our $5,000 second generates $3,379 in cash flow. Finally, the balloon pays off $4,727.17 = giving us a total of $8,097 for the 2nd.
The second route makes the deal much easier to sell, and gives us a total of $85,023 ($76,926 + $$8,097),
netting out $3,572 more total cash to the seller, than the $81,451 we would receive for selling a 90% 1st position note.
Obviously, just as it is done in the subprime markets, the pricing structure will decline in relation to the Payor’s credit scores and profile. Many times, we hear sellers question that - “well, if they have to go through all that, they might as well just go get a loan!” But, that’s precisely the point.
Either the buyer can’t qualify for one reason or another because of the low down and related factors (maybe the lender will accept the deal, but the PMI company won’t)); or maybe the property won’t qualify (noncorforming); or maybe, the buyer doesn’t like the costs of the subprime loan he just got approved for at 10.5% with 5 points.
Like any other dealmaking device, the use of seller financing is just one more tool to consider. Sellers shouldn’t offer just to be offering it. And there’s been a ton of discussion related to that very point, right below here… particularly some well reasoned answers presented by Mike Morrongiello over the past two weeks. There’s a time and a place for seller financing - and that time and place is when it satisfies the objectives of all parties to the transaction; and moreso… when it is the deciding factor as to whether or not a deal will even close in the first place!
Hope this helps, and Happy Selling!
David P. Butler