Compensating Note - Posted by Jeff

Posted by David Alexander on October 28, 1998 at 21:14:14:

  1. You end up with a 19.97 yield on your 50k
  2. Because you have given them a Note for there balance
    (secured by something else??)there out of the picture and your able to retain control of the transaction.

So in 180 months you will start making payments to him from this cash flow. Ok, what if the property cashs out in 5 to 7 years as most do (we’ll use 7 in this example). The cash out would be 94,649.36 by my calculator. With the time value of money that last series of payments is greatly devalued, so how do you compensate the seller for that. Is it just like doing a partial and you have to tell the seller they lose out in the event of early payoff?

David Alexander

Compensating Note - Posted by Jeff

Posted by Jeff on October 28, 1998 at 11:42:04:

John, I?m trying to understand the mechanics of using the compensating note technique that you described, but I?m still a bit unclear as to how to structure the terms of the new “mirror” note that gets created. Can you comment on the following example?

eg. A seller has a note with a 100k principal balance 10% int, and I want to buy a 50% partial for $30k.
When the seller executes a new “compensating” note to me with his original note as collateral, how do I structure this so that I am only paying $30k for a $50K promissory note? Since a new note is being created, it would seem that I would have to be careful about violating usury laws.

Compensating Note explained and structured - Posted by John Behle

Posted by John Behle on October 28, 1998 at 12:55:00:

Let’s look at a simple example and the logic behind it. If I paid $50k for half of a $100k 30 year note, it looks like this. If the note is at 10%, the payment would be $877.57 per month.

Price $50,000 cash and a $50,000 note.

The 50k goes to pay for the first half or 180 payments. The part I am not paying cash for is the last 180 payments. So, my note is structured as $50,000 face with payments of $877.57 per month for 180 months BEGINNING in 15 years (180 months).

The note could just specify the terms. It doesn’t have to have the interest rate, but the Infernal Revenue Service will want to compute interest, so what is the rate? Using the IRR and uneven cash flow functions of the calculator, it tells me the rate would have to be written at 5.23%. It actually acrues interest at that rate for 15 years then begins the amortization.

A couple other options are:

The note payment begins when the balance of the 100k note has amortized down to $50k. That would be 282 months instead of the 180. That would be an extra 100 months of payments, but doesn’t increase your yield that much (about 1%).

Some also structure notes so that the seller receives the last 50k in payments. Both of these I consider too extreme and unfair to the seller. A partial is a tool to help a seller that has little knowledge of TVOM, not to take advantage of them.

I also like to have a defensible deal if it were ever challenged by someone. I had a student a few years ago that came up to me at a seminar and said he had bought an 80k note from an estate. He said they offered it to him for 27k and he countered at 45k. I said Leonard - you must have missed my section on negotiation. He explained that he knew any sale would probably be challenged by one of the heirs as it was. He introduced my book The Paper Game in court as an expert witness as to the value of the note and he won.