Appraising/Valuing/Discounting Promissory Notes
Posted on 03 April 2013 | By Lawrence Tepper
What Affects a Note’s Fair Market Value—and Discounts?
What is Fair Market Value?
Fair Market Value Definition: The most probable cash price that an investment should bring in a competitive and open market; a reasonable time is allowed for exposure in the open market; the buyer and seller are each acting prudently and knowledgeably; the price is not affected by undue stimulus; the sale is consummated as of a specified date; the buyer and seller are typically motivated.
Factors Affecting the Appraisal and Valuation
Investors consider many things when making a note investment; there are risks to consider; there are incomes and yields to consider; there are personal financial conditions to consider. The key factors to be analyzed are:
- Borrower’s financial strength, credit rating and payment history
- Collateral Property quality, quantity, and marketability
- Loan to value ratio—collateral usually 125% of the invested amount
- Terms and language of the note—clear, understandable and customary
- Interest rate yield competitive to competing yields on similar investments
- Size of the note—large denominations are less marketable than smaller
What causes note discounts?
Promissory notes can be sold, but there are hurdles. No active, public market exists; notes are sold privately, one-at-a-time to one buyer at-a-time. If the interest rate is fixed, it may not reflect current yields on comparable investments. The way to adjust to current yields is to discount the price of the note; it will be sold at a discount (below par) so its effective yields is competitive with current market yields.
If interest rates have risen since the time the note was created, it will have sell at a discount. If interest rates have fallen, it is possible the note will sell at a premium.
Example–the Discounting Process
Assume a $50,000 promissory note was created December 1, 2008; first payment due January 1, 2009; interest rate 5%; payable $530.33 per month for 10 years. As of January 1, 2013, its balance is $32,329.51; the note holder wants to sell; the current market yield for a note of its quality is 7.75%. To adjust the 5% note to yield 7.75% it is discounted from $32,329.51 to $30,458.74—a $1,870.77 discount.
If we could predict the future we could avoid the risk of taking a discount. Unfortunately, we cannot predict future interest rates, future economic conditions, and future personal circumstances. But, we can minimize the risks by structuring the investment carefully. Here are ways to minimize the discount amount and risks:
- Make short-term loans—a two year loan is safer than a five year loan
- Make the interest rate high as possible
- Make the interest rate adjustable to a benchmark rate that will be competitive
- Make the payments high as possible
- Avoid “balloon payments”- –a large payment coming due in the future
- Obtain as much additional collateral security as possible
- Make smaller loans—three $50,000 loans are safer than one $150,000 loan
- Make loans to borrowers having strong, clean financial histories and high credit scores
- Employ an attorney with strong experience in the promissory note field
- Employ an experienced note advisor until you become an experienced investor
Most Fair Market Value Appraisals (FMV) will discount the note
Many factors affect the FMV—some you control, some you don’t—learn the difference
Recognize the risks you are willing to take and avoid the others
Engage competent advisors—a note specialist and a promissory note attorney