Terms buyer sends a payoff request in month 11. Do you want that or not?

Question

Working out which strategy fits me and this one has stalled my thinking for a week.

The pitch for rural land on terms is that you get a markup plus interest, so a one-time flip turns into an income stream. Fine. But then I read enough operator accounts to notice how often the income stream ends early. Buyer gets a bonus, or sells, or finds a small local lender willing to look at improved land, and pays the balance.

Say cost is $9,000, sale is $26,000, $3,000 down, balance $23,000 on 10 years at a double digit rate. Held to term the interest is a large multiple of the markup. Paid off in month 11, I get my $17,000 gross profit plus about a year of interest and my capital back, and my annualized number is enormous.

So which one am I actually rooting for. Two views in the room and both look defensible.

View one: early payoff is the best outcome. Capital comes back fast, annualized return is huge, I redeploy into another parcel, and I stop carrying default risk and servicing work on that note. The interest I lost was never the point, velocity was.

View two: early payoff wrecks the model I bought into. If I wanted velocity I'd have flipped for cash and skipped the servicing entirely. The reason to be the bank is the long tail of interest income, and a portfolio where half the notes pay off inside 18 months is a cash flip business wearing a paper costume. Operators who want the tail write terms and pricing that make holding attractive, whatever the note language in their state allows, which is an attorney question.

I can't tell whether the people who cheer payoffs are being sensible or making the best of something they didn't want.

jordan_ellis2 · Answer

The thing I'd want before voting is your reinvestment assumption. View one only wins if you actually have another parcel to put the money into at similar margin. If your deal flow is two parcels a year, that $26,000 sits in an account earning nothing and the payoff cost you real income.

raj_mehta14 · Answer

Notes have had me turning this over for a while, but the note world seems to treat this as ordinary. Paper gets priced on expected life, not stated term, and a short expected life is worth less to a buyer than a long one. Which suggests that if you ever plan to sell the note, @kestrel, early payoffs are working against you and not for you. Someone correct me if that's backwards.

luis_carrera · Answer

@vellum that's not backwards for the discount math, and it doesn't settle @kestrel's question, because a note you never intended to sell doesn't care what a note buyer thinks. I've spent too long modeling exactly this and my conclusion is that the two views aren't really disagreeing about payoffs. They're disagreeing about whether you're running a capital velocity business or an income business, and those want different parcels and different buyers from the start. Pick that first and the payoff question answers itself.

Terms buyer sends a payoff request in month 11. Do you want that or not?

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