Note Buying Due Diligence: Assessing Risk
Whenever you purchase something, especially something that costs you a lot of money, it's always best to research, do your due diligence, and know exactly what you're buying. We all want to get the best bang for our buck, and when it comes to buying notes, they're no exception. Due diligence with notes all comes down to analyzing your product and assessing risk, and it's important to note that risk tolerance is different for different people and they're business models. My business is delinquent institutional notes, specifically residential 2nd mortgage notes, but we are also delving into the 1st world as well. Having colleagues and friends in every aspect of the note industry, I’m going to comment on areas like Seller Financed and Institutional Commercial notes, but if I miss anything or need to elaborate more, I encourage anyone working in the space to please feel free to chime in below in the comments section!
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What to Do Before ANY Purchase or Trade:
If you're like us, you can't really start your due diligence until you reference your MLSA (Mortgage Loan Sale Agreement) and check over to see what representations (reps) and warrants are contractually included or not. It's a given that you must know your note seller as this is absolutely a relationship based business. Remember that collateral comes post closing, so you can't just trust everyone without some sort of verification. Sure you can have safeguards like a Bailee letter, exceptions reports, Power of Attorney's (so you can create your own assignments and allonges as opposed to waiting for the note seller to create them), and even escrow accounts, but at the end of the day know who you're dealing with. It's also important to know the cure periods and terms with any buyback scenarios or missing collateral. Back in 2007 contracts looked much different than today when there were plenty of reps and warranties. Today it's mostly buyer beware with few reps and warranties at all. If you are ever in need of document retrieval, I highly recommend trying Orion Financial.
Loan Life Cycle
Due diligence will always vary depending on what part of the life cycle of the loan you are looking at to purchase. Loan life cycles usually look a little something like this:
Due diligence criteria at origination is probably the strictest for a potential borrower. When you apply for a mortgage to buy a house, the loan officers go through an underwriting guidelines sheet (1003 Form). Hard money lenders on the other hand, in origination base the bulk of their due diligence on the rehab property they were lending on but now it seems as though they look much more into the borrower’s track record of rehab projects, credit history, etc.
Seller Financed Note Due Diligence
Once a private mortgage is seasoned for about 12 months, you may get a seller-financed broker to look at it. Seller financed note buyers look for pre-existing notes to purchase from people with “carry back” mortgages, private 2nd mortgages, and those owned by out of state mortgage holders, etc. Here’s some of their criterion, which is similar to that of loan originators (and sometimes this is even stricter since they expect to buy the loan at a discount after it’s seasoned for at least a year):
Borrower’s Credit Score:
Date of Sale:
Orig. # of Months:
First Payment Due:
# Payments Made:
# Payment Remain:
Next Payment Date:
Current Loan Balance:
Seller Financed note buyers focus on the quality of the borrower, the underlying collateral and property condition, completeness of overall loan paperwork (title commitment report, insurance policy, the loan application, etc.) as well as borrower pay history.
Institutional Note Due Diligence
Whether you’re a note buyer or a small specialty servicer who finally builds a relationship with a larger servicer or bank you often have the opportunity to bid not just on non-performing but re-performing loans as well. This is where the bank has agreed to accept a modified payment or terms from the borrower but is a case where the Homeowner has been re-paying for less than 12 months. These loans typically trade higher than non-performing loans but still don’t trade as high as a performer yet because the bank knows that these loans have a pretty high re-default rate (sometimes as high as 50%).
With performing notes whether it's 1sts or 2nds, many investors tend to focus on a solid pay history from the borrower, the borrower's credit score, and if the note has equity or not. If you're buying only one note you may be concerned with geography as well.
With re-performing and performing notes, most of the hard work is taken out of the equation and average returns are usually in excess of hard money returns. Many active investors seem to go after the even cheaper non-performing assets whether it’s purchasing pools or “cherry picking” loans on a “loan level” basis and either work out payment plans/exit strategies with the borrowers themselves or hire a company to do so for them for even higher returns.
Risk factors for commercial notes and higher end senior residential liens obviously start with value (FMV or Fair Market Value). No matter what type of lien you're purchasing you need to get clear on value, the property, the borrower, and their intent and then your potential exits.
There’s only two ways to exit a deal: one is through the borrower and the other is through the property. Obviously title is an important factor as well as occupancy, we typically pull at least an O&E report (Occupancy and Encumbrance) on the property. If a property is vacant you pretty much know that you’re exiting through the property. Besides title, things like taxes, insurance, and HOA’s (Homeowner Associations or Condo associations) can be risk factors because said fees could be lien-able. If you go after low end first mortgages it’s possible to see deals when the back taxes, other liens, etc. are higher than the FMV or senior lien for that matter.
Due diligence on residential junior liens can vary dramatically depending on the category. If you’re looking at a high equity 2nd lien your due diligence is similar to that of a 1st lien. If you’re looking at a no equity 2nd, FMV is not as relevant, and senior lien status and occupancy are more important for these less expensive liens. Title is rarely pulled at acquisition on 2nds since it’s normally done at origination and is normally not a big risk since it’s usually covered contractually in your MLSA for lien position and validity. Taxes and insurance are also not as important since they are usually escrowed and paid for by the senior lien. Senior lien monitoring and status becomes a primary focus since this can become one of your biggest risk factors.
Depending what you’re looking at, the type of asset and class, you’ll eventually start to know what’s relevant and what is not. Now the best advice is to track your data. The information you collect going forward about the performance of the assets you purchased will prove invaluable when making future trades. Obviously I can’t think of all different types of due diligence for EVERY type of note, I haven’t even started talking about unsecured notes! I’m positive unsecured notes demand a different type of due diligence then what I listed above, so please comment below with some of your best due diligence strategies and techniques!