Buying a mortgage loan that has a note rate of 5% in a portfolio in which you want to yield 15% doesn’t make a lot of sense on the surface. That’s like saying “I lose money on every deal, but I make up for it in volume.” Of course you can yield a great deal more than the note rate on a loan due to Discounting.
Discounting a loan is where a loan is purchased for less that the loan balance. A lender does this when the need to move a loan off the books to raise more cash or if the loan does not fit in their long-term plans. We’ll talk more about why a lender would do this later, but back to how a discount works.
HOW DOES DISCOUNTING WORK?: Discounting a loan works in a similar way that a bond is discounted. If a person buys a bond that yields 4%, they would receive payments at 4% until the bond matures, but what if they wanted to sell the bond off to another investor? How much would they get for their bond? The answer to that would depend upon the alternatives that were available to prospective bond purchasers. If the rates for a similar bond were now paying 5%, why would an investor want to guy my 4% bond when they could go buy a 5% bond. I as the seller would have to make that difference up to the buyer if I wanted to entice them into buying my bond. I would have to “discount” the sales price of the bond to allow the buyer to yield the 5% that the market was experiencing. In other words, I would have to sell it to them for less than the face amount of the bond. Conversely, if the going rate was now 3%, I might get someone to pay a “premium” for my bond, which means that I can get them to pay more than the face amount of the bond. This rarely occurs, but it has been known to happen from time to time.
The market for loans work in similar ways. Unlike a bond, however, there is no guaranty that a loan will pay out early or if it will pay off at all. There are many more moving parts to purchasing a loan than purchasing a bond, but with a little practice and the right guidance, you’ll get the hang of it.
Let’s say that there is a loan with a balance of $100,000. The property is worth $110,000 and the note rate is 5% and there are 12 years (144 months) remaining on the loan. The monthly payments would be around $928 per month. The loan has been paying well and you need to determine what you would need to pay for the loan in order to yield 10% if the payments were made on time for the remainder of the term of the loan. If all goes completely according to plan, the you would only pay about $77,000 for the loan in order to yield 10% on this particular loan.
We have to make a lot of assumptions to accurately calculate what you should pay for that particular loan. Most loans don’t last to maturity…they tend to pay off early. If that happens, the discount you would be paying would condense pushing your yield higher. If the borrower pays slowly or defaults, that will dramatically impact your yield.
WHY WOULD A LENDER SELL A LOAN AT A DISCOUNT? Does it really make a lot of sense for a lender to take a bath on a loan? In many instances it does. The lender or mortgage holder might need to raise cash quickly? They can do this by selling their loan portfolios. The loans might also be smaller loans that are costing them more to service (send out statements, collect payments, etc) than they are making on the loan. There are really a myriad of reasons why mortgage holder might sell a loan. It is more common than you think.
THE WHIP PRINCIPLE: Have you ever watched a cowboy handle a whip? A small flick of the wrist causes a great deal of movement at the other end of the whip. The further away from the hand that you go along the whip, the more it moves. Determining pricing for a discounted loan works in a similar way. If you are near the loan maturity, then very little movement in price would tend to occur. The farther away you are to the maturity, however, the bigger the movement in the pricing.
Let’s use our example above, but let’s say that there are only 5 years remaining until maturity on a $100,000 balance at 5%. What would we pay to yield 10% assuming that all payments would be made on time until the loan matures. If we use a standard amortization schedule (something we help our clients with), we find that the payment on such a loan would be about $1890 per month. Since we are closer to the maturity date at the time of sale, we can expect a smaller discount. If we go back to calculate what the Net Present Value would be at 10% on a payment of $1890 per month for 5 years, we discover that we would be paying about $88,700 for that loan. That is a significant difference from the $77,000 we would be paying on the other example. The only real change was the length of time to the maturity of the loan.
The farther you are from maturity, the bigger the discount. The closer you are to the maturity date, you can expect a much smaller discount.
PRICING A NON-PERFORMING LOAN: Pricing a non-performing loan can be much more difficult than pricing a loan that you would expect to perform. How to you determine the Net Present Value of payments if no payments are coming in? It’s a great question and one that will create debate from company to company. I’ll share with you how Castle Rock deals with that situation and you can come up with your own method.
Rather than look at a loan as if it is going to pay us, we say “what if they never pay us?” What happens then. We’ll, we turn to the value of the collateral on the loan. We’ll usually send a local real estate agent by the home to determine what the value of the home would be if it were in “market ready” condition, a term we call “As Repaired Value” or ARV for short. We also send a construction expert over to the collateral property to assess the property’s condition and to give us a quote on what it would take to get the property to “market ready” condition. Once we’ve done that, we assess how long we feel it will take to go through the foreclosure process, repair the property, and market the property. We add in our legal costs, our real estate commissions, our rehab costs, our closing costs, and any other costs we might think of. Once that has all been taken into account, we determine what our minimum yield would be on that particular investment and we use all of the above data to come up with the appropriate price, what we call the “Strike Price”, to purchase that loan. We have a good idea what our costs will be. We know where we want our yield and we have a good idea of how long it will take us to go from purchasing the loan to selling the property. With all of those variables in place, we can come up with a very realistic number to offer the lender for the loan. It might sound complex, but we’ve been doing it so long that it has become second nature to us. You can learn it to with practice, patience, and guidance.
Purchasing loans rarely goes to plan. Some loans pay of early increasing our yield. Some loans enter into bankruptcy. Others unexpectedly quit paying or start paying again. It can all be overwhelming. One thing that I like to do in our portfolios is to remove as much of the unknown variables I can from the equation. For those unknown variables that still exist, I assume the worst case scenario and calculate our yields based on those numbers. I also never put all of my eggs in one basket. You will often be wrong about how a loan will behave. You will be way head of the game on some and you will lose a bit on others. You simply need to ensure that you are mitigating your downside risk to the portfolio by gathering as much data as you can, leaning on your mentors for information and inspiration, and erring on the side of caution. With practice and the right support, you can gain the experience necessary to master purchasing loans at a discount. I promise you.