27 Note Investors Reveal How They Judge a Note

We asked more than two dozen veteran note investors what makes a “safe” note. Whether you’re mainly an investor or a broker, you’ll learn a great deal from their answers. Even if you broker everything and never invest your own money, you need to know what your investors need in a note.

The answers are revealing on several levels. First is the combined centuries of experience behind them. It’s also striking how differently investors weigh the same criteria, and how much credit scoring had changed the business. Some defend the credit score as the key safety net; others argue just as passionately that equity in the property is the best protection.

Here is the question we asked:

“Of course there are no guarantees, but what in your opinion are the priority characteristics of a residential mortgage note that a private investor should look for in order to have as safe an investment as possible?”

Why many investors put equity and loan-to-value first

“Equity is king”

Without question, equity is king. Credit matters, seasoning and payment history matter, and property type matters, but equity forgives a lot of sins. A good equity position almost always protects our investment dollars, even if we have to go as far as foreclosing to recapture them.

Of course, in a perfect world every borrower has 750+ credit, every property appreciates forever, and every payment arrives on the first of the month. In that world, however, the seller-financed industry wouldn’t exist. Investors who are too aggressive go out of business by buying too much of the wrong kind of paper; investors who are too cautious go out of business by buying too little of the right kind.

All investors expect clear title to the property, the original collateral documents, a complete endorsement and assignment chain, a current homeowner’s insurance policy and current property taxes. Most differences between investors come down to how they rank the “big three”: equity (or LTV), credit and payment history. We’ll take equity every time.

— Clint Hinman, Empire Mortgage, Spokane Valley, Washington

“Strong LTV and title insurance”

“I believe that a strong loan-to-value and title insurance are the most important factors.”

— David Spector, Waring Investments, Inc., Clifton, New Jersey

“Safety only lies in the property”

“I am strongly of the opinion that safety only lies in the collateral value of the property. I have seen too many people with a 700+ credit score go down the tubes, and a relatively high coupon rate hardly offsets the risk of a high loan-to-value, regardless of the borrower’s creditworthiness. It is only the relative value of the house that means anything, at least to me.

“At the end of a very bad day, if I have to foreclose, will I at least get my principal back after expenses? If so, then my principal is safe from loss.”

— Stephen C. Marks, Net1 Capital Corp., Boca Raton, Florida

“The lower the investment-to-value ratio, the safer the mortgage”

“An investor in mortgage notes in the secondary market has one objective: to earn a targeted return on investment. Although we evaluate the seasoning, the down payment, the payor’s credit scores and other elements, ultimately the most important factor is the value of the property relative to the amount owed.

“Just because a borrower has paid promptly for a while, has good credit or put up a sizable down payment doesn’t mean he or she won’t run into cash flow problems and be unable to make the payments. As mutual fund operators always caution, past performance may not be indicative of future results.

“However, if an investor holds paper with a low balance owing relative to the value of the property, the investor has a very high probability of coming out whole and earning its targeted return, either through the promised payments or, if they aren’t made, through foreclosure on the property. The lower the investment-to-value ratio, the safer the mortgage.”

— Rick Gordon, Director of Transactions, Florida Asset Financing Corp., Boca Raton, Florida

“Have a back-up plan, and a maximum 65% ITV”

“The ‘safe’ mortgage is the one for which you have a back-up plan in case the first choice (payment income) doesn’t happen and everything else goes wrong.

“About 20 years before I wrote this, when inflation was pushing property values up faster than a speeding bullet, I showed real estate agents how they could sell property by assumption, with the seller carrying back the down payment, and I would buy the second at a 40% yield. I had never experienced a down market, and my seconds became poor investments.

“To me, a safe mortgage is an investment-to-value of 65% or less. (In Texas we can go higher because foreclosure costs are lower and about six months faster.) Most of our investments are under 30% ITV because we buy partials almost exclusively.”

— Tom Hennigan, President, EscroServ, Inc., Metairie, Louisiana

“Good LTV and ITV are the number one factors”

While checking credit and getting a good credit report is important, it isn’t the most dependable measure of a safe mortgage. A change of circumstances, such as losing a job or the end of a marriage, can change a good payor’s dependability.

Good LTV and ITV ratios are the number one factors in the safety of a deal. If a payor becomes undependable, conservative LTV and ITV values are excellent insurance. My maximum LTV guidelines are:

Property type	Maximum LTV
Single-family homes	80%
Multi-family homes	65%
Small commercial property	65%
Raw land	50%
Improved lots	60%
Farmland	50%

This may sound elementary, but these are my guidelines, and I sleep better at night following them. If I also get a conservative ITV through a partial purchase, that’s even better.

