Trouble Ahead for Sellers in Private Mortgage Transactions

Investors in private mortgages are licking their chops over what some see as a pending tidal wave of note sales in the coming months.

They believe many sellers will be forced to finance their own sales – or, in the parlance of the trade, “hold the paper” – because their buyers won’t be able to qualify for a mortgage from traditional lenders.

“More than half of the loans made in 2019 would not meet today’s criteria,” said Sarah Strochak, a research analyst in the Urban Institute’s Housing Finance Policy Center.

Some sellers will be content to collect their money bit-by-bit over the months, as though they were landlords. But note-buyers think those who want their proceeds sooner, and in one lump sum, will want to sell their paper, even if it means putting less cash in their pockets.

“A seller-held tsunami is on the horizon,” said William Mencarow, publisher of The Paper Source newsletter.

Scott Arpan of Advanced Seller Data Services, a supplier of leads for seller “carry-back” notes, believes a slew of paper will hit the market in the coming months.

“History shows we will see a flood of new notes,” Arpan said. “Unless the economy can quickly return to full employment, many [homebuyers] will suffer damaged credit even when they are responsible borrowers.”

What Investors Want

The question for home sellers, then, is how to create a financing vehicle that investors will want to take over if and when the time comes to sell it.

For starters, spend the money to have a local real estate attorney create the necessary, state-specific documents. Absent that, find a paralegal to handle the task, or search the legal websites. Your house is too valuable to rely on standard forms sold at office supply stores.

Realize, too, that you’ll have to sell at a discount, otherwise there’s no reason for an investor to take the mortgage off your hands. And the price they pay depends on any number of variables. The closer the paper is to bank quality, though, the smaller the discount.

Said Mencarow, most legit note-buyers are looking for seasoned notes – those that are at least six months old, and that have been paid on time. Even more important, however, is what you collect each month. The monthly payment is “the single most powerful financial aspect determining the value of a note,” according to Mencarow.

An amortized note is more valuable than one with a balloon payment at the end of the loan’s term, he adds. In other words, all else being 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 and a balloon payment at the end.

According to Mencarow, a single-family house in a stable neighborhood and occupied by a borrower with an excellent credit record and an unblemished payment record is “the best collateral possible.”

Some note-buyers might use a different hierarchy. Either way, you’ll want your mortgage to be in the first lien position, because if you have to foreclose on your borrower, you’ll want to be the first creditor to be paid from the proceeds of the property’s sale. That’s why a first lien is more valuable than a second – and a second, though not as valuable, is more so than a third.

How to Finance a Sale

In taking back paper, the seller becomes the lender. Consequently, you should check out your buyer in the same way a conventional lender would. That means asking for a full-blown credit report, which the buyer pays for.

Also check his or her employment history, looking for at least two years at the same company (or at least in the same field). Ask for their tax returns, a list of all assets and debts, rental history and perhaps even a criminal background check.

Why go to all this trouble? For one thing, you will be protecting yourself from dealing with someone who doesn’t pay as promised. But for another, someone who buys your note will want to know the same.

Mark Donoghue of the Americus Financial Group said he pays “careful attention to our due diligence and underwriting.” Nathan Turner, also known as “the Canadian Note Guy,” said his pencil “is a little sharper” these days. And Kevin Clancy of the American Funding Group requires a borrower interview before closing the deal.

“We’re very concerned about a borrower’s ability to pay,” Clancy told The Paper Source recently.

You should always seek as large a down payment as you can obtain. Just like a conventional lender, you’ll want your borrower to have as much skin in the game as possible. After all, the more money your buyer has in the deal, the more difficult it will be for him or her to walk away.

“Equity, equity, equity,” said Donoghue. “This remains our No. 1 risk characteristic.”

Your location also may determine your ability to sell your loan to an investor, at least for a better price. For example, Donoghue is not buying in California, New York, Connecticut and a few other states. And Gene Powers of Nationwide Secured Capital is shying away from places related to large airline and tourism employment.

Paige Panzarell, aka “the Cashflow Chick,” said she has always been careful about buying paper in states where it is difficult or takes too long to foreclose. And she may even eliminate even more states over the coming months.