Borrowing to buy a note raises the return only while the unlevered return beats the all-in cost of the loan, and on a non-performing note the timeline decides which side of that line you are on.
Leverage raises the return on a non-performing note only while the note's unlevered return is higher than the all-in cost of the loan, and on a loan that pays nothing until it resolves the timeline decides which way that goes. On an illustrative note bought for 70,000 and resolved for 120,000 in month 30, a 50 per cent loan at 10 per cent plus 2 points lifts the IRR from 16.94 to 20.63 per cent. If resolution takes 43 months or more, the same loan makes the return worse, and the dollar profit is lower in every case.
Worked in full in The Mortgage Note Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A performing note pays every month, so its income can carry the interest on a loan used to buy it. A non-performing note pays nothing until the loan is reinstated, modified, settled or foreclosed and sold. Every month of interest on the acquisition loan comes out of the buyer's pocket on top of taxes, insurance and servicing, and the loan is repaid only from the final proceeds. Leverage reduces the cash put in on day one and adds a cost that grows with the timeline. Whether it helps depends on how long that timeline turns out to be.
Rates here are annual rates compounded monthly, as is the convention for notes.
| Input | Value |
|---|---|
| Purchase price | 70,000 |
| Closing and diligence costs | 1,500 |
| Carrying costs (taxes, insurance, servicing) a month | 300 |
| Net proceeds at resolution | 120,000 |
| Month of resolution | 30 |
| Loan: share of price; interest only | 50%; 10% |
| Points paid at closing | 2% |
1. Unlevered: pay 71,500 at month 0, 300 a month for 30 months, receive 120,000 in month 30. IRR = 16.94%, profit 39,500.
2. Loan = 50% × 70,000 = 35,000; points = 700; interest = 35,000 × 10% / 12 = 291.67 a month.
3. Levered equity at month 0 = 71,500 − 35,000 + 700 = 37,200.
4. Monthly outflow = 300 + 291.67; in month 30 receive 120,000 and repay 35,000.
5. Levered IRR = 20.63%, profit 30,050: 8,750 of interest and 700 of points lower than unlevered.
6. All-in cost of the loan: receive 34,300, pay 291.67 a month and 35,000 at month 30. IRR = 10.92%.
Excel: =IRR(EquityFlows)*12 on each column of monthly flows.
Leverage works here because the note earns 16.94 per cent and the debt costs 10.92. The 6.02-point spread on 35,000 of borrowed money is what lifts the equity return by 3.68 points. Points matter on a short loan: 2 points over 30 months add almost a full point to the cost.
| Month | Unlevered IRR | Levered IRR | Difference | Profit unlevered | Profit levered |
|---|---|---|---|---|---|
| 18 | 31.04% | 43.25% | +12.21 | 43,100 | 37,150 |
| 24 | 22.21% | 29.05% | +6.84 | 41,300 | 33,600 |
| 30 | 16.94% | 20.63% | +3.68 | 39,500 | 30,050 |
| 36 | 13.45% | 15.06% | +1.61 | 37,700 | 26,500 |
| 42 | 10.95% | 11.12% | +0.16 | 35,900 | 22,950 |
| 48 | 9.09% | 8.18% | −0.91 | 34,100 | 19,400 |
| 60 | 6.49% | 4.11% | −2.38 | 30,500 | 12,300 |
The crossover comes in month 43, when the unlevered return, 10.61 per cent, has fallen below the all-in cost of the debt, which by then is 10.67 per cent because the points are spread over more months. Before it, leverage magnifies a good outcome; after it, it magnifies a bad one. A buyer who levers a judicial-state note on the strength of a 30-month base case has bought a position whose leverage turns against it if the court is a year slower.
The sale price works the same way. At 30 months, net proceeds of 110,000 still leave leverage ahead, 14.76 per cent against 13.25; at 100,000 it is behind, 8.01 against 9.21; at 90,000 the levered buyer earns 0.04 per cent and a profit of 50. To get its money back the unlevered buyer needs 80,500 of proceeds; the levered one needs 89,950.
| Loan, % of price | Loan | Equity in | Equity IRR |
|---|---|---|---|
| 0% | 0 | 71,500 | 16.94% |
| 25% | 17,500 | 54,350 | 18.35% |
| 50% | 35,000 | 37,200 | 20.63% |
| 65% | 45,500 | 26,910 | 22.83% |
More debt adds return in the base case and steepens every row of the timeline table. The gain from 50 to 65 per cent is 2.20 points of IRR; the cost is a loan the note has to repay from a single sale, on a date nobody controls.
The book's non-performing loan, bid from its foreclosure floor month by month, with the leverage worked beside it, are in the free workbook for this case; what time in court does to the price is worked in what a judicial foreclosure takes off the bid.
The interest plus the points spread over the time the loan is outstanding, solved as an IRR. In the illustrative case 35,000 borrowed at 10 per cent with 2 points, 700, repaid in month 30, costs 10.92 per cent a year all-in. That is the return the note has to beat before leverage adds anything.
It raises the proceeds you need just to get your money back, because interest is added to the carrying costs. In the illustrative case the unlevered buyer is whole at 80,500 of net proceeds in month 30 and the levered buyer needs 89,950, so a weak sale hurts the levered investor sooner, even though it puts in less cash.
Only when the note out-earns the debt. On the illustrative 30-month case, raising the loan from 25 to 65 per cent of the price lifts the equity IRR from 18.35 to 22.83 per cent. If the same loan runs 60 months, the 50 per cent levered return falls to 4.11 per cent against 6.49 unlevered.
This article is one calculation from The Mortgage Note Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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