— Greg Wilson, President, Wilson Mortgage and Financial Solutions Company

“Low down payment is the best predictor of default”

“Four issues come to mind when I think about the definition of a ‘safe’ note:

1. The FHA studied this issue some years ago and found that a low down payment was the best predictor of future default. Being experts in the world of low down payments, they should know. In my opinion, this is still true.
2. A clean credit report has also been a good predictor in our experience. More accurately, a messed-up credit report is a good predictor of future problems.
3. Some of our software users only hold notes on properties they wouldn’t mind taking back and renting or reselling, so foreclosure becomes a major part of their business plan. That’s a sound tactic for valuable property, but it isn’t what we want to do. We don’t want to take property back, because it’s time-consuming and unpredictable, and we accept up front that we’ll be dealing with people who don’t always honor their commitments.
4. We’ve never been able to show that firsts are safer than seconds. You do want to be sure the investment-to-value (ITV) ratio makes sense when the first and your investment in the second are added together. More importantly, and many people may disagree with me, the loan-to-value (LTV) ratio is the better predictor of safety. ITV protects your investment, but LTV is the inverse of the down payment and tells you whether you’ll eventually foreclose.”

— John W. Moren, President, Princeton Investments, Fort Collins, Colorado, and author of the NoteSmith software

“Owner’s equity is the most important”

Going into this question, we assume there is clear title, as shown by a title insurance policy.

1. Equity. We feel the borrower’s equity is the priority characteristic of a safe note. For new loans, that means the down payment. For seasoned loans, the appraisal or broker price opinion (BPO) determines the equity above the unpaid principal balance (UPB).
2. Seasoning and pay history. Once 12 or more payments have been made, we feel the built-in default risk of a new loan has passed. Pay history is equally important, but only a verifiable, third-party pay history means anything. We require proof of payments from the start of the loan, or for the past 12 months on loans over 24 months old: copies of the checks as received, bank statements showing the deposits, or cancelled checks from the borrower. Missing or incomplete proof makes us step back and re-evaluate. The only time we’re flexible on proof is with good-to-excellent-credit borrowers.
3. Credit. We don’t hang our hat on credit scores, though we require a tri-merged credit report for every file. Maybe it’s because we were buying loans before FICO scores became common, but we feel the best insight into a borrower’s character comes from the individual trade lines and public records.
4. Employment. Self-employed people are more prone to default than people who work for someone else. We don’t make this stuff up; try borrowing from a bank and see what they say. Type and length of employment show character and stability. The job can be confirmed with a verbal verification of employment (VVOE).
5. Documentation. Safety applies not only to loan performance but to collectability. Buying the loan is the easy part; servicing and collecting are the hard work. We review the loan documents for the normal, expected clauses. We see homegrown forms all the time, and we must be sure that if we buy the loan, we can collect. Was a 1003 credit application taken? Are there errors in the legal description? Are the security instruments on proper, state-specific forms? Is the loan calculated correctly on the note? Does the HUD-1 add up?
6. Pride of ownership. It may sound old school, but when the photos in the appraisal or BPO show a maintained property with pride of ownership, we breathe a sigh of relief.
7. Taxes and insurance. On non-escrowed seasoned loans, we value a borrower who pays real estate taxes and insurance premiums on time. It shows responsibility.

— Wm. “Kelly” Crow, President, Morningside Mortgage Management Inc., Atlanta, Georgia

Why some investors put credit first

“My number one criterion is credit”

“Like many things, my opinion on what makes a safe mortgage has changed with experience.

“Years ago, as a loan officer for a commercial bank, I always looked at capacity: the borrower’s ability to make the payments. That was the bank’s standard, and it seemed a good indicator.

“Then I became a contract buyer for Metropolitan and shifted my focus to equity. We didn’t always have the payor’s income information, and after all, someone with a lot to lose is less likely to walk away. Well, that’s what I used to argue to underwriting, anyway.

“Now that I buy for my own portfolio, and have had sad experiences with payors who had both the capacity and the equity, I can tell you my number one criterion is credit. Not necessarily the score, although that can help, but the report itself. People are in the habit of paying their bills, or they’re not. Next would be a verified repayment history from the seller, but if I had to choose one thing, it would be credit.

