A common question that we get at the Institute is “How do I come up with a reasonable price for a note?” Doug Smith, the Portfolio Manager for Castle Rock and an Institute instructor gives us some ideas…
“It’s been my experience that pricing a note, whether it be nonperforming or performing” is somewhat subjective, but if you know a few things, you can accurately come up with a price that makes sense for you and your note-buying business.
First, you’ll need to know a few variables to plug into basic formulas. Some of these are assumptions, which is why two experienced note investors will come up with two different valuation numbers. We always need to know the following:
- What yield do I need to hit on the deal?
- How long do I anticipate holding the loan?
- If I have to foreclose (worst case scenario), how long will it take to get the property back and sell it.
- If I do have to get the property back, what is the amount I would sell the property for?
- Will I need to rehab the property if I got it back? How much will it cost? How long will it take?
- What would a foreclosure cost in legal and other fees?
- What is the note rate, loan balance, and remaining term?
Of course, we dive deeper on our deals, but this will give you a great start. We always calculate our note purchase “strike price” by answering two questions; “What if the borrower pays as agreed?” and “What if I have to foreclose?” We then use a model that we created to calculate the strike price in both of those scenarios by plugging in the variables we bullet-pointed earlier. We then go with the lowest strike price based on if the borrower were to pay and if they don’t.
That, of course, is overly simplified, but it will give you an idea of how our fund prices notes. We put together a basic model and more information in the membership section of the National Institute of Lending and Real Estate’s web site.”
Once again, no two experts will come up with the same answer as they will use different variables and assumptions in their modeling, but if you can answer the questions above, you will have a huge head start when it comes understanding how to price a note.