In this article I will share many of the core ideas on note partials, and why they make great investments in times like these.
I’m going to assume you are not familiar with what a note partial is, so we will start from the beginning.
What is a Partial?
Partials, or “note partials” is the act of buying or selling the legal rights to a set amount of remaining payments due on a note and mortgage.
This means the lender, or the entity receiving the payments from the borrower each month, is selling some of the payments for cash now. Someone buying the partial, is not purchasing the entire remaining payments due on the note. Only a pre-determined or agreed upon amount of remaining payments.
Here is an Example
I own a note and mortgage that is paying as agreed. There is a total of 120 payments remaining due from the borrower. I need cash to go into another deal or reinvest. Because of this, I want to sell the next 50 payments I am due on this note.
I can sell you the next 50 payments, and you would start receiving them from the borrower starting next month. We arrange a purchase price where you are happy with your return, and I get money now to reinvest.
To protect you, I would assign the ownership of the note and mortgage over to your entity. This means you would have legal ownership, while you are receiving your 50 payments.
In the real world, a transaction will only take place when both parties perceive it holds value for them. Both parties must believe they are better off doing the transaction than not doing it.
For example, if I buy a book for twenty dollars, it means that I value the book more than the twenty dollars. The seller of the book must value my twenty dollars more than the book, otherwise he would not sell. This is a very basic example, but it’s true for most transactions. Both sides must perceive value greater than what they are trading in return.
This line of thinking also implies that value is subjective. Different people (buyers and sellers) place different value on the same items.
Let’s talk about some of the challenges a buyer has when purchasing a note of any kind. Then we can look at unique way’s partials solve many of these problems for a buyer.
Here are a few challenges buyers encounter when purchasing a note
- Locating a suitable asset
- Negotiating a fair price
- Determining yield and profit
- Locating deals that fit a specific amount of money he/she has available
- Being properly protected from borrower default or non-payment
- Assistance reviewing and analyzing a deal to determine if the deal is good
Let’s Look at a Few Ways Partials Solve These Issues!
Locating Suitable Assets to Purchase
Most buyers I work with are business professionals. They are educated, busy and smart. They have a well-funded IRA or savings account and are looking to grow it in a safe manner. These are people who have a day job, families and a full schedule taking up much of their time.
Since finding suitable notes to purchase takes time and a lot of work, (they don’t just fall from trees) most folks don’t have the time or connections to locate these assets on a consistent basis.
This is where locating a note seller who is a true professional comes in. Professional sellers want repeat business. They don’t want to sell one partial; they want to sell dozens or more over time. This is great for a buyer, because after a level of trust and rapport is established, this can be an avenue connecting them to great deals. It eliminates the work searching for that next investment.
Partials help establish a level of trust because both parties are in the transaction together. Both have a vested financial interest, and both have real money to lose if the asset goes south or does not perform as expected. This is very appealing to buyers.
Negotiating a Fair Price
Using an amortization schedule shows a buyer in plain English how many payments he is buying, along with his purchase cost and annualized yield which makes up his profit.
Yield is like an interest rate. It is a representation of the return the investor is receiving on an annual basis, over the holding period of the loan.
Amortization schedules incorporated into the purchase and sale agreement show exactly how much money the buyer stands to make. It is very straightforward to determine the yield and overall net profit in dollars to the buyer.
I will say that in many partial transactions the price can be fixed and not open to a lot of negotiation. This is because the seller has a certain amount of money in mind that he needs, and a certain amount of payments he is willing to give up. This is both good and bad for the buyer. The buyer may want to negotiate heavily, and because the seller feels he is already giving a good deal, he may not be willing to budge. However, this can work to the buyer’s favor, since a partial seller will not usually have you “bid” on a loan blindly, but rather tell you exactly how much he wants for the partial.
This eliminates a good deal of the haggling that a normal note transaction has, and it’s a positive for the buyer in most cases. You don’t need to be a professional negotiator to purchase good, quality partials. And you also don’t need to take a loss, get into a bad deal, or get the short end of the stick either.
Buyers Can Find Deals to Fit Exact Dollar Amounts
When you have an IRA or retirement account, usually there is a fixed amount of money available to invest. You may have exactly $26,500 available in the account. If you are a prudent investor, the odds are good you want all that money earning a return, not just part of it.
But where do you find a note to purchase that gives you the warm and fuzzies and costs exactly $26,500?
