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What Makes a Good Note?
by PAPER SOURCE
President & Editor William J. Mencarow, Jr.
The value of a note depends ultimately on the economic conditions that
support the value of the property.
An owner-occupied single family house in a good
neighborhood located in an area with a long-term stable economy is the
best collateral possible. It is further enhanced by a payor who
has an excellent credit record and unblemished payment history.
Less desirable collateral, in descending
order: owner-occupied (owner lives in 1 unit) duplexes/triplexes;
non-owner-occupied single family houses; non-owner-occupied
duplexes/triplexes; other non-owner-occupied multi-family units;
improved land; commercial (non-industrial) properties; resort
properties; subdivided but unimproved lots; raw land (some buyers would
use a slightly different hierarchy).
Due to the current regulatory environment in the
U.S., industrial properties, gasoline stations, even properties with
underground oil tanks have many hidden liabilities. Notes secured
by such properties should be avoided. Cooperatives, time-shares,
mobile homes and personal property are not real estate and by
themselves are not adequate security for notes.
The higher the investment-to-value ratio, the
riskier the note (ITV = amount paid for the note + senior lien
balance/market value of property).
If there is little or no appreciation in the
property, the loan-to-value ratio is a barometer of the likelihood of
default. Notes on property purchased for $1,000 down or less
often default. The higher the downpayment, the better.
An amortized note is more valuable than one with a
balloon, since the payor may not be able to make the balloon payment.
The single most powerful financial aspect
determining the value of a note is the amount of the monthly
payment. For example, all else equal, a 10 year note with a large
monthly payment and no balloon is worth more than a 10 year note with a
smaller monthly payment and a balloon.
A note in the first lien position is more valuable
than one in the second lien position. Third lien or lower notes
are worth very little.
A second lien note with a huge balance first lien
should be avoided. In case of foreclosure, the owner of the
second lien would have to make the payments on the first.
A seasoned note (one with a payment history of
several years or more) is better than a green note (little or no
payment history).
The payor's credit history is important to help
determine the character of the payor and likelihood of default, but it
is not infallible. Everyone, even those with the best credit, can
lose their incomes, have medical emergencies or suffer other unforeseen
catastrophies. The best use of a credit report is to identify a
potential bankruptcy candidate.
A second note behind an assumable first is always to
be preferred over one behind a non-assumable first.
Again: The value of a note depends ultimately on the economic
conditions that support the value of the property.
These are just some of the factors to weigh when
considering a note. For an in-depth treatment of this subject,
see (Almost) Everything That Could Possibly Go Wrong With A Note - And
How To Prevent It, by William J. Mencarow Jr. - mpnnotes
Fax (219) 886-2237.
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