“I have a few notes with poor-credit payors that are performing, but they’re a constant collection headache, always some excuse. Most of the notes I bought with poor-credit payors have defaulted. (A 25% yield isn’t as good as it sounds if you never receive a payment!)

“And of course I always speak with the payor before buying. If I can’t reach them before I buy the note, I surely won’t be able to find them when they’re in default. So I look at:”

1. Credit
2. Conversation with the payor
3. Repayment history
4. Seasoning
5. Cash equity
6. Property type and location (how hard would it be to resell?)
7. Repayment ability

— Lynda Vaillancourt, President, Western Capital Investments, Durango, Colorado

“Most important is credit, then equity”

“When investing in mortgages, I’d say the most important component is credit, followed by equity. With a high credit score you rarely chase the payment, and there are few headaches. Equity is second because the more the borrower has to lose, the more pressure there is to make the payments.

“However, in the world of owner-held mortgages, most notes were created because there was a problem with credit, little or no equity, or a property that isn’t so desirable to own. That’s the real challenge for the note buyer. The most desirable notes are rarely bought at high yields, so we’re all pressured to buy B and C loans with built-in credit or collateral issues, simply because they’re more profitable.

“When buying the less-than-perfect note, keep your investment under 55% of the appraised value, and you must be strong on collection. The payor has to feel that you’re not afraid to own the property, that you’d welcome it. If you can convey that, the payor holds no cards against you. It’s when the payor knows you’re afraid to foreclose, or don’t want the property, that the payor holds you hostage.”

— Joseph M. Pepitone, R&P Capital Resources, Inc., White Plains, New York

“The credit score is number one”

First National grades the notes it’s considering on four criteria:

Criterion	Weight
Credit score of the buyer (payor)	40%
Equity the payor has in the property	30%
Seasoning	20%
Payor’s pay history	10%

We’ve tested our system internally many times against our history of holding thousands of seller carrybacks to maturity. We also had it tested by statistical experts at Michigan State University, who confirmed it, especially the reliance on credit score as a predictor of future collection headaches and foreclosure risk. Equity was also a very strong predictor of default and, as our weighting reflects, seasoning turned out to be a surprisingly weak predictor.

Beyond the scoring system, we’ve found it very important to understand the circumstances under which a transaction was created. This is key.

Professional creators of notes, such as rehabbers and land developers, are skilled at showing equity or high credit in deals where it would be wiser to price as if neither were present. Professionals are slicker about showing equity on paper even when it doesn’t exist. Big down payments can be supplied by the broker, paid “outside of escrow,” or returned to that broker as payment for services such as setting up a mobile home, painting or other possibly overvalued improvements. The ways to show equity in this type of deal are endless, and blind faith in stated equity has gotten many note buyers in trouble.

Many professionals will also put a high-credit-score buyer on title as an investor and then have the property occupied by a low-credit person. That high score is misleading: the payor may know very little about the property or its value, and may have an understanding with the professional about what happens if the occupant stops paying.

In sum, while credit and equity are our primary considerations in predicting defaults, it’s important to understand the unique pitfalls of a professionally created note.

— Frederick C. Foote, President, First National Acceptance Company of North America

“Credit is the most important”

In my opinion the most important factor in this market is credit. Good credit is the driving factor. It makes it possible to do marginal deals with high LTVs. If the economy falters, all the rules change.

Obviously, the safest mortgage is on a single-family residence with an LTV of 50% or less. If those were the only deals we bought, we couldn’t stay in business.

— Leon Steinberg, President, Steinberg Capital

Weighing credit, equity and seasoning together

“Every deal is different and stands on its own merit”

When evaluating seller-financed residential notes, start with this approach: every deal is different and stands on its own merit. That said, we look at four crucial risk characteristics, in this order:

1. Equity (LTV). Equity can puzzle inexperienced investors, because sellers so often say the property was worth more than it sold for. We feel the sales price is the best indicator of value unless we’re given solid evidence otherwise. To find true equity, take the sales price, subtract the current unpaid principal balance of all loans, and divide the result by the sales price.
2. Seasoning and verified pay history. This is often overlooked. Our pricing models show that borrowers with 12 to 36 months of seasoning default at a very low rate. It’s equally important to verify that the payment history and current balance check out and match the seasoning.
3. Credit. Credit is really quite simple. The buyer’s credit score (300 is poor, 800 is excellent) generally determines that person’s ability to pay his or her debts. The end!
4. Collateral. In the residential category we include single-family homes, townhouses, duplexes, triplexes and four-plexes: essentially 1 to 4 units. Another important factor is whether the property is owner-occupied or rented.

