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What factors do you need to consider when pricing performing notes? Important as that question may be, it seems to be an underserved topic, and many note investors still make avoidable mistakes. Dan Deppen takes us through some of the basic things we need to know about pricing notes, specifically performing ones. How is price determined? What are the risk factors that you need to consider? Why is pricing subjective? What are the most common pricing mistakes that note investors make? Get the answers to all these and more on this episode.

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Pricing Performing Notes

I’m going to be talking about doing pricing on performing notes. Pricing is a little bit of an under-discussed topic. A lot of times online, when pricing is discussed, they talk about using some of the basic pricing formulas or the HP calculator. I’m going to get into some of the considerations and some of the strategies around pricing performing notes. Also, some of the common mistakes that note investors make. You’ll be able to get more information on this. I’ll talk about this at the end of the show, but you can learn more if you go to FusionNotes.com/pricing.

I strongly urge you to subscribe to the YouTube channel at YouTube.com/FusionNotes. You’ll be able to see some of the slides and some of this stuff might make a little bit more sense. I’m going to start by talking about some terminology. When we talk about interest rates, it’s a topic that can get confusing because a lot of times, if someone talks about an interest rate or a return or yield, people are often talking about different things. When I’m pricing performing notes, I focus on what I call the yield to maturity. That’s the interest rate you’re going to get if you hold the loan until all of the payments are received and the borrower makes all of the payments on time. In reality, that’s not probably ever going to happen, but this is a good way to compare the yields between two different notes.

You’ll end up using the rate function in Excel. We’re putting in the number of payments remaining, the payment you’re receiving every month and the price you paid for the loan. You’re going to want to do other things like not just put in the payment on the loan, but you’ll want to subtract the monthly servicing costs. You get your net monthly income. On your purchase price, you also want to subtract a lot of your upfront costs. You might have costs like whatever you pay to a broker, cost for due diligence and other things. One of the important concepts to understand is we want to capture a cost so that we’re getting our actual yield because those costs, depending on the size of the loan or the payment amount can have a big impact on the actual yield to maturity.

The other thing that I don’t use but I want to touch on is what I call initial yield. The initial yield would be taking twelve times the number of monthly payments divided by the price you paid to get an initial indication of the yield. I’ve seen one guru recommend using this. You want to be careful with doing this because it can sometimes give you a different yield than what you’re going to get from the yield to maturity. For example, if the number of payments remaining on the loan is large within the yield to maturity and initial yield is going to be similar, but if the loan is getting closer to maturity, the number of payments is smaller. These are going to diverge a lot and the initial yield could potentially grossly overestimate the yield to maturity. Be careful with using initial yield. I don’t recommend using it because it’s going to overestimate the return that you get.

An Overall Theory Of Note Pricing

I like to layout the overall theory of how we price these things. If you look at any investment, whether it’s a performing note, a nonperforming note, it could be like a dividend-paying stock or anything. What you’re doing is you’re looking at, what are all of your costs? When do those costs happen? What cashflows are coming in? What are your cashflows over time that you’re anticipating? What risks are involved overall? Your money, your cashflows out and in are going to determine your yield. The risks involved are going to inform how much of a yield you might need to get to have the investment makes sense on a risk-adjusted basis. For example, some of the cashflows out are going to be the price you paid for the note. It could be broker commissions. There will be servicing fees that you pay monthly. In some cases, there could be property taxes and insurance if the borrower isn’t paying them. If it’s a performing note, the borrower’s paying them but that is something you can run into sometimes.

I have seen loans where the borrower makes the regular payment every month but refuses to pay the property taxes. The cashflow is coming in, which is going to be a monthly payment that comes in. Although sometimes, borrowers may make extra payments or if you’re lucky, you may be able to get an early payoff. One of the risks to consider when you’re looking at performing notes is that unexpected costs can hit. You can have code violations sometimes depending on the servicer you are using. Your servicer may hit you with fees that were in the fine print of your servicing agreement that you weren’t anticipating. The biggest risk is always if the borrower stops performing and stops paying.

