We’re going to discuss pricing cash flowing notes to start. If you recall from reading, Real Estate Note Investing: Establishing Your Buy Box, you found out that it’s imperative to establish a Buy Box, which is just another way of describing the purchase criteria. Now the Buy Box lesson provided foundational material that you’ll find very useful as we dig deeper into the pricing in this lesson.
I’ve gained some great insights as a note investor myself, but it was the hundreds of loan transactions with other investors that gave me a unique outlook on pricing. To be clear, when we talk about cash flowing notes, that includes performing notes, re-performing notes, and sub-performing notes. Now the first pricing variable I want to cover is credit quality. Everybody’s heard of a FICO score. But what is it? A FICO score is the type of credit score created by the Fair Isaac Corporation, and a FICO score is simply used to determine the credit risk. Credit quality for a borrower is essential when pricing a loan because it’s a great predictor In most cases of the future cash flow.
Credit quality also affects the borrower’s ability to refinance. And when you buy notes at a discount to the loan balance, a refire can result in a significant payoff on your note investment. Credit quality also affects your ability to retrain a note to another investor. Let’s take a closer look at some credit scores and make some distinctions. Credit scores are typically going to range from three hundred to eight hundred fifty. Over six hundred and twenty is generally an attractive credit score for most note investors. Usually, between 580-620 is often acceptable as long as there are some other compensating loan characteristics such as the higher equity in the property, or the borrower has an immaculate pay history.
A credit score under 550 tends to be a challenging score for a lot of investors to get comfortable with. Just a quick note on pulling credit when you’re conducting due diligence. A hard pull as opposed to a soft pull that’ll show up on a borrower’s credit report as an inquiry. It’s important to know whether your vendor is offering a soft pull. I’ve heard stories about litigation between borrowers and note investors that stemmed from an inquiry where there was no lawful reason to pull the credit. The average cost of pulling a credit score is about twelve dollars. But besides credit, another critical factor that will drive the pricing of performing loans is the note rate. The note rate or coupon is the interest rate stated on the mortgage note. A higher rate generally translates into a higher yield for the investor. So you’ll typically need to price loans with higher note rates more aggressively to be competitive in the market as a note buyer.
Let’s get specific about what constitutes a high and a low rate today. Now 6-8% as a note rate would tend to be pretty attractive for most note investors. Now 4-6% is probably a little more common. That’s where we see a lot of note rates today. Under 4%, and it tends to become a bit more challenging to generate an attractive yield. That is unless you’re able to buy at a very steep discount to the unpaid principal balance.
Equity is another pricing variable, under 70% loan to value or LTV would be considered a powerful equity protection. There’s a higher likelihood that the note investor will receive a full payoff with this level of equity. The biggest reason is it’s easier for the borrower to refinance if they have equity. 70-85% loan to value would be considered excellent equity protection. There’s a decent chance that the note investor will receive a full pay off or near full pay off in this scenario. You get up into 85-100% LTV; that should be reviewed with a little more pricing conservatism. The reason is, the value could easily be inflated by 10%, meaning the loan to value is much closer to or even at 100%. Secondly, it’s important to consider there’s 8-10% in closing costs when you liquidate a property. And as the LTV approaches 100%, it merely becomes less likely that the note investor will realize a full repayment of the loan. That’s mainly when there’s an event of default from the borrower. The total debt to the investor is likely to exceed the value of the property in that case.
Let’s discuss pricing underwater loans. We’ve just discussed how vital loan to value is or equity in pricing notes. If you’re going to price a portfolio of loans, I’d recommend shorting the data in an excel file by the loan to value or LTV. It’s going to give you a clear look at which loans have equity and which dumped. Again you’re evaluating which loans have LTV under 100 and which are over a hundred. Loans with equity are priced off of the unpaid principal balance. Underwater loans are priced off of the property value. It’s always the lower of the two. 100-125% loan to value can be concerning. But if there is a spotless pay history and healthy credit score that might offset some of the concern. So I wouldn’t rule those loans out. However, over 125% loan to value can get a little bit more problematic. Here’s why. When a loan is over 25% underwater, 125% LTV, this is generally considered the level where the borrower psychology shifts a bit, and they could be less committed to pay the mortgage when they feel like they’re always going to be underwater. This simply means there’s potentially a higher probability of default, and it should be factored into your pricing.
Let’s shift gears talk about seasoning. That’s a term used to describe the age of the loan. A loan is typically considered fully seasoned after a year of on-time payments, and seasoning sometimes plays a role in pricing performing notes. The reason being is investors tends to have more confidence when they see a year of history in terms of on-time payments. Talk about a balloon payment mortgage here. That’s a mortgage that doesn’t fully amortize over the term of the note, and it leaves a balance due at maturity. That final payment is called a balloon payment because it’s of large size: balloon payment mortgages, their more common in commercial real estate than residential real estate. But you’ll still see them with residential. When pricing alone with a near term balloon payment, a note seller is typically going to require more aggressive pricing because the full repayment of the loan is coming due. A borrower facing a balloon payment generally is either going to refinance, pay the loan off in full, or request an extension from the current lender. In the event the lender declines that request for an extension and the borrower doesn’t make that balloon payment, It’s referred to as a maturity default.
Let’s review how to calculate yield. A discounted cash flow approach, or DCF, is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a net present value or NPV. Some performing note buyers will calculate what’s called yield to maturity while others will take a slightly different approach and calculate what’s called cash on cash yield. Investors often assume the borrower is making twelve of twelve payments per year and doing so on time. But this isn’t always the case and can result in artificially high yield and the risk of overpaying for the note. This is particularly true when pricing alone has a spotty pay history. Spend time evaluating the likelihood of receiving a full twelve of twelve payments per year when pricing a performing note.
Let’s recap—credit quality matters as a driver of pricing performing loans. High note rates tend to mean higher investment yield and thus drives higher pricing on performing loans. Equity has a strong correlation with the investor’s loan payoff and also impacts the borrower’s ability to refinance. The age of a loan or seasoning is another important pricing variable. Finally, investors use a variety of methods to determine investment yield on cash flow.
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