with a payment history of at least a year) is less risky than a green note (little or no payment history). CREDITHISTORYAND CREDIT SCORESARE NOT INFALLIBLE. It is important to help determine the character of the payor and likeli- hood of default, but everyone— even those with the best credit—can lose their incomes, have medical emer- gencies, or suffer other unfore- seen catastrophes. The best use of a credit report is to identify a potential bankruptcy candidate. COLLATERAL SAVES DAMAGE. The best collateral is an own- er-occupied single-family house in a good neighborhood located in an area with a diversified, histori - cally stable economy. It is further enhanced by a payor who has an excellent credit record and unblem- ished payment history. Less desir - able collateral, in descending order: owner-occupied (owner lives in one unit) duplexes/triplexes; non-own - er-occupied single-family houses; non-owner-occupied duplexes/ triplexes; other non-owner-occu- pied multifamily units; improved land; commercial (non-industri- al) properties; resort properties; subdivided but unimproved lots; raw land. Some investors use a slightly different hierarchy. All else being equal, the val- ue of a real estate note depends ultimately on the economic con- ditions that support the value of the property. Always keep that in mind when considering a note. •
“The single most powerful financial aspect that determines the value of a note is the payment amount.”
such as sell it all, sell the next X number of payments, or sell half of each payment, etc. KEEPTHE ITVLOW. ITV = Investment-to-Value ratio, calculated by dividing what you pay for the note by the value of the property. If you pay $100,000 for a first lien note on a $200,000 prop - erty, the ITV is 50 percent. If you have to foreclose you would have $100,000 in equity. The higher the ITV, the riskier the note. These days, I want 60 percent or less ITV. KEEPTHE LTVLOW. LTV is a barometer of the likeli - hood of default. LTV = Loan-to-Val - ue ratio, calculated by dividing the loan (note) balance by the value of the property. A loan balance of $150,000 on a $200,000 property is an LTV of 75 percent. The clos - er the LTV gets to 100 percent, the more likely the debtor will default since they have little equity. If the property is underwater (the loan balance is more than the property value) there is a high risk of default. WATCH INTEREST RATES. When rates rise, note val- ues drop. That is when it pays to know how to restructure your notes to increase their value. AVOID SPECIFIC NOTES. Notes secured by industrial properties and those with under- ground fuel tanks have many
liabilities. Chattel notes such as those on cooperatives, time- shares, mobile homes without land, equipment, and personal prop- erty can be very risky since they are not secured by real estate. CONSIDER DOWN PAYMENT AND PAYMENTAMOUNTS. The higher the down payment when the property was purchased, the better. Notes on proper- ty purchased for $1,000 down or less often default. A veteran note investor told me that every note he has ever bought on property pur- chased for $1,000 down or less has defaulted—every single one. The single most powerful financial aspect that determines the value of a note is the payment amount. For example, all else equal, a 10-year note with a large monthly pay- ment and no balloon is worth more than a 10-year note with a smaller monthly payment and a balloon. A fully amortized note is less risky than one with a balloon. Balloon payments are often never paid. KNOWTHE LESSER OFTWO RISKS. A first lien note is less risky than one in the second lien posi- tion. Third lien or lower notes are very risky. Avoid buying a second lien note with a huge balance first lien. In case of foreclosure, you would have to make the payments on the first in order to keep your note position. A seasoned note (one
W. J. Mencarow has been investing in notes since the 1980s. He teaches what he knows to help others and offers a free introductory e-course at www.PaperSourceOnline.com.
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