This one is not much a risk. It’s almost more of an opportunity, but sometimes the borrowers pay early so that changes what you anticipated. If there’s one of the things that affects the riskiness of a performing note, is how much equity the borrower has. If the borrower has a lot of equity, they’re going to want to protect that. They’ve got an extra incentive to continue to pay. The more equity the borrower has, the less risk there is. Sometimes the borrower doesn’t have any equity and that can increase the risk. There’s a level of crime in the neighborhood, which even on a performing note, where that comes into play as if it’s a higher crime area, there might be more chance of the borrower not performing. If the borrower stops performing and you have to foreclose and take it back as an REO, that’s going to be a riskier situation, the higher the crime level. There are all kinds of surprise costs that can hit you like code violations and water bills.

At the end of the day, we’re looking at where the cashflows are coming in, where the cashflow is coming out. That’s going to determine our yield to maturity. The risk level is going to determine the yield to maturity that we think we need for that given loan. I’m going to go into some of the costs that we have. When we look at upfront costs when you buy the note, your expenses are more than just the price you pay for the note. A lot of this is going to be due diligence. You’re probably pulling a BPO, which typically costs around $100. You’re hopefully pulling in O&E report, which is Ownership and Encumbrance report. It’s a form of a title report, not quite a full title report. I get those from ProTitleUSA for $85. They’re usually around $100, depending on where you go. You have an attorney review the docs as well and that’s generally $100 to $150 sometimes more depending on the attorney and the state. There could be code liens or delinquent taxes that need to be taken care of.

If it’s a performing note, that shouldn’t be the case but sometimes it is. If there are these kinds of expenses, I’m usually negotiating that with the seller up front. That is something you have to factor in. Maybe the seller gives you price release because there are taxes due. You still then need to take care of those afterward. You need to make sure that you’re considering those when you do your pricing. After you complete the purchase of the notes, you’re going to have docs that you have to record. If it’s a contract for deed, you’re going to be a quick claim deed and probably an assignment assuming the land contract is recorded or recording an assignment of mortgage otherwise. Your loan servicer often has an onboarding fee. I’ve been sending a lot of my stuff to Allied and they have a $100 upfront fee when you board the loan.

You want to make sure you have all of these things captured so you can get a good idea of what your actual yield to maturity is going to be. We’ve also got recurring costs every month. That’s going to be the monthly servicing fees. When we look at our net monthly cashflow, what we care about is that net it’s going to be the P&I, payment on the loan minus the monthly servicing fee. Let’s say a $400 P&I payment on the loan and we’re paying $30 a month for servicing, whether our net cashflow in is going to be $370 a month. When we’re calculating our yield, we want to use $370, not $400. Otherwise, we’re going to overestimate the yield. A big factor I consider too is the amount of the P&I is relative to the servicing fee. If you’ve got a high P&I amount, then that servicing fee may almost be a noise.

For example, if your P&I that you’re receiving is $600 and you’re paying $30 a month for servicing, your monthly servicing fees have taken about 5%, which is nothing but it’s not too bad overall. I see a lot of loans out there with low P&I. Let’s say your P&I is $150, and now you’re paying $30 a month for servicing, we’ve got to realize you’re paying 20% or you’re losing 20% of your income just on servicing costs. All things being equal, what I’m going to be willing to pay for a loan where I’m paying 5% of the P&I and servicing fees versus 20%, the prices I’m willing to pay for those two loans are going to be quite a bit different. We want to make sure that’s captured in our ROI calculator.

Risk Factors To Consider

Getting into some of the risk factors to consider, and this is where things start to get subjective. The big risk with the performing loan is going to be if the borrower stops paying. There are all kinds of different forms of the borrower not paying. I had borrowers miss 1 or 2 payments and then continue on. A lot of times I have a lot of my borrowers’ making regular payments. One of the things I like is buying sub-performing loans where there’s a lot of cashflow but it’s irregular. Sometimes you have borrowers who will make a couple of payments in a row, have a couple of misses, maybe make 2 or 3 to get caught up. In that case, your cashflow is going to end up netting out to be about twelve payments per year.