Remember to look at these four factors both independently and together on every deal. Strength in one can outweigh a significant weakness in another.

— Mark Donoghue, Authorized Member, Americus Financial Group, LLC

“Credit, equity and seasoning”

Our pricing philosophy is pretty straightforward. Every deal is different and stands on its own merit. As long as a deal makes sense (and money), we want to buy it. Three key factors drive our pricing:

1. Credit
2. Equity (LTV)
3. Seasoning

We evaluate these three both independently and together. Strength in one or more can outweigh a significant weakness in another. Say a deal has weak credit (a 540 FICO score), but the loan has 36 months of seasoning and a 75% LTV. The seasoning and equity help offset the credit risk, so our pricing will reflect a strong offer.

Or say the credit is extremely strong (a 685 FICO score) but the loan is new (3 payments made) with only 5% cash down. That still brings a strong offer. Why? Our pricing models show that borrowers with credit in this range default at a very low rate.

Other factors affect pricing too. Property type (single-family, multi-family, commercial and so on) tells us how comfortable we are with our exposure on a deal. The note’s interest rate also comes into play. We aren’t yield-driven overall, but higher-rate loans tend to be worth more and trade at higher prices than lower-rate loans.

Evaluating each deal on its own merit lets us price as accurately and aggressively as possible, whether that means stretching a bit for great credit and five years of seasoning, or being more conservative on a brand-new, high-LTV deal.

— Bob Repass, Senior Vice President, InterBay Funding, LLC

“LTV, credit history and the seller’s honesty”

Obviously the terms of the note are important, but they rarely guarantee safety on their own. The things we look at first are:

• The LTV. Can we recoup our funds if we ever need to foreclose?
• The borrower’s credit history. Does he or she have a history of paying bills on time?
• The seller’s honesty. Is the seller trying to hide something?

These are basic, common-sense things, but they’re still the foundation of our analysis. Once that foundation is laid, other factors come in:

1. The borrower’s income. Can this borrower truly pay this mortgage now and in the future?
2. Payment history on the note itself. Has the borrower consistently paid on time?
3. Use of the property. Is it the borrower’s home? An investment property? Currently rented? Can they afford the payment if it is, or becomes, vacant?
4. The interest rate. A high rate may look like a profitable note, but it can also contribute to foreclosure later if the borrower can’t make the payment. We’ve actually paid less for some very high-rate notes than for notes with a more reasonable rate.
5. The term. If a balloon is approaching, can the borrower pay it, or are we taking on a risk of default?

So many factors determine the risk in a note purchase that it’s virtually impossible to list them all. That’s why due diligence is so vital to our success.

— Michele L. Robbins, CPA, Note Funding Resources, LLC, Centreville, Maryland

“A seasoned, timely payment history”

American Equities, Inc. (AEI) has lasted in the real estate receivables industry by following a thorough analysis program when buying. Like a bank, we carefully consider the borrower’s financial ability as well as all the particulars of the property. We’ve followed this program since we began operating in 1979.

When a file comes in, our staff first evaluates the buyer’s credit and payment history. We’ll accept lower credit scores if the buyer has a seasoned, timely payment history. We also buy receivables at the same time as a new sale of a property; in that case we require a minimum 10% cash down payment and an acceptable credit application.

Next we consider the property. AEI will only invest where the total investment won’t exceed:

Property type	Maximum total investment-to-value
Single-family residences	75%
Commercial and improved land	65%
Unimproved land	60%

We’ve also limited our exposure to a number of western states where we’ve carefully analyzed the foreclosure laws and the strength of the economy. We judge current value with a drive-by market analysis and photographs.

At the same time, we review title to make sure we’ll be in first position at closing with no delinquent property taxes (at times we also buy some second-position notes). When we fund, we feel confident about the security of the investment, which is critical because the final product either goes into our portfolio or is resold to our pool of investors.

— Bridget Bosch, President, American Equities, Inc., Vancouver, Washington

“Is it safe enough?”

What makes a note almost foolproof? Unfortunately, I’ve seen enough seemingly good notes go bad to know that the completely foolproof note investment system has yet to be discovered. There are certainly tried-and-true ways to identify a good note investment, including credit, equity, seasoning, property condition and pay history.

