This article presents reasons why investors purchase trust deed notes at a discount and the calculations used to produce a desired yield.
Economic factors in a discount
A trust deed investor, after investigating the real estate securing a trust deed note and before preparing an offer to purchase the note, must calculate the discount necessary to set the price he is willing to pay to buy the note.
Most trust deed notes available to be purchased by trust deed investors are carryback notes created on the sale of real estate and junior in priority to an existing first trust deed.
As carryback paper, a second trust deed note will most likely be sold at a discount.
A discount on the sale of a carryback note will be demanded by investors to deliver the investor a market-level yield, since carryback paper usually:
- bears interest at a below private-money market rate;
- has low periodic payments on a long amortization period; and
- has a medium- or long-term due date.
The market rate of interest sought by investors in second trust deeds is influenced by the risks of loss and management inherent in a second trust deed investment. The short-term rates, influenced by the federal rate, and long-term mortgage rates, influenced by prospective inflation, are not the basis for rates charged by second trust deed investors. They are not concerned about either rate.
Second trust deed investors simply demand a yield on their investment which is higher than either the current short-term or long-term rate, whether the current rates are high, low, or overlap one another.
Thus, the second trust deed market interest rates are higher than any carryback note rates. Accordingly, investors demand a higher yield on a carryback note than earned on the principal amount at the note rate — which leads directly to the discount.
As a result, the price a trust deed investor will pay for a note, called the cash value, is forced by the discount to move contrary to the yield sought by the investor. The higher the yield, the greater the discount and the lower the cash value.
The cash value paid to buy a trust deed note is stated as a percentage of the principal balance remaining on the note, such as 80% of face value, or a 20% discount. [See first tuesday Form 175]
The present cash value is determined based on:
- the scheduled payments;
- the principal balance remaining at the due date; and
- the yield sought by the investor.
The discount, of course, is the percentage of the remaining principal balance which is not paid for the note, such as a 20% discount.
The discount may be further influenced by the exposure of the investor’s capital to loss due to abnormal risks, including:
- the inadequacy of the equity position in the real estate to fully secure payment of the note, called the loan-to-value ratio;
- a delinquent payment history on the note;
- nonrecourse enforcement;
- lack of guarantees or letters of credit;
- unusual terms of the underlying senior trust deed loan;
- questionable creditworthiness and unverifiable net worth of the owner of the secured real estate; and
- the occupant’s use and lease of the secured real estate.
Carryback sellers frequently maximize the sales price of their property by carrying back a trust deed note containing:
- a high loan-to-value ratio for the principal amount of the carryback note, usually due to a small down payment;
- a low interest rate for the risk of loss inherent in the highly leveraged carryback note; and
- a medium-term due date of four to nine years.
Thus, a carryback note provides attractive financing for buyers, and is often employed by the seller to facilitate the sale of property when the buyer does not have or cannot borrow sufficient funds to cash out the seller.
As for the benefits to the seller, carrying back a trust deed note containing profit from the sale produces the deferred tax liability of an installment sale (until the note is paid, sold or hypothecated). [Internal Revenue Code §453]
Taxwise, an above-market price for the real estate and a carryback note with a below-market interest rate and a long-term due date translates, respectively, into:
- greater profit to be reported in the future at lower capital gains rates; and
- lesser interest to be reported now at higher standard income tax rates.
The savings experienced by deferring the tax liability on a larger profit compensates financially for accepting a below-market interest rate which is taxed at higher standard rates.
Editor’s note — The note rate and principal amount of the note are subject to reallocation under the imputed reporting rules based on the Applicable Federal Rate in effect on the date the purchase agreement is accepted.
However, structuring carryback terms to boost the sales price of the real estate (maximizing profits), defer tax liability on the profit (installment sales treatment), and create interest income has drawbacks in the marketplace for the carryback seller – if the note must be sold or hypothecated.
The cash value to be paid for a trust deed note is further reduced if the equity remaining in the property over and above the trust deed note is unacceptably small, a risk situation referred to as a high loan-to-value ratio or LTV.
