by Dave Van Horn
“Appreciation” is often used to describe something that increases in value, such as a piece of real estate.
Property values may go up over time due to a number of factors, including inflation, market fluctuations, and overall cost of living. Or maybe you’re adding value either by improving the property (i.e. finding the “highest and best use”) or by increasing cash flow and decreasing expenses (for example, separating the utilities so the tenant can pay them directly).
Another way real estate can increase in value is from a change in financing terms, like a refinance that lowers the interest rate or shortens the term on the mortgage. This happens often in commercial real estate, where an increase in cash flow raises the value of the property, allowing the property owner to refinance.
But what about other types of investing, like real estate notes? How do notes rise in value?
Phantom appreciation is really just a made up term to describe when a note rises in value. Notes are much different than real estate because note values, especially the UPB (or unpaid principal balance), are usually going down over time (unless it’s an interest-only loan) as long as the P+I (principal and interest) payment is being paid by the borrower. In other words, the amount borrowed on a mortgage rarely goes up.
That said, there are a couple of scenarios where you’ll see some appreciation.
3 Ways Your Real Estate Notes Can Rise in Value
1. Pay History
Pay history has a large impact on the value of your note. If the note is a re-performing note, meaning that it was once delinquent but is now back on track, that positive change can make the asset more valuable. Once a re-performing asset hits certain milestones—like 12 months, 18 months, 24 months, etc.—it becomes more and more valuable because a potential note buyer sees the asset as being more consistent with a better likelihood of continued payments.
I remember how shocked I was when I first found out that a newly originated mortgage could sell for more than the UPB (i.e. $100,000 loan could sell for $103,000-$105,000) if the borrower is an A+ candidate with a strong likelihood to pay consistently and to pay a high amount of interest over time.
For example, I once paid $70,000 for a house where I mortgaged $63,000 at 6.5% for 30 years. If I made all 360 of my P+I payments of $398.20, that would total $143,352 paid over the life of the mortgage, and the total interest paid on that $63,000 loan would be a whopping $80,352.
If an investor had come in and bought this loan for 105% of its UPB 18 months after I started making payments on it (showing a solid pay history), that note buyer would still be getting a nice yield of over 6% over 28.5 years. The point here is that a solid pay history equates to low risk, which makes the loan an attractive investment.
So, what could this mean for a note investor who bought a re-performing note at a discount? The note investor may be able to collect payments on the note for a year or two (collecting payments over time is also known as “seasoning” the note) and then sell the now-seasoned note for close to the same or even more money. And don’t forget that since most mortgage amortization schedules are front-end loaded with interest, the principal balance decreases very little in the first years of the mortgage. How cool is that?
2. Changing Real Estate Market
The second big way one encounters phantom appreciation is from a rising real estate market. It actually takes a down real estate market at first to create this scenario since note values are in direct correlation to real estate values. So, when real estate values drop, notes are cheaper.
Generally, notes that are covered by equity in the property are perceived as less risky and therefore more valuable. So if, for example, you buy a note that’s not fully covered by equity at a discount in a down cycle , the investor is taking on a little more risk. But be patient and wait for the market to come back up because, as John F. Kennedy once said in reference to an improving economy, “A rising tide lifts all the boats.”
In other words, when the real estate market goes back up and your performing note is now fully-backed by equity, your note is worth more.
3. Cash Outs
Besides selling your asset after it increases in value, you can occasionally enjoy a higher yield due to the borrower paying off the loan early. This is known as “cashing out” a note.
Cash outs are more common when the economy is improving, unemployment is low, or real estate values are increasing because these factors make it more likely that borrowers will have the means and desire to refinance out of their previous loan.
The sooner a note investor cashes out of a note, the higher the yield on their investment. Take it a step further by doing this inside your self-directed IRA account, and you’ll avoid or defer taxes too.
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