It may seem simple to calculate the internal rate of return on your note investment. Most investors just assume it’s the interest rate they receive on the note. But your IRR can vary greatly if there are other sources of cash flow involved besides just an interest payment. The most common forms of additional cash flow, both positive and negative are:
Points and/or Fees – received up front at the origination of the note
Late Fee Income – received over the course of the note
Servicing Fees – paid over time to the loan servicer
Discount Premium – The difference between the discount paid for an existing note and the amount paid off when the note matured.
Let’s start with a simple example.
Example 1: A $300,000 note originated with a 3 year term and an interest rate of 10%. The Private Money Lender (PML) received 5 points up front, and agreed to share ½ with the investor. The loan servicer charges $75 per month to service the loan, and late fees are split equally between the loan servicer and the investor. We’ll assume the borrower is late 4 times per year and the late fee penalty is 5% of the $2500 monthly payment amount or $125.
Using Microsoft Excel, the IRR is calculated as 10.8% and is set up as follows:
Notice that the first entry is a negative amount of $292,500 because that reflects the initial cash outlay to originate the loan (The $300,000 less $7,500 investor’s participation in the points).
Late fees count as positive cash flow as they are received and servicing fees are reflected as negative because they are deducted and paid to the servicer.
IRR is most sensitive to time. If we condense time from 3 years to 1 year, the IRR increases to 13.2%! The increase is primarily because the up front point split of $7,500 is calculated across just one year instead of three.
There are many circumstances in private money lending where a return can be realized in one year.
Bridge – Loans which bridge the gap of other financing in which the term is less than a year.
Balloon – Some loans have short term balloon payments which can boost returns.
Foreclosure – Buying a discounted note just prior to foreclosure. The gain is realized either at the auction where the note is sold, or through the sale of the underlying collateral.
Discounted – For the adventurous investor, it is possible to buy discounted notes just prior to foreclosure and realize the return in less than one year by having the note pay off.
The key is to understand that the shorter the loan term, the greater the impact the up front points will have on your IRR.
Let’s consider some more advanced examples involving discounted note purchasing and foreclosures.
Example 2: Buying at a Discount
The terms are the same as Example 1, but an investor purchases a note with $300,000 unpaid principal balance for $260,000. The note pays off at the full $300,000 at the end of 3 years.
The result is an IRR of 16.9%.
The IRR analysis is similar to Example 1, but notice the purchase price is negative $260,000. This is because $260,000 is the amount of cash outflow to acquire the loan , even though it has a balance of $300,000. Another interesting but subtle part of this analysis is to observe that the interest payment stays at the same $30,000 per year as in Example 1 even though only $260,000 was paid for the note. This is because the borrower’s terms haven’t changed. The borrower still has a promissory note that has $300,000 owing at 10% interest.
At the end of year 3, the $30,000 interest is received, plus the full payoff of the loan. In essence, the IRR increased from 10.8% in Example 1 to 16.9% in this example because the discount of $40,000 ($300,000 payoff less the $260,000 purchase price) was received in the end of year 3 to boost the overall yield.
Now let’s take this analysis one step further for more adventurous investors.
Example 3: Purchase at a discount and realize the gain in 1 year
You can imagine the boost to the IRR if the note was purchased at a discount and then paid off in full after just 1 year. The return now increases from 10.8% in Example 1 to 32.1% in this example!
The IRR has virtually tripled because the note was purchased at a discount, and the full discount premium was realized within a year. This is frequently the result when a note is purchased at a discount just prior to a foreclosure. The investor then takes the note to foreclosure and either realizes the discount premium by selling the collateral at the trustee or Sherriff sale, or by taking back the collateral as an REO and selling the collateral to realize the gain.
Be cautious. Although this example looks good on paper, the IRR is high because the risk is extremely high. Consider all the things that could go wrong:
- The collateral is worth less than the investor thought and instead of a premium, a loss is realized.
- The investor takes back the property as an REO and finds an unexpected problem with the collateral (e.g. a structural defect, an environmental issue, etc.) which could create a loss.
- The borrower files bankruptcy and prevents an immediate foreclosure.
- The borrower reinstates the loan in full and the full term of the note must be honored.
Understanding the IRR on a note investment is critical to being a great note investor. In just these three examples, we have demonstrated that the same $300,000 note with a 10% interest rate can yield either 10.8%, 16.9% or 32.1% depending on how the loan is purchased or originated, and how fast the note pays off.