A prudent investor interested in buying a trust deed secured by a single- family residence will require the secured real estate to have at least a 20% gross equity – over and above the secured position held by the trust deed note offered for sale.
In the event of a default on the note, the cost to foreclose, to carry the senior loan and taxes, and to resell the property will entirely consume (and exceed) an equity smaller than 20% of the property’s value. [See first tuesday Form 303]
Further, property owners with large equities in their properties are more motivated to keep payments current on the trust deed note than owners with a smaller equity.
However, during the initial stage of a rising market, a lender may lower the loan-to-value (LTV) ratio to as low as 10%. Conversely, when prices become static or fall, the 20% gross equity standard should be increased.
Thus, secured real estate with an insufficient LTV ratio will require the note to be further discounted to cover the additional risk.
As an alternative, sellers who hold trust deed notes on property with an LTV in excess of 85% should consider obtaining a collateral loan secured by the carryback note, rather than selling the carryback note at a drastic discount. By borrowing against the note, the discounting, which would be heavy, is entirely avoided.
Discounting balloon payment notes
By using the note’s current balance, interest rate, payment schedule, due date and a handheld financial calculator, an investor can easily calculate the present cash value (PV) of the note based on the return sought by the investor.
Editor’s note — The payment schedule and the final/balloon payment amount – not the principal amount or the note’s interest rate – are use to determine a note’s cash value.
Consider an investor who assumes a greater risk by purchasing a note with a long-term due date. Inflation could rise during a long payoff period causing the real rate of return on his invested funds to fall and erode the future purchasing power of the note. Also, over time, events not now foreseeable may render the secured real estate obsolete or otherwise impair its value.
The longer the time period for the note’s stream of payments until the due date, the greater the discount and lower the note’s present value when the greater risk of loss due to inflation and obsolescence is taken into account. The lender wants compensation for the additional risks present in waiting for the return of his principal.
Due to discounts, the actual balloon payment amount on a note is usually more than the note’s present cash value. If the difference is significant, the carryback seller can entirely avoid a discount by not selling the note. Instead, he can borrow against the note and use the note as collateral for a loan, called hypothecation. Sometimes, erroneously, the collateral loan is labelled a sale of monthly payments. This type of sale cannot occur.
Before calculating the discount on the purchase of a note, the investor must:
calculate the amount of the final/balloon payment; and
decide what yield he wants to receive on his investment in the trust deed note.
Again, calculating the discount follows the onsite investigation of the secured property and an analysis of the risks of loss to set the yield.
The balloon payment
Consider an investor who investigates a carryback note which is offered for sale. The note has a remaining principal balance of $60,000, an interest rate of 10%, a monthly payment of $600.00, and a final/balloon payment due in five years.
Before purchasing the balloon payment note, the investor must establish the amount of the final payment. The entries in Figure 1 are used to calculate the final/balloon payment.
Balloon payment calculated on an HP 12-C Financial Calculator
|Enter the number of monthly payments [ 60 [N] ].|
|Enter the monthly interest rate [ 10 [g] [I] ], or [ 10/12 [I] ].|
|Enter the amount of the note’s remaining principal [ 60,000 [PV] ].|
|Enter the amount of the payment [ 600 [CHS] [PMT] ]. This will be displayed as a negative.|
|Request the final/balloon payment of principal due on the note [ FV ]. $52,256.29 is due with the 60th payment.|
The cash value
The investor wants an 18% yield on his investment in the $60,000 trust deed note, not the 10% interest rate yield provided in the note. The entries in Figure 2 establish the cash value which the investor will offer to pay to acquire the note.
|The investor computes the discount necessary to receive his desired 18% yield as follows:|
|Retain the entries from Figure 1 above, and make the following substitutions:|
|Enter the desired yield [ 18 [g] [I] ].|
|Request the note’s present cash value [ [PV] ]. The present cash value of the note is $45,016.45|