Partials are the answer. Since partials are just a piece of a note, you can get into much higher quality deals without buying the whole thing. Higher quality deals mean higher value homes securing the note, in better neighborhoods with more equity and more financially stable borrowers.
This means you don’t need to invest your $26,500 on a note which has a lower value home as collateral, say $45,000. Instead you can buy a partial with a home as an asset securing your investment with a value of $400,000 in a better area.
This is a big advantage to buyers, because they can take advantage of compound interest and avoid having money sitting idly in their IRA or 401k.
The flipside to this is that small partials (below $25,000 purchase price) are often not worth creating, since the same amount of time and effort creating the deal and signing paperwork go into every transaction.
Some people have asked me to do a partial for $500 or $2,000 and it’s simply not worth the effort (for either party) to create such a small transaction. Usually a partial with a purchase price of $25,000 and up is more attractive to sellers.
If you are a buyer, be open with your seller and let them know how much money you have set aside to purchase. You may be surprised at how flexible they can be.
Less Risk for the Buyer
Because partials are only a piece of a note and not the entire payments remaining, the buyer has less risk than if he purchased the entire note. To show you this, we need to learn the meaning of two new terms.
Loan to Value (LTV)
The loan to value calculation shows how much protective equity is available to protect the lender, as a percentage.
Investors can easily calculate the loan-to-value ratio on a home by dividing the total mortgage loan amount into the fair market value of the home. For instance, a home with a fair market value of $250,000 and a total mortgage loan for $180,000 results in a loan-to-value ratio of 72%.
Investment to Value (ITV)
The investment to value shows how much protective equity is protecting the investor as a percentage, based only on his amount of investment.
This is very similar to the Loan to Value calculation, but it considers only the amount you have invested. As an example, if you purchase a $50,000 partial on the same $180,000 mortgage loan on the property worth $250,000, your investment to value is 20%. This means technically you have at risk only 20% of the actual value of the home. This gives you a huge amount of protective equity, since you will be in first position to recover your funds before the partial seller can claim his tail end if things ever go south.
On the flipside, if you purchased the entire note for $180,000 as in this example, you would have much less equity protecting you should the loan default. If you purchased the entire note for $180,000 you now have 72% of the value of the property tied up as your investment. This means you still have an equity cushion, but it’s not nearly as good as if you purchased a partial.
With the $50,000 partial, you have 20% of the value of the property tied up in your investment and eighty percent free as equity to protect you.
Look at the numbers a few times to see what I mean. What you are basically doing here is taking smaller amounts of ownership in each deal to minimize your risk.
In the days of wooden ships, ship owners would purchase and own a ten percent ownership stake in ten different ships. This spread their risk in the sense that it was very risky to own one ship outright, since it could easily sink or be captured by pirates.
By the same token, it is likely that one of the ten ships could sink. However, because the percentage of ownership was spread out, the loss of one ship was not financially devastating to the owner.
The same is true for partials, and it is about spreading risk.
The Buyer’s Warranty
This is possibly one of the most attractive things about buying a partial. A warranty is written agreement of what actions will be taken if the borrower defaults.
Please notice I did not use the word guarantee. There is no guarantee the borrower will continue paying. They could lose their job, fall ill or get in a divorce tomorrow. These are things outside of our control, and I cannot promise my buyer they will not happen.
Rather, a warrantee is a pre-determined safety net of agreed upon actions the seller will take, to help the buyer should the borrower default and discontinue paying.
Think of this as a security blanket for the buyer.
How it Works
Here is the language I use in my warranty for buyers. You can change this to suit your liking. Always consult an attorney before utilizing any legal agreement.
“Upon borrower becoming 90 days or more delinquent, buyer will notify the seller via written notice of the default.”
Default is defined as 90 days or more of consecutive non-payment. If a borrower skips paying for a month or two then makes it up and repeats the cycle, we cannot prevent that. In those cases, the note is delinquent but not in default. It is not far enough behind to initiate any legal action. After 120 days lenders can begin taking actions to collect on the note, which include sending a demand letter or initiating foreclosure if necessary.
If a default happens, here are three options sellers will take to remedy the situation.
Option #1 – The Buyback
“Repurchase Buyer’s interest in the applicable Note and Security Instrument within 30 days of written notice by payment to Buyer of an amount equal to the sum of Buyer’s currently outstanding Principal Balance. This will be calculated using the Principal Balance on “Exhibit B.” If this option is chosen, Buyer agrees to assign the note to Seller, including full ownership and all rights to collect outstanding balances and payments.”
