ONE OF MY students sent me this example. It's a good example of a note that many might not be able to calculate, would turn away from, and many funding sources would not buy. Yet, when I can invest some of my money at a 26% yield, I'm happy. The best deals and profits in this industry come through your creativity.
Here's a note that came in yesterday. Try running this one through your calculator.
The loan is about 2 months old and goes as much as 36 months. The loan is structured with three scenarios. If the loan is paid in full before 24 months, then the note bears 0% interest with no payments (just one lump sum payment). If the note goes past 24 months, then there is an interest rate of 5% that applies for the whole time period and interest only payments from the 24th month. If the note goes all the way to 36 months, then there is an interest rate of 10% that applies to the full amount.
The seller said he is “hoping for $20,000” and would probably just buy the note himself with one of his investment accounts. Others he has talked to convinced him that an 18% yield would be what investors would acquire. Assuming the property and LTV are acceptable, what would you pay for the note?
Frank, January 6, 1998
This note has to be calculated all three ways. You always pay for a note based on the “Worst Case Scenario.” Usually that is the longest term, but with the interest rate twists of this note, you need to calculate all three.
Step One – Identify The Cash Flows
Scenario One – no interest, no payments, paid within 22 months (subtracting the two months that have already passed). There is one cash flow which is $32,250 paid in 22 months (take the longest possible period). This is a lump sum cash flow and simple to calculate. Go to step three.
Scenario Two – 5% interest, no payments for 22 months and then interest only payments and a balloon in 34 months. The cash flows are:
CF1 = payments of X amount beginning in 22 months and payable for 12 months.
CF2 = a lump sum payment of Y amount payable in 34 months.
Scenario Three – 10% interest, no payments for 22 months, interest only payments for 12 months (based on 5% – since the 10% hasn't kicked in yet), and a balloon in 34 months.
Step Two – Solve For Any Unknown Factors
Scenario One – There are no unknown factors, go to step three.
Scenario Two – Since interest accrues for two years on the $32,250, then we have a higher amount and the interest only payment would be based on that amount. The lump sum (balloon) payment in 34 months would be this higher figure. The first calculation shows the amount the loan will grow to in a total of 24 months.
So our cash flows then are:
CF1 = $148.48 per month for 12 months (beginning in 22 months)
CF2 = $35,634.36 in 34 months.
Scenario Three – The interest accrues for two years at 10%. The interest only payment is based on 5% and therefore 5% continues to accrue for another 12 months.
First we need to know how much the note grows to in the two years.
Since we know what the payment would be based on the last calculations, we can plug that in. The loan will be in a reverse amortization mode (“Walking Backwards”) and we need to know how much the balloon payment will be.
Step Three – Discount and Add the Cash Flows
Scenario One – CF1 = $32,250 in 22 months.
First we'll look at what we might pay based on his suggested yield of 18%, then we'll look at what the yield would be if we paid the $20,000 that he suggested as his bottom line.
CF1 = $148.48 per month for 12 months (beginning in 22).
CF2 = $35,634.36 in 34 months.
Since this is a “Future Series” cash flow, we need to factor in the 22 months we wait for the cash flow to begin. We do this by discounting a second time. We take the value of the cash flow ($1,619.55) and then discount that value as a lump sum payment due in 22 months.
Now for cash flow two:
Total value of both cash flows at 18% = $1,167.19 + $21,479.47 = $22,646.66.
Yield if we paid $20,000 for the note = 21.88% (This is too complicated and confusing a calculation to display here – it's a one week course.)
CF1 = $148.48 per month for 12 months beginning in 22 months.
CF2 = $41,613.13 due in 34 months.
CF1 value is $1,167.19 as determined in the last example.
CF2 value is $25,083.32 as shown below.
Total value of both cash flows – 18% yield = $25,083.32 + $1,167.19 = $26,250.51.
The yield (IRR) if we paid $20,000 for the note would be 27.08%.
With the interest rate twist on this note, it is more valuable as time goes by. So we would buy based on the shortest term 0% interest scenario – and hope it goes longer.
One crucial factor with creatively structured notes is whether they are enforceable. Sometimes the two different parties have different interpretations as to what happens when. The important thing is “what does the note say?” Most of the time they are not worded and put together by attorneys (which doesn't necessarily mean much anyway) and can be vague and parts could be un-enforceable because of that.
Assuming the note and property check out, it could be a good deal – assuming an investor can forego the need for cash flow for the first 22 months and monitor the note properly. There can be greater risks and a greater need for monitoring if the note does not have monthly payments.
Go The Extra Mile
Many investors will not buy these notes. Some would turn away just because they do not want to deal with the creative payment structure. The real sad news is many investors would turn away because they couldn't figure the yields and IRR. Many note investors have way too little financial and real estate background to even be in the business. If you educate yourself and go the extra mile in analyzing “creative” notes, you won't have any competition!