I wish I could buy notes on single-family, owner-occupied homes with 650-plus credit scores, two years of seasoning and 25% equity, on well-maintained homes in appreciating areas, at 12% yields all day long. In reality, that inventory has dwindled, and we’re constantly faced with something less than ideal. Rather than deciding what makes a note safe, we’re deciding what makes it safe enough.

For me it becomes a balancing of the scales, weighing the negatives against the positives. If the credit is poor, is there a verifiable pay history and/or equity? If it’s a simultaneous note with little down, can we confirm the down payment, prior rental history and sufficient income? If the property needs work, do we have a reliable payor with plans to make repairs? Am I familiar with the area?

You might buy a note with one or two negatives when they’re balanced against mostly positives. But when the scale tips toward the negative, consider a pass, or a low-ITV, high-yield partial.

We invest in quite a few notes with credit scores below 600, and we’ve found the buyer interview a valuable tool for confirming employment, contact information, satisfaction with the property and comfort with the monthly payment. We also like to get a verifiable payment history when credit is poor.

In the end, on the riskier investments, it comes down to keeping your investment at a level where you’d be satisfied owning the property.

— Tracy Z, President, Diversified Investment Services, Inc.

Asking whether you would own the property at this price

“Do I want to own the property at this price?”

“What is a safe mortgage or deed of trust? Will I always have hair? Will the Yankees win another pennant? These questions are often asked among kings and cabbages. But, as any king will tell you, things change. That nubile neighboring kingdom’s daughter sometimes turns out to be Macbeth’s mother.

“Due diligence is a term much used in this business, but it often turns into nothing more than filling in some investor’s checklist. Old-time note buyers always ask the question: if this deal goes sour, do I want to own this property at this price?

“The arrival of major players from a mortgage lending background has fostered a dependence on credit scores that often doesn’t address whether the collateral can at least return the investor’s original capital. This business is not about 95% to 97% financing through a government-sponsored program where your personal funds are never at risk. The broker mentality, as opposed to the business-owner mentality, just looks for the next deal the way an employee looks for the next payday.

“A safe mortgage or deed of trust is one where your answer to my question about owning the property is a loud yes.”

— B.H. Tilton, President, Cross Creek, Inc., Wasilla, Alaska

“You have to be able to legally foreclose”

First, what is a perfect or ideal mortgage? It would have a payor with perfect credit or high credit scores, easily marketable collateral (in case we had to take it back), great equity, perfect paperwork, a high interest rate and a short payoff period.

In terms of safety, three of these factors dominate: paperwork, type of collateral and equity position.

First, the paperwork has to be correct. Probably 20% to 25% of the mortgages we buy come with faulty paperwork, and some take months to fix. Title work has to be the first step, because we have to be able to legally foreclose in the event of default.

Second, the type of collateral. When buying a mortgage, I ask what is going to keep the payor in this deal, still paying, if he has a financial hardship. Even payors with perfect credit can lose a job, fall ill, get injured or divorce. If our payor suddenly couldn’t pay all his bills and his payment to us was on his home, that would probably be the last payment he’d let go, since he needs somewhere to live. If the mortgage were on commercial property, land or a business, he could stop paying without affecting his lifestyle. And in a foreclosure, the single-family home is the most marketable collateral, because there are far more buyers for houses than for commercial property, land or businesses.

Third, the equity position. The more the payor has to lose by walking away, the more likely he is to find a way to make the payment, so his problem doesn’t become my problem. This is a very important factor. When I come across a mortgage with a great equity position, an internal alarm tells me to look at it as a “keeper” for the company or for a personal IRA.

— Kevin Clancy, President, American Funding Group, Inc., Stuart, Florida

Due diligence, documentation and the appraisal

“Documentation, documentation, documentation”

That’s the most important word I’d use to describe what we need to make a fair offer on a mortgage loan and expect a safe investment. The more documents the seller can provide, the more comfortable we as the buyer become. Examples include:

• Pay stubs
• Credit report
• Arm’s-length verification of the payment history, such as cancelled checks, money order receipts or bank statements
• Title policy or title search, to help us confirm the recording information
• Photos of the property (we’ll get our own updated value)
• Enough loan detail to quote a bid: original balance, current balance, maturity date, interest rate, principal and interest payment, and first payment date
• Some indication of appraised value, or at least the tax roll value

The more information we receive, the better we can analyze rate, risk and reward. Ultimately, the safer we feel about our investment, the more aggressive our price will be. Bottom line for the seller: the more documentation you can give the investor, the more the seller and the buyer both win.

