Balloon notes have always presented a special problem for Note Buyers. The yield of a Note Buyer is dependent on the note being refinanced or paid off on or before the due date. If the payors could not get a conventional loan at the time of sale, what makes anyone think they will be able to refinance at the time of the balloon?

Let's take an example of a note with a $100,000 balance @ 5% interest, paying $659.96 monthly, with a balloon payment of $83,455 due in 5 years. Assume the Note Buyer wants to achieve a 12% yield. Remember that a balloon note actually has two cash flows; the monthly payments and the balloon payments. With this in mind, let's examine different ways of purchasing balloons. If the Note Buyer is aggressive and desires to purchase the entire note, he/she would pay $75,606.

N = 60
I/Yr = 12
PV = -$75,606
PMT = $659.96
FV = $83,455

The issue with this method of purchasing a balloon is if the payor is not able to refinance, then the Note Buyer must either foreclose or extend the note. If taking the property in foreclosure is the goal, then this aggressive method might prove beneficial. However, if the main purpose of investing in notes is the outstanding yields and cash flow, this method will fall short of expectations. Why? Because if the note has to be modified or extended to avoid foreclosure, the yield will drop immensely due to the fact the yield was based on a lump sum payment in 5 years. For this reason, most Note Buyers do not feel comfortable with a full purchase offer. If you are selling a balloon, do not be surprised if you do not get a full purchase offer.

If the Note Buyer feels uncomfortable the payor will be able to refinance in 60 months he/she will be more cautious in the purchase. Purchasing only the payments, while letting the note seller keep the balloon, will eliminate the risk of the payor not being able to refinance in 5 years, while at the same time maintaining a 12% yield.

N = 60

I/Yr = 12

PV = -$29,668
PMT = $659.96

FV = 0

When I use this method I will actually purchase only 58 months of payments. This will allow for a two month cushion until the balloon is due. This just gives me a little more security, as well as if the payors think they are going into default, traditionally they will quit making payments a couple of months out.

Another method of purchasing a balloon note is to assume the payor will not be able to refinance to pay off the note, and compensate by treating the note to be self liquidating. "Self liquidating" means assuming the note to be a straight 240 month amortized loan. If in 5 years, the note cannot be paid off, the note can be modified with the same terms and payments, and the Note Buyer will maintain his/her yield. The purchase will look like this:

N = 240
I/Yr = 12
PV = -$59.937
PMT = $659.96
FV = 0

Still another method to help assure the Note Buyer will maintain his/her yield, is by assuming the note will have to be modified at the time of the balloon, but rather than modifying the note as self liquidating, the Note Buyer will assume the note to be paid off in say 120 months instead of 60. The assumption is that in 10 years the property will be sold or paid off. A ten year balloon has much less risk that a 5 year or under balloon. The purchase looks like this:

N = 120
I/Yr = 12
PV = -$64,852
PMT = $659.96
FV = $62,222

Notice the difference in the purchase price of these four methods. How does a Note Buyer determine which method to use? This is a subjective evaluation which depends how the Note Buyer weighs the risk based on the credit score of the payors, the seasoning of the note, the property's valuation, and lastly, the goal of the Note Buyer.

There is still another way to purchase a balloon note; purchasing the payments and part of the balloon. This method is becoming more and more popular among many note buyers. However, because of the complexities and the different methods to purchase part of a balloon, this is not the forum to discuss this method of purchase. I will be teaching this method in my advanced workshop, the date to be announced later. If you are interested in attending this class, please CONTACT ME to make sure you will be informed.

Conclusion: The four methods of purchasing balloons discussed here are the most popular of Note Buyers. Each have their strengths and weaknesses. As a professional, it is your responsibility to be aware of these different methods whether you are buying a balloon or selling a balloon. CAUTION: WITH THE DODD FRANK LAW BEING IN PLACE THAT AFFECTS BALLOONS, I STRONGLY SUGGEST YOU SEEK EXPERT LEGAL ADVICE. CONTACT ME if you have questions or comments. And remember, if you know of someone who has a note to sell, I DO PAY REFERRALS.



Copyright © H&P Capital Investments LLC
All rights reserved
Tom Henderson
a.k.a. THE NOTE PROFESSOR

If you have not attended a Note Professor "How To Get Rich with Notes" class, be sure and purchase the Note Professor Note Book manual to enhance your knowledge of creative real estate financing and note buying and selling.

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One of my favorite readers asked me to comment on inflation and rising prices. At the same time another of my readers asked why inflation was not rampant due to all the money the Federal Reserve (FED) has been funneling into the economy.

Here is the quick answer. The measurement of inflation via the Consumer Price Index is flawed. We do have inflation. Moreover, inflation can lead to both consumer price increases which create consumer bubbles, as well as asset price bubbles. With this in mind we can address the issue of inflation.

