Mr. Note Seller, Sorry… I Need to Come First
I guess I’m no different than anyone else… I want to be first. I hope I’m the first person you’ll call when you’re putting an owner financed deal together or you have a note to sell, but I definitely need to be in 1st lien position when I buy a note.
The situation I’m going to describe kinda blindsided me. It was so unexpected that I didn’t get to the bottom of it until after both note seller and myself had already put some effort into putting a deal together. We could have saved ourselves some time if I’d simply thought to ask one more tiny question in the interview process.
Here’s how I thought the deal was shaping up with a note holder that sold a property 4 months ago:
- Sales price: $47,500
- Down payment: $1,000 🙁
- Credit score of payor: 600 🙁
- Note amount: $46,500
- Interest rate: 8% 🙂
- Amortized over: 120 🙂
- Due in 60 (some pluses, some minuses)
- Monthly payment: $564.17
Because of the low down payment & credit score, there was no way that I could buy the whole note, so I offered to buy a partial.
I would buy the next 55 payments for $19,500 and leave the balloon to the note holder.
- $19,500 (proceeds from sale of 55 payments)
- $28,200 (balloon amount left for the note seller)
- $47,700 total to seller (for a note with a $45,473 balance)
He thought that sounded great and we were off to the races. Then, I get all of his documents. He had failed to mention that there was a $22,000 bank loan against the property that he had wrapped with his seller carry back transaction.
When I called to verify that he would be bringing in funds to close ($22,000 less the $19,500 = $2,500 to pay off the first) he said,
“Whoa, now wait a minute! Why would I sell a note just to have money go out of my pocket at closing? The point is that I need some cash right now.”
Somehow he thought that I would pay him $19,500 and stay behind the $22,000 first, which he would, of course, continue make payments on.
Uh… I don’t think so.
That would put my combined investment-to-value (ITV) at 87%! No way!!! Where’s the equity to protect me in the case of default? And statistically speaking, there’s a fairly good chance of default from a buyer with less-than-average credit and who doesn’t have much skin in the game (low down payment).
“Well,” I told him, “you could save yourself the negative cash flow for now (his mortgage payment to the bank was $1,071 each month, and he was only collecting $564 from his buyer/payor) and then have a nice $28,200 coming to you in 4 1/2 years”.
That just wasn’t going to work for him, so our deal fell apart.
To all you note sellers out there… us note buyers have to manage risk well in order to buy your note, and a big part of that is limiting ITV: Investment To Value. I usually don’t want my investment in the deal to represent more than 50-60% of the value of the underlying collateral, and I’m a prima donna… I HAVE to be in 1st position!