I like those kinds of loans because you can usually get them at a better price, but then the cashflow is good. You can get a higher yield. The big risk we’re always concerned about is the loan goes completely red and the borrower stops paying entirely. We then have to go through the foreclosure process or maybe a forfeiture process if it’s a contract for deed. Another big risk is code violations serve right into these quite often. If it’s a contract for deed and you’re on the title and the borrower starts letting things go and not cutting the grass or doing whatever, putting trash outside, those code violations are going to wind their way back to you. You’re going to have to address them in some form or another. The other one for the contract for deeds is water utility bills.

In some cities, they want the water bill to be in the name of whoever is on the deed. I run into these situations. I’m running into one right now. It’s getting a little concerning if the water bills in your name and the borrower stops performing all the loans and starts paying the water bill. You’re in a tricky spot because you’re ultimately going to be on the hook for that water bill. Because you have a borrower and the property, you can’t necessarily just turn the water off. These are risk factors to be considered. The other big one is if it does stop performing and you go through the legal process, that’s a risk in and of itself that you might have to start the legal process. Once you get into the legal process, there are additional risks on top of that.

The borrower may contest the legal action or fight you over it, which you don’t see happen too often on $700,000 properties. Generally, those borrowers aren’t sophisticated and aren’t going to fight you too hard. The bigger risk you run into when you do go through a foreclosure or forfeiture that I’ve talked about in our previous show is once you do get the property back, the value is usually not what you expected. One of the biggest risks with notes is unlike other forms of real estate investing is you can’t inspect the inside of the property before you buy the note. You don’t know what you’re going to find once you get in there. The other problem is borrowers who tend to ride the ship down in foreclosure or forfeiture tend to live a rough lifestyle, or they decided to let it go because there was some major problem with the house. Maybe a roof problem or a foundation problem. Usually, once you get the property back, the surprises you get generally tend not to be good ones.

There’s the risk of having to go into legal, then on top of that, the risk of running into complications once you start down that road. However, it’s not all bad. There’s upside potential as well to consider. One of the most common ones is that the borrower makes additional payments. If the borrower starts making additional payments, what that’s going to do is decrease the number of payments received or the timeline until you get to maturity. That’s going to increase your yield to maturity. Let’s say you buy the loan and you get some discount to the unpaid balance. Let’s say you paid 75% of the unpaid balance. If the borrower pays that back over 360 months, you’re going to be collecting that 25% discount that you got over 30 years. If they pay it off early and let’s say they pay it off over two years, you’re now collecting that discount over a shorter period of time. Therefore, your yield to maturity is going up. Whenever the borrower pays back faster, that’s good.

Don’t mind that you’re getting principal back or UPB is decreasing, which you may not want but if they pay back things early, your overall return is going to be better. The second one is that the borrower pays off the loan. I have had this happen before. It’s like Christmas when it happens. This is always the ideal scenario that you hope for. When it does happen, it seems to be random. One thing you can do to try to increase your odds of seeing a payoff is buy loans with a smaller balance or a lot of equity. If you’ve got a loan that’s maybe a sub $20,000 balance, that’s where I’ve seen these payoffs. At some point, the borrower may get into a position where they can write a check to pay you off. There’s no way to plan on these things. I don’t factor them in when I’m doing pricing. They’re things to note and to keep in mind.

If you are trying to figure out, “What price can you pay for a given loan?” You need to decide what your desired yield to maturity is. What kind of yields do you want to see? This is where pricing gets tricky because as much as I’m a big Excel guy and an analyst, at the end of the day, pricing always gets subjective. Some factors to consider when you’re coming up with what kind of yield to maturity you might need for a given loan. One is the BPO value. The lower the BPO value of a property, that’s the Broker Price Opinion or the value of the property, the higher the risk generally. The higher the value of the property, the lower the risk. Where that comes from is let’s say you’ve got a sub $50,000 property and you get it back. You find out that there’s a roof issue or a foundation issue.

