Promissory Note Red Flags, Hints and Alerts

3 Recurring Causes of Valuation Discounts

Part One

Investing Overview

Every investment has some risk. The amount of risk and the yield determines its appeal to individual investors. Some investors are cautious and conservative; some are daring and adventuresome. Investing opportunities exist that satisfy all types of investors. U.S. Government obligations have the lowest risk; they pay the lowest interest rates. Defaulted and non-performing bonds and notes are examples of assets that pay high returns to compensate for high risks of loss. There is a flavor for every taste.

Promissory Notes –A “Middle of the Road” Option

In today’s interest rate environment, an annual yield of 5% to 8% is acceptable to typical investors. Promissory note investments are available that provide this “middle of the road” interest rate. The challenge to the investor is to identify those notes that will provide this yield with reasonable safety. Not all promissory notes are created equal. Good appearance does not assure good performance.

Because a borrower signs a note stating it will pay 7% annually, and repay the investment over five years, does not guaranty this will happen. Often, a borrower cannot keep the promise because of unanticipated circumstances, or because the promise was based on unrealistic expectations, or because the borrower never intended to keep the promise.

Regardless of the reasons for non-performance, the note holder will incur anxiety, inconvenience and/or loss of money. Let’s look at three recurring reasons that cause a promissory note to suffer a loss in value.

Recurring Causes of Valuation Discounts

1. Interest rate too low: Investments are made to receive income. The main determiner of value for any investment is its income producing ability. If the interest rate on a promissory note is less than what the investor can receive through a similar competing investment, the value of the low-paying asset will be discounted to compensate for its low yield. As an example: If a note pays 4% and the market rate for a similar asset is 8%, the 4% asset is worth half of the value of the 8% asset; the 4% asset must be discounted 50% to compensate and become competitive with the 8% asset.

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2. Note is unsecured; no collateral security; only a “naked” promise to repay: All financial assets reflect the risk of loss in their pricing. The higher the risk of loss the higher the yield must be to compensate. If a promise to repay a debt is backed-up or supported only by a borrower’s promise, it is more risky than a similar asset that has both a promise to repay and additional assets supporting the promise. Lack of confidence in the borrower’s ability to repay causes the note to have a higher interest rate requirement; if the note doesn’t have a high enough face rate, it must be discount to achieve the necessary rate.

To attempt to predict the future financial ability of the borrower, current information must be analyzed. Income and expenses statement, profit and loss statements, employment history and current earnings, credit ratings, credit history, and prior payment history must be provided and be analysis.

3. Collateral security exists, but is not properly pledged and encumbered. A so called “secured note” that is improperly secured is potentially more dangerous to the investor than an obviously unsecured note. If the investor is lulled into a false sense of security by believing the investment is safer than it is, small oversights an omissions can become serious threats and even fatal to the investment.

Examples of situations creating a false sense of safety and security: Collateral security is real estate, but no Lender’s Title Policy is provided; collateral security exists, but its value is too low to protect the lender’s investment; collateral security exists, but its value is unknown—a current appraisal is not provided.

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Depending upon the individual deficiencies and facts related to the asset, the discounted value of the promissory note can range from 90% of par or face value to as low as 5% of par or face value. Remember, any discount will cause tax and fee savings!