This means the seller will step in and buy the partial buyer out, for whatever he is owed at that time. The buyer won’t collect all the scheduled payments, but he won’t lose money either. He will keep all payments he received from the borrower up till the date of default. He will then be paid any outstanding balance he is owed at that time, per the amortization schedule.
Option #2 – Seller to Make Payments to Buyer on Borrower’s Behalf
“Within 30 days of said notice make payment to Buyer of any amounts then in default and undertake in writing to make future scheduled payments to Buyer to the extent that the Payor might fail to do so. If this option is chosen, Buyer agrees to assign the note to Seller, including full ownership and all rights to collect outstanding balances and payments.”
This means the seller will step in and make payments directly to the partial buyer on behalf of the borrower. The reason the buyer assigns the note rights to the seller, is because the seller needs to step in and start foreclosing or collecting on the note to recover the money.
Option #3 – Pursue Legal and Collections at Seller Expense
“Within 30 days seller shall undertake loss mitigation efforts against the non-performing loan, which may include legal, attorney and foreclosure work at seller’s expense. Seller shall coordinate and manage all aspects of loss mitigation. Buyer shall have no responsibility whatsoever to manage or perform loss mitigation efforts. However, Buyer must approve of collection action and workout or settlement options, prior to committing to any change of terms or settlement with the borrower.
All NET profit derived from a foreclosure, discounted payoff or settlement of any kind, whether through the borrower or the property, will be split 50/50 between Buyer and Seller.
Upon any kind of settlement, Buyer will first be paid his currently owed Principal Balance at time of default, and then fifty percent (50%) of NET profit. In this way Buyer will participate in upside. This will not apply in the course of a normal refinance, payoff or otherwise, but only in a loss mitigation scenario where borrower was in default.
Principal Balance will be calculated using the Principal Balance on “Exhibit B.” In all cases, buyer will be paid first before seller.
To arrive at NET profit, the following will be deducted from gross receipts or settlement of any kind.
All attorney’s fees, collection, legal and servicing fees. Any reasonable and provable fees associated with collecting on the loan or protecting the property, such as in property preservation.”
The seller gets to choose which of the three remedies to use in the event of default. This limits the seller’s risk exposure if several notes were to default at the same time (unlikely but could happen). If the seller had to pay multiple notes back at the same time, this could put the seller in a cash crunch. By providing multiple remedy options, the seller is giving himself different options, but still providing reassurance to the buyer that things will be handled in a timely and professional manner.
In general, the warranty is there to protect the buyer and give them assurance that if borrower discontinues payment, there are options and help on the way. It does not guarantee borrower performance, but rather addresses the question: “How do I get my money back if the borrower stops paying?”
Partials Create Honest Sellers
One of the great things about partials is that the seller is heavily invested in making sure the asset is of good quality and borrower pays as agreed. Many of the concerns with the quality of the note and “why the seller is selling” go out the window in a partial transaction.
This is because the incentive for the seller to sell you a loan that is likely to stop paying or that he thinks may stop paying is near zero. Having real skin in the game, which is tens of thousands of dollars at stake, creates tremendous incentive for sellers to provide only quality assets to partial buyers. This is very different from a normal note transaction, where the seller could simply be unloading a problem asset with defects onto an uninformed buyer.
Buyers still need to perform proper due diligence, but partials greatly reduce their risk because both parties have strong financial incentives to ensure that the note continues paying.
This is true because in some sense, the partial seller is selling the “tail end” to their future selves. You would not want to give your future self-non-paying assets, would you?
Spread the Risk and Diversify!
Buying notes allows you to diversify across multiple assets and geographic areas, and buying partials allows you to increase your level of capital protection even further. This is because you don’t need to spend $100,000+ on a single note.
You can buy pieces of notes – partials. You can now take that $100,000 and be involved in two or even three different partials on different notes. This provides increased safety both in the form of asset and geographic diversification.
Assistance with Due Diligence (hand holding)
Performing proper due diligence is probably the most time-consuming and frustrating part of the purchase process for all buyers.
When evaluating a potential investment, due diligence is the process of answering these questions:
- What is my real risk?
- Will I make money from this?
- What happens if the borrower defaults?
- What is the likelihood the borrower will continue to pay?
The good news is that the partial seller already has this information. Since the seller owns the full note already, they have the answers to most of these questions. Regardless, the buyer should always verify the information provided by the seller before purchasing.
The best way for a seller to help the buyer answer these questions is to provide as much of the due diligence items as possible. In this manner the buyer can be fully informed and make the decision for themselves.