Let's begin by reviewing that inflation is the artificial increase in the supply of money relative to goods and services produced. This increase in the supply of money results in the dollar being worth less, and therefore a general rise, or inflation of prices occurs. Why? Because it will take more and more dollars to buy the same products.

The rate of inflation is erroneously measured by the Consumer Price Index (CPI). I do not have the space here to revisit why the CPI is an invalid measurement of inflation, but in a nutshell the CPI does not measure energy or housing, nor does it take into account how consumers will substitute other goods and services for higher priced products. It goes without saying that if the cost of energy, housing and food is not considered, then inflation might well appear to be minimal. Hence, the rate of inflation the politicians expect us to believe is bovine scatology. We know prices are increasing no matter what the CPI. The fact is: there is inflation. If we used the same measurement of inflation that we used in the Clinton administration, it would be around 9%.

Another issue is that many government programs like Social Security are tied to inflation. If there were a rise in Social Security payments to keep up with real inflation, Social Security would instantly become unsustainable. Hence, the false measurement of inflation.

The cost of fuel also relates to rising prices. Is there any doubt when energy prices increase, so do all prices, since goods must use energy to be produced and transported. Although there are other reasons for the rise in cost in fuel, such as increase in demand and world events, the FEDs printing money also raises the price of fuel. Since the price of oil is determined in dollars; when the Federal Reserve prints money, the price of oil goes up to compensate for the dollar being worth less.

However, in this issue I want to point out another factor of inflation; sometimes the printing of money will result in modest consumer price increases, while at the same time lead to immense increases in the price of assets. Where the price increase takes place depends on where the printed dollars are introduced and funneled.

Keep in mind the Federal Reserve introduces new money into the economy via debt. In other words, banks will borrow from the FED then lend that money to borrowers. Depending on how the debt is introduced will determine what prices will be "inflated". For example, in the 70s banks were borrowing from the FED to lend money on credit cards, mortgages, cars along with other consumer items, as well as practically any oil venture that was presented to them for funding. As a result of banks lending heavily in consumer goods, consumer prices rose to almost runaway levels, along with the price of capital goods.

Similarly in the latter 90s and the early to mid 2000s, because of the FED's easy money policy, banks were borrowing from the Federal Reserve to enhance their ability to make loans on almost everything. Again credit cards were being issued like candy on Halloween, there was virtually no limit on mortgages, while corporate depth rose to unsustainable levels. Any business loan with the phrase "DOT COM" was immediately granted. People were actually borrowing from their credit card to purchase dot com stock. As a result consumer prices along with assets prices like stocks and real estate skyrocketed. When the bubble burst, both corporate and individual bankruptcies exploded. (As a side note, the reason there are so many bankruptcies in a recession is because money was borrowed that was not sustainable when the FED quit printing money)

This brings us to the present. Although the FED is introducing some $45Billion a month into the system, (down from $75Billion) this money is being channeled mainly into corporate loans and Fannie Mae. Banks are not issuing credit cards, nor making consumer loans in the haphazard way they were in the past. The result is twofold. First with corporate interest rates artificially low, corporate profits will soar. When corporate profits soar the price of stocks will also soar. An asset bubble in stocks is being formed, while at the same time consumer prices are still rising, just not to the extent they were in the 70s due to the lack of increase of consumer loans.

The same asset bubble in real estate is being formed with the FEDs buying Fannie Mae loans. While it is providing artificially cheap loans to the housing market, the result is an artificially induced price of real estate.

Tom's Axiom: The price of real estate is directly proportional to the financing available.

When the FED quits funding Fannie Mae, which will greatly reduce the financing of homes, the demand and price of real estate will fall. Housing is another asset bubble being formed, while consumer prices are only moderately rising.

The second outcome of the FED investing in corporate loans and Fannie Mae instead of consumer type loans is although consumer prices will rise steadily, as they are now, there is no upsurge because the newly created money is not being channeled to consumer loans. But make no mistake, prices are rising. The Federal Reserve is merely keeping interest rates artificially low.

Conclusion: The Consumer Price Index does not give a true indication of inflation. Inflation is caused by the Federal Reserve creating money that exceeds the supply of goods and services, thus an "inflation" of prices and a bubble. A rise in prices do not cause inflation; but rather inflation causes a rise in prices. Inflation can manifest in a rise in consumer prices, assets or both. Presently, the FED is "feeding" corporate loans and the housing market. The result is an asset bubble in the price of stocks and real estate, although consumer prices are not rising at the same rate.

To determine where any bubble will appear, find out where the banks and FED are introducing the newly created money. Look for stocks and real estate to have a bubble burst when the FED quits introducing money. It does appear that this time, the FED has decided to shut off the supply of money slowly, in hopes of reducing the effects of Quantitative Easing. We shall see how effective this approach is.

If you have questions or comments, CONTACT ME Tom Henderson /a.k.a. THE NOTE PROFESSOR .

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