Real Estate Acquisition Tips

What To Do With A Note Secured By Depreciated Collateral

by Marvin Levin

Sam has an installment note that he wants to sell. He carried this note on a sale that he made several years ago. The note is current, and Sam is pleased with the fact that the obligor has never been late with his monthly payment.

Sam is willing to discount the note. The coupon rate is 9%, and the discount would provide a 12% internal rate of return on his discounted price.

You check the obligor’s credit, and it looks good. You are satisfied with the 12% yield. You also like the fact that the note is amortizing (so your yield does not depend on a balloon payment in the near future). Also, the note is well written and contains all of the lender protections (See also Beware of that Form Note, It Can Bite).

Everything is just fine, except for one problem. The collateral property has declined in value since the sale that created this note, and you correctly conclude that, in the event of a default and foreclosure, you would experience a loss in attempting to recover your investment. Or, to put it more simply, the collateral is over-valued to support the note.

You are really anxious to move some of your bank money now earning a trivial rate of return into this higher yield. Well, here is a menu of some of the things that you might consider:

1. Ask the holder of the note to put up some additional collateral. You might be willing to release the collateral in the future depending upon obtaining an adequate reappraisal. Until that should happen, you hold on to the extra collateral and might be safe.
   
   
2. Request that the seller of the note transfer the note to you by his general endorsement in blank, which makes him a guarantor of the note. (It is not likely that a sophisticated seller would do that because it amounts to his borrowing money from you at a 12% per annum cost. If his credit is good enough for you to value an endorsement, then he might be able to borrow the same money from his bank at a lower rate.)
   
   
3. Consider purchasing less than the entire note, such as one-half of the note. Then you would be buying a $50,000 note balance for a substantial discount. However, your agreement with the seller of the note is that in the event of a foreclosure, repossession and sale, all of the proceeds up to your investment plus a 12% rate of return would be paid first to you and the balance to the seller. That forces the seller of the note to put his “money where his mouth is,” because if the note pays in full obviously both parties will be satisfied.

If you come across a junior note for sale at a discount, please contact me.