What Is Your Perception of Value?

A key to understanding the power of using “paper” in real estate transactions is to understand that despite what a promissory note might state on its face as the amount of debt owed, it could very well have different perceptions of value to different folks.

When you are negotiating to acquire property for long-term investment or in a “buy and hold” strategy, the financing you are able to obtain is secondary to the negotiation over the property sales price; however the financing allows you to “structure” deals that can make economic sense.

There are really limited reasons to acquire properties that cannot be rented so that the rental revenues will cover all debt service and expenses and leave at the very least a “break even” or positive cash flow transaction for you, the investor. Debt service is the repayment of principal, interest, or principal and interest.

When entering into negotiations with sellers, you must keep in mind this fact: “If my tenant cannot afford it, I cannot afford it.” Structuring seller financing with “flexible” property sellers allows us to pay them their asking price by negotiating their repayment of “debt service.”

Put the sellers equity “off to the sidelines”

Often to make a deal work, a property seller must place part of their equity off to the side or suspend it for a period of time where it will require no interest payments or perhaps no payments at all.

For example, you acquire a nice rental home worth around $200,000 for 10% under its value or a sales price of $180,000. The home will lease and stay leased for about $1,400 per month. You obtain a new institutional first lien mortgage for $160,000 from a mortgage lender that is amortized over 360 months at 6.5% and payable $1,011.31 per month in principal and interest payments.

The sellers are willing to finance $20,000 by agreeing to carry a second lien mortgage & note. After adding in the cost of hazard insurance, property taxes, and management, the home just slightly produces some modest cash flow each month from the rent coming in versus what must be paid solely on the $160,000 first lien mortgage note.

Thus, no payments can be made to for a period of time on the sellers $20,000 second lien mortgage note until rents support the additional debt service. This is a form of putting the sellers $20,000 of equity still due them off to the side until a future point in time.

Is $50,000 really worth $50,000?

Now let’s take a look at a $50,000 promissory note. The present value or “cash value” today of an income stream can vary significantly from its “par value” for different people requiring different yields and/or attractive or acceptable rates of return.

If we look at a $50,000 note, it states on its face (the front page) that the amount of debt owed is $50,000, so that is its “value”–or is it? This $50,000 note produces an income stream of $537.30 per month over a 180-month (15-year) period of time if amortized at a 10% interest rate. To many folks, the 10% interest return is very acceptable, and its perceived value to them is a par value or $50,000.

Despite the fact that the note states $50,000, to folks who are overjoyed and pleased to earn an 8% return on their money, this note might be worth a premium value of $56,223.66 to them.

An astute investor understands that dollars in their hand today (present value) has more purchasing power than dollars to be collected in the future (future value). Do you remember what the cost of a gallon of gasoline was just five years ago? What does that same gallon of gas cost today? What about an ounce of gold?

The astute investor is concerned with the present value or cash value today of such a note because they have to part with their hard earned cash today and will have to then wait to collect the future installment payments. Additionally there is always a risk that those future monthly installments might not be collected because of the risk of default.

So this type of investor must discount the future income stream to a present cash value. While to others this $50,000 note might be worth $50,000 or even $56,223.66–to the astute investor who requires a 12% rate of return on invested dollars, its perceived value or worth might be the discounted value of $44,768.94 even though it does say $50,000 on its face.

The price you agree to pay, or principal balance on the note, the interest rate, and the repayment periods of time are all negotiable! In negotiations, most folks tend to focus mainly on price (the original principal balance). They are less focused on the interest rate and even less focused on the time in repaying the note.

Bottom Line: If you can negotiate favorable terms surrounding when you have to repay the note, notes can be very profitable and allow for that “suspension” of repaying the sellers equity referred to above.

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