— Gene O’Bannon, CMB, President, Walter Mortgage Company, North Richland Hills, Texas

“It’s the due diligence”

“In my opinion, it’s the note broker’s or investor’s due diligence that makes a good note. The investor or broker needs a sixth sense about whether to move ahead or cancel out. A good investor or broker has an in-depth checklist and sticks to it strictly. Every item on the list is investigated and either approved or disapproved. No shortcuts are taken.

“The investor should operate like an airline pilot. Without fail, the pilot goes through every item on the preflight checklist before takeoff, because flying doesn’t allow for errors. It’s the same with buying a note.

“When shortcuts are taken, problems arise. We all know about good credit, protective equity and whether you’d be comfortable owning the property if you had to foreclose. Quite a few note brokers have only one thing on their mind: the commission. Can you imagine how they’d react if they had to invest their own dollars in the note alongside the investor, like I do?”

— Dick Ballard, CCIM, President, Dick Ballard, Inc. Mortgage & Investment Brokers

“The seven areas of due diligence”

“There is no absolute formula to guarantee a note’s performance. But there are seven areas of due diligence that can help you evaluate it before you buy:

1. Equity. Look not only at the appraised value but at the investment-to-value (ITV). I always run an ITV amortization schedule alongside the original amortization schedule.
2. Pay history. Collect as much history as possible and chart how many days past the due date each payment arrives. This sometimes reveals a potential problem. If the note is very new, equity matters even more.
3. Credit history. I’ve stopped looking at credit scores. Instead, I analyze the old-fashioned way: I read the entire report and form my own internal credit rating.
4. Job stability. Very important. How many job or career changes the payor has made in the past few years can be most revealing.
5. Debt ratio. Calculate the payment-to-income ratio as closely as you can, including taxes and insurance. The range should be 28% to 38% for hourly-wage workers and 32% to 40% for professionals. Then add rent, recurring debt, car payments and so on, and the overall financial picture becomes clearer.
6. Documentation. The deed of trust, the note, the title policy and any other documents the payor has signed. Read the note and the deed of trust. Make sure you can live with the terms and conditions the parties agreed to. You may be surprised at what you find.
7. Property inspection. How has the owner taken care of the property that will become your investment?

“Anyone can have a problem: lose a job, fall ill, die. The objective is for the investor to recoup the investment and not lose on any one transaction.”

— Allen E. “Al” Myers, President, Private National Mortgage Association (Pennie Mae), Houston, Texas

“The weakest element: the appraisal”

The three basic tools we use to evaluate real estate notes are the borrower’s credit, title insurance and an appraisal. In my experience, the weakest element of the process is the appraisal.

Credit is much easier now that credit scores come with the actual report, although you still need to review the data. The score is a quick indicator of whether to proceed. Title insurance is usually pretty cut and dried: you can get good title or you can’t. In some cases you can correct minor title problems.

Since most of our purchases are on out-of-town properties, the appraisal is what concerns me most. We usually don’t drive by the properties ourselves. The appraisal is very subjective and depends on the appraiser’s skill, education, experience, data and honesty. We’ve all dealt with appraisers who will “get you the number.” We give them as little financial data as possible because we want a real number. But always remember, it’s simply their opinion of value.

Beyond the typical drive-by appraisal, we sometimes take these added precautions:

1. Request a broker’s price opinion (BPO) from a local, respected real estate broker. At the time of writing, this cost us about $50 to $100.
2. Have an appraiser we trust review the original appraiser’s work.
3. Order a new appraisal from another appraiser.
4. Most importantly, read the appraisal and understand it.
5. Whenever possible, get a full (inside) appraisal. Sometimes we offer the payor a free copy of the appraisal if they’ll allow a full one.

— Hank Harenberg, President, Capital Concepts, Inc., Albuquerque, New Mexico

What the Metropolitan underwriters said

The underwriters at Metropolitan had years of experience in this field. It can be difficult to define a safe note, since each investment has its own combination of risk factors. They developed resources to deal with this very issue, but no resource is as valuable as the combined knowledge and experience of the underwriters themselves.

“The three C’s are collateral, capacity and credit. In some instances we may have constraints on the credit issue, so marketability (demand, supply and alternative use) is becoming very important, especially in commercial transactions.”

— John Widman and Earl Ruddach, former underwriters, Metropolitan Mortgage & Securities Co., Inc.

“The structure of the note itself should be sound. A note that negatively amortizes, or one with a short-term balloon, may be less desirable than a straight amortizing, fixed-rate note.”

