Investment Value Definition
The value of an investment asset depends upon it’s the ability to produce income in the future -cash flow. A buyer will not pay more for an asset than the present value of its future income, considering the risk of realizing the future income. A buyer will not pay more for an asset than it would cost to acquire or create another asset that would provide equal or greater income. These basic truths are not subject to opinion, but there is no “foolproof way” for determining future cash flows; no one can predict the future. The note investor estimates future cash flows; those cash flows are then discounted back to the date of valuation at some appropriate yield rate that reflects the all of the risks.
“Cheapness” is Not the Whole Story”
Investing is seeking value that justifies the amount paid; just being cheap is not enough. Many “cheap” promissory notes are cheap for a good reason-they have real problems that require real talent to solve. In investing it’s not how much you know, but how realistically you define what you don’t know. “Bottom fishing”, “Fire sale”, and “Undervalued” are exciting terms that can be bait to lure you into an investing trap.
You need to do just a few things right if you can avoid doing a big thing wrong. What are some of the “wrong things” that are value traps?
Cheapness” by itself does not make an investment good
Try to learn why it’s cheap; dig out the reasons for the low price of this asset. Remember, the seller may know more information then is being disclosed to you. Sellers are not obligated to “educate you”; you do your own due diligence. A “bargain” may initially appear very promising, but it can become a trap. The goal is to hunt down a valuable note while avoiding getting stuck in a value trap.
Bad management is a value destroyer
A management responsibility, called “note servicing”, is created when investing in a private promissory note. This responsibility comprises: monitoring payments due monthly, recorded payments received, monitoring hazard insurance and property tax, and preparing year-end reports to the IRS and to the borrower. If this seemingly routine and dull is mishandled or neglected, the value of the note can be diminished and discounted. Poor loan servicing is a major value trap. Value is a relative thing, not an absolute measure. What’s valuable to one investor may be a trap for another.
Not recognizing or not understanding the asset is a value destroyer
When looking for bargains, a note that appears cheap because it can be bought for less than its unpaid balance may actually be overpriced when its risks are recognized and understood. The trap springs when the investor buys at a low price and later learns that many risks were overlooked, and the low price paid was actually too high. A low price (or any price) means nothing until it is compared to the actual risks assumed and benefit obtained. As with any investment decision, thorough research and evaluation is recommended before investing—especially in any asset that appears to be a bargain.
Value traps are found in two main areas
1) Cash flow: The quality and the quantity of the cash-flow or interest income is a primary component of value. The main reason most investments are made is to earn periodic income. If the income stream is weak or questionable a value trap is set to spring.
2) Collateral security: The quality and the quantity of the security backing the promise to repay is a primary component. A promise to repay a debt is always to be doubted unless it is supported by valuable, liquid assets. The ability to protect the investment is crucial.
How to improving the odds of success and avoid value traps
• Don’t buy blindly-understand the risks and benefits before writing the check.
• “Cheap” promissory notes are cheap for a reason; learn those reasons before writing the check.
• “Cheapness” by itself is not indicative of a bargain or a good investment; it is just the starting point of the evaluation.
Lawrence (Larry) Tepper specializes in the valuation and appraisal of promissory notes, mortgage notes, and cash-flow instruments nationally. Nation-wide services for banks, trust companies, self-directed IRA accounts, estates, attorneys, CPAs, and individual investors.
Consulting Services-Free Appraisal Price Quotes
EDUCATION AND TRAINING
Law Degree /Accounting Minor University of Denver
Managing Colorado Real Estate Broker– Promissory Notes Specialization
Certified Commercial Investment Member from the National Assoc. Realtors (CCIM)
PRACTICAL EXPERIENCE
35 + years of national promissory note and mortgage note appraisal and valuation for Banks, Trust Companies, Attorneys, CPA’s, Estates, Trusts, Executors, Administrators, and Financial Advisors.
“No charge” review and discussion of your file and documents–Fee appraisal quotes– Call or email.
Lawrence (Larry) Tepper