This week we're going to figure out how we fare if the borrower on the note we own doesn't pay!
THE SCENARIO:
Last month I purchased a first mortgage on a house. The house is worth $45,000 and the borrower owes $41,500. The borrower (Bob) still owes 244 payments of $319.35 per month. After that point, he will own the home free and clear. Desiring a 20% yield, I purchased the note for $18,821.50 (we figured this out last week).
There's a problem, however. Namely, the first of the month, when Bob's supposed to pay me, came and went, and no check arrived. In fact, I knew before buying the note that Bob hadn't been paying for quite some time, and that the holder of the note has legal standing to foreclose on Bob and take the house. That holder is now me (the old note holder didn't want to go through the hassle of foreclosing on the house, so they sold it to me instead).
After a brief attempt to work with Bob and get him to start paying what he owes fails (he doesn't respond to the calls, letters, or emails), I start the foreclosure process. This process varies by state, but let's say that it takes two months and costs me $5,000.
a) How much money do I have into the deal?
Once I'm awarded the collateral for the loan (the house), I decide tosell it. It's not in 100% great condition, and I want to sell it quickly, so I discount the property by 25%. It sells in another month.
b) How many months have passed since I purchased the note?
c) What's the sales price for the house?
d) If expenses relating to selling the house run at 10% of the sales price of the house, how much money do I get paid when the house sells?
e) What's my annualized yield on my initial investment?Assume that I paid all of the money I have into the deal, up-front.
THE SOLUTION:
a) I have $18,821.50 plus the $5,000 cost to foreclose. Therefore, I have $23,821.50 into the deal.
b) One month passed from when I bought the note to when I determined that Bob wasn't going to pay me. It took two months to foreclose. It took one month to sell. Overall, four months have passed since I purchased the note.
c) The full retail price of the house is $45,000, and I'm giving a 25% discount. The sales prices is therefore $45,000 x 75%, or $33,750.
d) Since sales expenses eat away 10% of the sales price, I receive $33,750 x 90%, or $30,375.
e) N is 4 ( as determined in part b)), PV is -$23,821.50, PMT is $0 (I don't receive payments during the time between when I buy the note and when I sell the property), and FV is $30,375. Solving for I/YR, I discover that my annualized yield is 75.17%. I can live with that.
DISCUSSION:
Seasoned note investors often discuss 'happy-happy-happy' notes, and the fact that whenever they buy a note, they want it to be a happy-happy-happy note. This means that if they purchase the note, they'll be happy if the borrower pays as agreed, they'll be happy if the borrower pays them off early (through refinancing or selling the collateral), and they'll be happy if they end up getting the collateral back because they can sell it at a healthy profit. Last week, we discussed the first two 'happys', and this week we can see that (with a low enough purchase price), we can get this note to have a third 'happy' as well.
Notes in default can often be purchased for exceptionally deep discounts (much deeper than the one in this example), so it's definitely plausible to make a purchase of a note like I'm describing here.
Well, that's it for this week! I hope you've enjoyed learning about happy-happy-happy notes and how to turn a 'sad' (foreclosure) into a 'happy' (exceptional profit) by buying intelligently. See you next time!
