- LTV (Note balance-to-Value)
- ITV (Investment-to-Value)
LTV is the ratio of the note balance to the value of the property. For example, a $100,000 property that sells with 5% down and a $95,000 note balance has an LTV of 95%. The higher the LTV, the higher the risk of the note. Why? Because a high LTV at the initiation of a mortgage indicates how much “skin in the game” the mortgagor has put at risk. To put it in perspective, if a property buyer puts only 5% down on the purchase of a property and borrows the remainder, who is taking the bigger risk; the buyer who has only $5,000 at risk, or the note holder who has $95,000 at risk, with collateral of only $100,000?
Let’s take this scenario into the future ten years where the note has been paid down to $83,000. What is the LTV? 83%, right? Now who has the more at risk, the mortgagor or note holder? Since the mortgagor now has $17,000 equity, as opposed to the original $5,000, the probability the mortgagor will just walk away is reduced.
More importantly, since there is ten years of seasoning, the mortgagor has accumulated what is called “emotional equity” or “psychological attachment”; meaning the mortgagor has established roots in the community, in schools and employment. The chances of the mortgager just packing up and leaving are much less.
An offer based on yield will differ from an offer based on ITV.
Which one should you make?
In other words, even though the property buyer put only 5% down, as time went on, he or she accumulated equity, as well as demonstrating to a note buyer that they are a safer risk now than ten years earlier when they had virtually no risk because of the small down payment, no equity and no roots in the community.
Contrast this to a buyer who puts $20,000 or 20% down on a $100,000 house, with an $80,000 note balance. The LTV is now 80%. The buyer has $20,000 invested in the property. Not only do they have “skin in the game”, but should they get into trouble, they will have more of an opportunity to sell the property to get some, if not all of their investment back. Add to this that the note holder’s collateral is higher with an 80% LTV, than a 95% LTV. In other words, the note holder taking less of risk, and the buyer is taking more of the risk.
Why LTV Matters To A Note Investor
For a note investor, the LTV indicates the amount of “skin in the game” a property buyer put at risk at the origination. As time moves on, the LTV reflects the monetary equity the buyer has accumulated, as well as emotional attachment they have in the property.
With this in mind, let’s examine ITV, or investment-to-value. ITV is the amount a note buyer invested in the note divided by the “as is” value of the property.
To minimize the note investor’s risk, ITV is often tied to the credit score, down payment and property value.
Remember, the only real protection a note investor has is the collateral, or value of the property in the event of default. Since we know the collateral can be devalued by market conditions( the 2008 melt down) and/or deterioration of the property, ITV is very important to the amount of the discount a note buyer requires.
In the above case study, let’s assume the house sold for $100,000 with 5% down, and a $95,000 mortgage at 8% for 30 years, with payments of $697.08. Let’s further assume the mortgagor’s credit scores are in the low 600s. Because of the low credit scores and low down payments, a note investor requires a 65% ITV and at least an 11% yield. What will the investor offer?
For a 65% ITV he would pay $65,000 (65% of $100,000).
To receive an 11% yield a note investor would pay $73,197.
Since the offers are quite different, which one will the note buyer favor?
The note buyer will favor the $65,000 offer.
Rule Of Thumb
An investor should make the offer that gives the note investor the acceptable ITV or yield, WHICHEVER IS LOWER.
In conclusion; LTV tells a note buyer how much “skin in the game” the mortgagor has, or how much monetary or emotional attachment they have in the property.
ITV, on the other hand, tells the note investor how much he or she will invest in the note in relation to the value of the property. Yield is determined by the best and safest use of the note buyer’s money.
The amount of the mortgagor has invested, along with the value of the collateral and their credit score, will determine the ITV of the note buyer. Yield is the rate of return a note buyer demands when considering mortgagors’ credit, property value, and mortgagor’s equity and other risks. When applying LTV, ITV and yield to the purchase of a note, all three are important and should be tied to one another. In other words, the down payment, credit score, value of the property, equity in property should be tied to the ITV and yield a note investor demands.
The more risk an investor incurs because of high LTV, the lower must be the ITV, and the yield must be higher. The note buyer will offer the lesser of the ITV vs. yield.
So, which is most important, LTV, ITV or yield?
The answer is that all are important and interrelate to one another.
Yield is determined by the best and safest
use of the note investor’s money. BUT….
YIELD IS NOT REALIZED UNTIL THE NOTE IS PAID OFF.
The above article was reprinted with permission from The Paper Source newsletter—January, 2017 edition. Tom Henderson, the author, has been buying notes and real estate since the 1980s. He is president of H&P Capital Investments, LLC, which buys, sells and trades owner financed notes.