— Scott Spence, former Vice President, Underwriting, Metropolitan Mortgage & Securities Co., Inc.

Reading the seller and the payor

“It’s the attitude of the seller”

After many years of people contacting us, we sense the seller’s attitude more than anything else. We like to think we can feel the honest intent of the seller.

Our seller-financed loan buying has mostly been in rural and semi-rural areas across the United States. Sellers contact us rather than us contacting them first. We’ve lost so little in our 35 years of note buying that perhaps we don’t check as closely as we should.

We like the seller to send us a copy of the amortization schedule showing the date each payment was received. On the inquiry sheet we send the seller, we ask for a complete description of the property and “What is the payor’s employment, how long has he been on the job, and does he pay by bank check or money order?” We feel this personal information helps us decide.

Also, my wife of nearly 68 years helps me make decisions. We talk over each possible purchase, and we’re guided by her decision. She “weighs and decides”: How is his credit? Why does the seller want to sell? If the note is nearly new, we might buy a portion. Is it a first? If it’s a second, is the first more than twice the size of the second? If so, no.

We actually have no list of what to do or not do. Each note is weighed on how the seller has made us feel. One time a lady called, and we asked why she wanted to sell such a good note. She said, “We want to get our daughter’s teeth straightened.” We answered, “You sound like a good mother.” She said, “Well, I try.” We bought the note and made a good profit.

There’s no guarantee of a safe note. But if we as buyers slow down and weigh and decide, rather than trying to beat someone else to the purchase, the odds are we’ve bought a safe note.

— Dale Ketcham, private mortgage investor for 35 years

“Get to know the payor first”

“There are no guarantees on a safe note. But from experience, these are the factors I consider, in order of importance:

1. Talking to the payor and getting a feel for his or her purchase. Do they have plans for improving the property? Beyond normal buyer’s remorse, do they seem satisfied with it? In short, as Mike Meeker says, “Does this dog hunt?” (Beats me, but that’s what he says.)
2. Credit score. I value the credit score over loan-to-value. Over 600 FICO is great. I also verify employment myself.
3. Loan-to-value. In my own purchases this is offset by number 1. If it looks like a good deal, I’ll go up to 90% LTV, especially when I’m comfortable with the payors and the property, and especially if the area is improving.
4. In my case, I’ve had great success buying Realtor commission notes at a 30% yield. But I do the due diligence described above, and I only buy the payment stream, never the balloon. These are risky, yet I think the yield outweighs the risk. I’ve never lost one.”

— Jon Richards, NoteWorthy Investments and NoteWorthy Newsletter, San Francisco, California. Jon wrote this shortly before he passed away.

“It’s the note in your possession”

“A safe note is one you have in your possession. It has a reliable, cooperative and creditworthy payor. It is secured by collateral worth significantly more than what you paid for it, and that collateral is backed by title insurance and fire and hazard insurance.”

— Lorelei Stevens, Wall Street Brokers, Inc., Seattle, Washington

Safe versus profitable: matching risk to the investor

“Decide what kind of investor you are”

When buying a note there are many things to consider, and the most important factor truly depends on the investor’s situation. Are you willing to take the property over? If you’re buying a junior lien, do you have the funds to pay off the first? If so, the net value of the home is the most important factor.

You must make sure there’s enough cushion between your purchase price and the value of the property to go through the entire foreclosure process, eviction, possible rehab, closing costs and the carrying cost of your money, and still turn a profit. There are more factors in the decision than I can cover here, but the value of the property is by far the most important. The value is what secures your debt.

In real estate, there are people who specialize in office, retail, industrial and residential. Each understands their niche, and the thinking is different in each one. The note business has the same differences. Some investors want a set return and will pay 90 to 95 cents on the dollar for an extremely secure loan with a decent interest rate, a paying debtor and a very low LTV. Others want more risk and will pay 10 cents on the dollar because they, and the bank selling the loan, know the home is vacant and will be foreclosed on soon.

The investor who isn’t scared of risk had better not be scared of hard work. Loans bought for pennies on the dollar take a lot of maintenance. If the debtor stops paying on the first, your equity position will disintegrate before your eyes, and you can end up throwing good money after bad trying to protect your second.

Basically, once you decide what type of investor you are and agree on the net value of the property, the other factors, such as credit and payment history, adjust the final price you’ll pay, for better or worse.