The seller should provide to the buyer the following items for review
- property value and the method used to determine it
- copy of note and mortgage
- copy of note and allonges
- borrower background and pay history
- length of time borrower has been in home
- down payment (if newly originated or modified)
- title report (showing lien is secured and what position)
- negative or risk issues of the deal
When a seller provides these items to a potential buyer, it goes a long way towards a smooth transaction. You don’t need to spend days or weeks researching things. Missing this simple step is a major reason why seller’s struggle to find good buyers.
The more information you can provide to your potential buyer the better. Now I will say it is possible to get “lost in the weeds” analyzing minutia, because some people will analyze a deal to death. No deal or borrower is perfect. I have seen buyers concerned over the fact the borrower had two cars or a motorcycle, something that has no bearing on the note itself.
No deal is perfect, not everyone has an 800-fico score and never missed a payment. At some point we need to accept we have done as much as possible to mitigate our downside and be confident in our upside on the deal. This is called investing. If every outcome were guaranteed, it would be called a “sure thing”.
Partial Buyers Earn Same Yield as Buying Entire Note
It’s important to understand the difference between yield and an interest rate. Interest rate is a simple interest calculation. An example would be 12% annual interest on $100,000 equals $12,000.
Yield is different. It considers the entire length of the loan amortization. Yield calculation considers your purchase price, the remaining term, payment, balance, rate on the debt obligation, which in this case is the note and mortgage.
Yield also does one important thing most people miss. It considers the time value of money.
Here is the definition of Time Value of Money (TVM)
According to Investopedia.com
“The time value of money draws from the idea that rational investors prefer to receive money today rather than the same amount of money in the future because of money’s potential to grow in value over a given period of time. For example, money deposited into a savings account earns a certain interest rate and is therefore said to be compounding in value.”
Many people become confused with the difference between a simple interest calculation and yield. They are not the same thing. Yield is almost universally used in note transactions, as well as other financial instruments like bonds. As it turns out, bonds are actually notes as well. Bonds are usually larger in size and issued by municipalities, businesses and the Government, but the basic mechanics are the same in most cases.
To calculate yield for yourself, you can read my book Paper Profits, which has example calculations you can perform for yourself. I also recommend a program called Time Value, which simplifies the process even further. You can find it at www.timevalue.com
Should I buy a Whole Note or a Partial?
The decision to purchase a partial or a whole note will be different for each investor because each investor has certain criteria that matter more to him than others.
Partials are wonderful but they do have drawbacks. One of these is the fact you do not have a big discount built in.
When you purchase a partial, you have a set number of payments you are buying. The money is made by collecting principal and interest payments from the borrower. If the borrower pays the loan off early by selling or refinancing the property, a partial buyer does not lose money, but also will not make as much as originally planned.
Here is an Example
Assume there is a note with an unpaid balance of $75,000.
The partial buyer spends $30,000 to purchase 60 monthly payments.
If the borrower were to sell the home or refinance, effectively paying off the $75,000 balance, the partial buyer would receive only his outstanding unpaid balance owed. This amount is not larger than the original $30,000 invested.
The partial buyer would keep any payments he has received, up until the time the loan was paid off.
If this happened early in the process, say in the first year or two, the partial buyer may only collect a few thousand dollars before the payoff happens.
Partials come with a relatively small discount, and most of the profit is dependent on the borrower making monthly interest payments. The most desirable scenario for a partial buyer is the borrower making his/her monthly payments, without paying the loan off early. This is how partial buyers will maximize profit.
Buying a Whole Note
By contrast, purchasing the entire note usually involves purchasing at a discount.
You may purchase a note with a remaining Unpaid Balance of $75,000 for a purchase price of $65,000. In this scenario, you have a discount of $10,000 built into the purchase. ($75,000 – $65,000 = $10,000).
If the borrower were to refinance or sell the property early in the process, say in the first couple years, you would receive nearly the full $75,000 owed and realize an immediate profit of $10,000.
In other words, there is the potential for more upside if the loan pays off early with a whole note than a partial. There is also risk of total loss if purchased incorrectly, as you do not have a borrower warranty with a whole note like you do with partials.
There is more to learn on this topic of course. I am publishing a book on partials in the next few months. Once available I will let you know so you can either purchase or I can send you a copy free of charge. Have a great week!
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(This article is an excerpt from Joshua N. Andrews Book titled Paper Profits – How to Buy and Profit from Notes a Beginners Guide)
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