You get to the point quickly where it doesn’t become worth even fixing up. Lower value properties have inherently higher risks. If you give me two properties and one has a lower value and one has a higher value, if I’m going to buy the one with the lower value property, I’m going to need a higher return for that, all things being equal. The other factor is payment history. The longer the borrower has paid on time, the lower risk that the loan is going to be. The other one is the risk level of the borrower. This is one thing new note investors key off on a lot. It has more of an impact on seconds. I only do first. In general, you would want to pull a credit report, but that information can be difficult to get.

We’ve also got the location. One of the big factors on location is, do I already have teams in that area? If there’s an asset in a city where I’ve already got a good realtor and a property manager, then all things being equal, I’m going to be willing to pay more for that loan. If it’s in a new area and maybe it’s a little riskier and I might have to eventually take the property back, which means setting up a team, that’s a big pain in the butt. I’m going to want to factor that into my pricing as well. Also, the level of crime. If you have to take a property back and it’s in a war zone, that’s going to be a big challenge and a big headache that you may not want to deal with.

Why Pricing Is Somewhat Subjective

When we’re determining what price to pay, a couple of important things to keep in mind and one of the big ones is I talked about how you nee

d to figure out what your required yield is. Keep in mind that that’s not the same for every note. You don’t want to just have one target yield and apply that to all notes because there are a lot of different factors to consider. If it’s a lower risk loan, then expect to get a lower yield or you don’t target as high as yield. If it’s a riskier loan, then you’re going to need to get a higher yield if you’re going to buy it. Make sure that your desired yield is in line with the amount of risk that you’re willing to take and that you’re biting off. Don’t treat them all the same because they’re not the same. Let’s say you have a $500,000 BPO value property with a $250,000 UPB. The high-value property, boatloads of equity, maybe the borrower’s gone five years without missing a payment and the neighborhoods are good. That would be a low yield loan. You may have another asset you look at that has a $30,000 BPO and a $25,000 UPB and its just reperforming that only made four in a row and it’s a rural town. I’m going to need a much higher yield for that. In the example of these two, make sure you’re not pricing those the same. Those yields are going to be radically different. In some cases, you’ll be pushing 20%. In the other case, you’ll be well into the single digits.

Common Pricing Mistakes

At the end of the day, the thing to keep in mind is that these things are always subjective. As much as I like to do Excel and analyze things, when it comes down to it, there are many factors. Some of the factors are subjective, like the location, crime level and things like that. What you’re going to do is determine your yield threshold. You’re going to do your analysis but that determination of the yield threshold is going to be subjective. There’s always going to be some level of subjectivity in this. I’m going to talk about some of the common mistakes that note investors make in pricing. Number one is the note buyer who wants to be ultra-safe, who wants to burn down all the risk and wants everything to be flawless. This borrower wants high value, lots of equity and long payment history. They want to get a credit report on the borrower and have it above $800. They want to make sure they’re getting a low price. There’s no risk there. The result of this is these note buyers end up not finding any loans that meet their criteria or they make low ball offers and nothing gets accepted.

It’s good to try to burn down risk and be thoughtful about that. If you’re overly conservative and you’re trying to ring out every little piece of risk, then you ended up not buying any notes. There are a lot of note investors like this who liked to study notes, research notes and do this and that may be put offers out now and then, but they always end up without buying any notes. Be conservative, be thoughtful, but don’t go to this degree that you ended up not buying anything. The second common mistake is the investor who only wants to buy loans at a super high yield. This person considers themselves a savvy real estate investor, and they measure that by the level of yield they get. They want to be able to tell people, “I bought stuff that I only buy at 20% yield,” or some sky-high yield. Some people call this getting drunk on the yield. That comes up from bond investing. What happens is if you’re only targeting your super high yields, you’re going to end up getting offers accepted on loans that are insanely risky or junky.