— Ken Lebovic, President, North Shore Holdings, Ltd., Mount Prospect, Illinois

“How much will it cost to foreclose?”

Deciding what makes a safe mortgage is a matter of what you want to experience. How much pleasure? How much risk? We’ve bought high-risk notes that paid off early and made a handsome profit. We’ve bought “safe” investments and lost our shirts.

With experience being the best teacher, what any private investor should look for must be measured by how much risk he or she is willing to endure if foreclosure becomes necessary, whether for missed payments, unpaid taxes or “waste” of the property. It depends as much on who the investor is as on the property, the payor’s creditworthiness and the amount of equity and seasoning.

These comments are broad generalities, so please take the concepts rather than the specifics. An aggressive, young, energetic “I want to foreclose, fix the place up and sell it for a profit” investor will buy a higher-risk note hoping to get the place back and make a killing.

A more passive investor doesn’t want the risk of loss. That investor looks for a note where the payor has good credit, perhaps some seasoning, definitely some substantial equity, and a mainstream property type and location. That minimizes the risk that something will go wrong. And if it does, and they have to foreclose, there’s something worthwhile to work with that, even from a distance, can be fixed up fairly cheaply and resold to cover the exposure.

Personally, my main concern is whether I think I’m going to get paid, and if I’m not:

1. How much will it cost me to foreclose? Is it an easy state to foreclose in, such as a deed of trust state where it only takes a few months to get a property back? Or am I secured by a contract for deed, where I don’t have to go to court? If I have to go to court to foreclose, as in New York, Florida or New Jersey, I’m less likely to buy the note personally. In truth, I’ve had many successful purchases in those states, but this is always my first consideration.
2. What kind of property is it? This mainly tells me my risk on resale.
3. How much equity is there? If I have to foreclose, is there room to cover all my legal and repair costs, the time without payments, and the value I can gain by spending those dollars? This includes whether it’s a first or a second, whether I’ll have to carry the first in a default, and whether that’s worth doing.
4. What do the credit scores show? I always look at them. Very important. I also look at how much debt is on the credit cards and accounts versus the credit available. Someone with good credit can be charged up to the max, which may be an accident waiting to happen.
5. Seasoning isn’t a priority for me, except when any of the other factors are weak.
6. My sense of smell, and a history of eating a lot of terrible properties around the country that were apparently underwritten properly but went bad anyway. There is absolutely nothing more valuable than experience.

— Judy Miller, President, SellerFinances.com

“A safe note is one where risk is balanced by return”

What makes a safe mortgage? I think the answer lies in the delicate balance between risk and return.

There’s little doubt that a 10-year seasoned note on an owner-occupied single-family home at 50% LTV, with a 750-score payor, is a safe note. But a note like that would probably be bought at the lowest market yield available, perhaps 8% to 9%, and that investor would feel safe with a low-risk note. On the other hand, a business note buyer might feel safe at a 20% yield on a 2-year seasoned note on a strong business where the 700-score payor put 50% down. These are clearly different notes, yet both investors feel safe. In my opinion, they feel safe because the return exceeds the perceived risk.

At Financial Resources, Inc. we buy real estate notes of all kinds, both seasoned notes and simultaneous closings. One of the riskiest notes we buy is the 80/10/10-type second mortgage. We have roughly a 25% to 35% default rate on them, yet we keep buying, and the only way we can is by paying 30 to 35 cents on the dollar. Then we can actually feel safe buying these high-risk notes.

We also originate residential and commercial loans. At the time of writing, we would make a 97% LTV loan to someone with ideal credit, income and debt ratio at 7.5% and have a safe loan. Likewise, we could make an 80% LTV loan to someone with weak credit, unverifiable income and a high debt ratio at 11.5%, and also have a safe loan.

Safety is like beauty: it’s in the eye of the beholder.

— Jeff Long, CPA, President, Financial Resources, Inc.

“There’s a difference between a safe note and a profitable one”

I believe several responses to John Moren’s question, “What makes a safe note?”, actually answer another question: what makes a good, or profitable, note investment?

The answer to John’s question is easy: good collateral. The other question is much more complex. I’ve had several safe note investments that weren’t as profitable as some of my riskier notes.

If we want a safe note that’s relatively trouble-free, we need good collateral and good credit. But everybody wants these no-brainers, so the price can be high enough to leave a modest return of 10% to 14%. To really make money, bring me a marginal deal in my neighborhood that the big boys don’t want.

— Terry Preuit, President, Cash For Contracts, Inc.