As note investors, we make a living buying discounted notes and show others how to do the same in our online academy. One of the most common questions we get from real estate investors interested in learning how to buy discounted notes, is why you can buy discounted notes to begin with?
So we decided to explain what a discounted note is, common reasons why a note holder would sell a note at a discount, and why you would want to buy a discounted note as an investor.
What is a discounted note?
In real estate, a discounted note is a mortgage note that is sold for less than the current value. In the financial world, real estate notes are bought and sold between all the time. Most of the time these notes are sold at par, or for face value. Meaning if the borrower owes $176,920.18 on the note, the buyer would purchase it from the seller for $176,920.18. There is no discount. The buyer is investing in the mortgage or security receiving the a return at the interest rate stated in the original note.
However there are times mortgage notes are sold at a discount or for less than the face value of the note. Meaning if the borrower owes $176,920.18, the note buyer would purchase it from the note seller for $143,891.12 as an example. In this case, the buyer’s yield or return on investment increases because of the discount from the actual value of the note.
Why would a note be discounted?
While not always the case (as you will see below), most discounted notes are sold because the seller is in some sort of distress which is typically attributed to:
- Complications or challenges with the note.
- The seller needing liquidity or cash now.
But in reality, the reason for the discount relates to who the seller is and what is causing distress.
Why a bank might sell discounted notes
On an institutional level, lending institutions like a bank, credit union, or non-banking lender, do not sell notes at a discount — unless they are in distress. These institutions have certain requirements to meet including liquidity and reserve ratios that state how much money or assets they need at any given time in relation to their debts. To increase liquidity, these institutions package and sell mortgage notes at par on the secondary mortgage market to institutional buyers. This gives them the cash they need now to maintain liquidity and continue lending. If their liquidity is compromised or becomes too low, like during a recession when mortgage default rates are high and purchasing by investors is reduced, the institution may need to sell a portion of their loans at a discount.
Typically, if this happens the financial institutions will sell their non-prime loans, which are loans that have a lower rating in terms of value or may be delinquent. When a loan is 90+ days delinquent it becomes non-performing note and no longer is an asset for the institution, but a liability. If the now non-performing loans were originally packaged and sold to investors as a security, the institutions is on the line for paying the principal and interest payment to the investor each month even though the borrower is no longer paying. To minimize losses and keep liquidity from dipping to low while they cover or advance these payments to investors, many times they will sell the non-performing notes at a discount. Since the notes are not paying, they have less value in the marketplace thus justifying a discount from the note’s face value. The more the bank needs money, the greater the discount they will offer in hopes to gain liquidity and complete the sale as quickly as possible.
Why a private note holder might sell discounted notes
Private note holders may also sell discounted notes because they are in distress, just slightly different distress than banks or financial institutions might be facing which could include:
- The note being delinquent and they are unsure of how to proceed.
- The note being delinquent and they do not want to be the person to proceed (could be a family member of friend in the home and it would tarnish the relationship further).
- Inheriting a note from a family member after they passed and prefer cash now then payments over time.
- Liquidity issues. They need cash now for personal or business reasons.
- The note is causing them distress and selling at a discount is better than dealing with the “headache”. For example, the borrower may be arguing with them, challenging the foreclosure, not maintaining the property, or possibly have filed bankruptcy.
- The marketplace demands a discount (meaning the market will not buy it at a par). If no one will buy at par, you have to sell at a discount.
The amount a note is discounted will vary with the market. The more distress the market is in, the greater the discount. The stronger the market is and the more competition there is in the marketplace, the lower the discount will be.
Why buy discounted notes?
Investors buy discounted notes because of the higher yield or return they can produce but also because of the time value of money (TVM). TMV is a formula that illustrates how the value of money today will always be worth more than it will in the future — primarily because of inflation, but also because of time lost not earning a return or a yield. If you have $1,000 earning a 10% return, after one year you would have $1,100. $1,100 one year from now is surely more than $1,000 would be having not earned any interest at all. If your money is not earning a return, it is not keeping up with inflation and thus it will be worth less in the future than it is worth today.
Savvy investors surely factor TMV as one of reasons they purchase discounted notes, but most investors will say they buy discounted notes because of the higher returns they can provide. If a 30 year mortgage note was created for $200,000 at 5% interest it would have a monthly principal and interest payment (P&I) of $1,073.64. The person who created the mortgage would earn 5%, or $186,513.24 in interest on the original $200,000 they lent the borrower returning a total of $386,510.40 if they held onto it the entire 30 years.
But let’s say the original note holder decided to sell at year 10. The borrower has paid on time every month, bringing the balance at year 10 to $162,684.71. Because the seller has a strong enough need or desire for cash now they are willing to take a 25% discount from the face value, selling it for $122,013.53. The note buyer is now able to collect the remaining 240 payments of $1,073.64 but because of the 15% discount, their yield increases to 8.69% if they hold the loan for the remaining 20 years. The greater the discount, the better the return for the buying investor. There are ways to turn “headache” notes or non-performing notes into a profitable note investment, as long as the discount is great enough.
As you can see there are a number of different reasons why buying discounted notes can make sense for both the buyer and seller. But it really comes down to what the seller needs, how badly the need it, and what the marketplace demands in terms of discount at that time.
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