If you’ve planned and carried out your negotiation strategy well, you will reach an approximate agreement on the price, terms and conditions of your purchase. Now it’s time to put that agreement on paper and have it signed by everyone who owns the note. You can do that at a meeting or by mail. Either way, it’s time to collect and evaluate more documents.
Collect the seller’s file and the payor’s details
At a personal meeting, I ask the seller to bring their entire file. I get the agreement signed and a copy of everything in the file. I bring two copies of my documentation checklist so we can check off what the seller has given me and what they still owe me.
If the seller doesn’t have a recent credit report on the payor, they need to give me the payor’s name, Social Security number, address and, ideally, date of birth so I can run a credit report of my own. Note buyers have different views on the legality of running that credit check.
By now everything on the checklist should be in hand except possibly the homeowner’s insurance information. We want it for three reasons: to be sure the property is insured, to be sure the amount and type of coverage protect our interest, and so we can call the agent and be added as mortgagee as of the date the mortgage is assigned to us.
What the payor’s credit report reveals
The credit report tells us a lot about the payor, which matters because I base the transaction partly on the payor. You will usually get about a 10-year history of addresses, employers, job titles and salaries. You also see the payor’s age, how many times and by whom their credit has recently been checked, how many accounts they have with a summary of their ratings, and usually any judgments or bankruptcies.
Many judgment calls can be drawn from this report. If I’m going to resell the note, most investors want to confirm that any judgments have been satisfied, and they will probably use them to lower the credit rating and raise their yield a notch. If the report shows a past bankruptcy, all of my investors say forget it. If they did it before, they would do it again. I take the same position for my own portfolio.
Amortization schedule, plat and photos
Next on the list is an amortization schedule. It should agree with the note and with what we are told we are buying. Are any payments behind, or have interest or late charges been added?
Some people use the amortization schedule as a ledger to show when payments were received, as proof of payment history. I consider that sloppy record keeping. For my own records, I copy the front and back of every check or money order. That is solid proof of payment, and it gives me other useful details such as account numbers.
The plat of the property usually comes with the appraisal. It shows that the structures aren’t on someone else’s land, what structures are there as of the date it was drawn, and possibly flood plain information and other dimensions.
Photos also usually come with the appraisal. I request photo comps, meaning photos of the subject property and of the comparables used to arrive at its value. When this was written it cost around $30 extra. It makes me more comfortable, and many investors I sell to require it.
The three ways appraisers value property
Comparable sales
This method compares recent sales prices of similar properties. The appraiser looks at closed transactions in the same area and price range. (Hint: MLS closed transactions also show whether owner financing was offered.) After choosing three comparables, the appraiser adjusts the subject’s value up or down against their actual sales prices.
Adjustments are made for differences in features such as a fireplace or extra bath, for square footage, and for anything else that might affect market value. There is usually a standard price list for the extras, and the local tax assessor’s appraisal often comes into play.
If an appraiser misses interior features, maybe even extra finished rooms in the basement, the appraisal can come in unduly low and limit the price you can resell for. Comparables more than six months old are generally not acceptable because the market may have changed, and they aren’t acceptable to me or most investors. Many investors also require photo comps, which I consider good standard practice. There should always be a photo of the subject property. When this was written I typically paid about $165 for an appraisal, plus about $30 for photo comps.
Replacement cost
Here the appraiser uses a basic price per square foot for the structure, based on current building costs for that type of construction, and adds the extras from the standard price list. A standard depreciation figure then reduces the replacement cost to today’s depreciated value, and the value of the land is added to produce the total.
You can guess my opinion of the reliability of tax appraisals: I protested mine every year for fifteen years and always received substantial reductions. The value reported by this method may also be influenced by statistical handbooks appraisers use.
Income approach
The income approach is generally used only for income-producing property with a substantial rental history, and usually only when more than four units are involved. If you get involved in that type of note, you might end up owning that type of property, so you had better understand how to operate it.
The final appraisal report should show the values from each method and then a final composite value. After studying the approaches, you can see why people say appraising is an art, not a science.
How to use an appraisal on a note
The appraisal is used in several ways:
- It tells you whether you could foreclose and resell the property and at least recover your investment and projected profit.
- It tells you the most your investors would pay regardless of yield, so you know you must buy for less if you plan to make a profit.
- It should tell you something about the neighborhood and how the subject fits in.
- For rental property, you should see rental comps to judge whether you could rent it at a profit if you kept it. If they aren’t supplied, check with two or three real estate agents who handle rentals in the area.
On fit: I once looked at a 5,500-square-foot house with every amenity, from a swimming pool to copper gutters. It was gorgeous, but the builder had built it for his own use right in the middle of a large project of moderate- to low-priced townhouses. I looked into converting it to multiple units, but the cost was prohibitive. It was a white elephant in that setting, not something I’d want to hold a note on, because I might be forced to own it.
Order a drive-by, quick-sale appraisal. Most good appraisers will know this if they know you’re buying a note, but don’t leave it to chance: specify it. A quick-sale appraisal generally means the price at which the property could be expected to sell within 90 days. If you plan to resell the note, ask your investor whether the appraiser must be on their approved list.
Market value versus the seller’s number
A note holder’s ultimate recourse is the collateral, so you need to know what it’s worth and what you would do with it if you had to take it back. That means an appraisal by an expert. Appraisers were blamed for many of the savings and loan industry’s real estate loan problems, and federal legislation now requires states to set standards for appraisers, test and license them, and police the industry.
When a note is offered to me by phone, the seller often refers to the property’s “fair market value.” That’s a figment of their imagination and not the basis on which I buy notes or property. True market value is the price a willing and able buyer will pay and a willing and able seller will take. It varies with market conditions, so deal with today’s reality and with what you believe the market will do.
I remember when we could always count on the market, at least in our area, to go up. Then, in many areas, the sellers’ market of the eighties turned into a buyers’ market. Both extremes should influence how we view appraisals. Here is one mortgage I own:
| Measure | Value |
|---|---|
| Current appraised value | $167,500 |
| Previous year’s tax appraisal | $167,950 |
| Current year’s tax appraisal | $163,760 |
When the taxing authority drops values, you know values really are down. In a balanced market that is neither buyer- nor seller-dominated, value is reasonably predictable. So look at the local market and economy where your collateral sits before you make a value judgment. Buyer’s-market conditions are especially harsh on higher-priced properties.