If you’re targeting a high yield, you will be able to buy loans at that yield. You’re going to have a sky-high level of risk that it may not be risk-adjusted for even that high return you’re getting. It may be a level of risk that you’re not personally willing to accept. While targeting a high yield is good, be careful with how high you go and if you buy it high yields, make sure it’s appropriate on a risk-adjusted basis. The third common mistake, and this is one of the bigger ones is focusing on the percentage of the unpaid balance that you pay. Various percent of UPB is used as a rule of thumb and that can be handy. The amount you want to pay should be driven by the yield to maturity. All these factors in the loan that we talked about, namely the time to maturity and the underlying interest rate on the loan is going to have a big factor on the ultimate yield and maturity that you make.

What happens is if you go down the line and you’re trying to bid a certain percentage of the unpaid balance, then your offers on loans ended up being a high yield to maturity will get declined. The ones that happen to be a low yield to maturity, like let’s say a low underlying interest rate on the loan, those are the ones that are going to get accepted. If you just do that, if you use the percentage of UPB as a rule, you’re going to tend to end up overpaying or you’re going to underbid a bunch of stuff and not have your offers get accepted. Stay away from that as well.

A lot of times, people ask like, “What’s the market pricing for performing notes or what the things generally sell for?” It’s hard to answer because notes in general, whether it’s performing or not performing, “market pricing” doesn’t seem to exist. The market for notes is inefficient. If I talk to different sellers at different points in time, I tend to get radically different pricing expectations. Sometimes I see notes for sale that are outrageously expensive, then a short time later, I see very similar or even higher quality notes that are priced much lower. It’s hard to target rules of thumb. A lot of the pricing you can get depends on the seller’s motivation. The ideal scenario is you get somebody who’s closing a fund. You’re going to get much better pricing generally.

Although other times you deal with sellers who are holding a pool of assets. They’re working them off themselves and they say, “I know I’m going to get X return by working them myself, if I can sell them and get a better return, that’s great.” In that case, the pricing they’re looking for, there’s not going to be any meat left on the bone. There’s a lot of variation. What you need to do is develop as many sources as you can. Keep looking over time and if you get access to enough assets that you can view, then eventually ones with good pricing are going to pop up. The good thing about this is if you’re buying for your self-directed IRA or your funds, you only need to buy so many notes. You don’t need to buy a hundred of these things. There are enough of them out there even if you’re going to some of the exchanges like Paperstac. You’ll be able to find decent assets at a good price.

A lot of the material that I was talking about here and some of the slides I showed are excerpts from a new training course that I put together on performing note pricing. You can find more about this if you go to FusionNotes.com/pricing. In that course, I do go in more in-depth than I do here. You can get the ROI calculator. That will do a lot of things for you. It’ll calculate the yield to maturity based on the price and based on the costs. You can also come up with a price based on a percentage of UPB. While I said not to price based on the percentage of UPB, a lot of times, people sell that way. If someone’s selling on a percentage of UPB, what you can do is run all of those through the calculator and then see which ones mapped to the best yields.

Also, come up with a price based on a target yield to maturity. This is priced for $27. It’s not a profit center for Fusion Notes. I wanted to put this out there so people had access to it. This is set up to help me cover some of my costs of this show, getting it produced, the website and some other odds and ends. There’s more info on that. Hopefully, that helps give you some things to think about when you’re pricing performing notes that maybe you hadn’t thought about as much before. If you got any questions, leave comments or reach out. Send me an email at Dan@FusionNotes.com. I’ll see you next time.

Important Links:

• www.SystematicDueDiligence.com
• www.FusionNotes.com/pricing
• YouTube.com/FusionNotes
• Dan@FusionNotes.com

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