Mitigating Risk – The 7 Ways Outside Parties Can Threaten Your Real Estate Note Deal
The idea for this article came from the question I often hear from new note buyers:
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“How do I know I’m buying a good note deal?”
The problem for me is that they probably won’t like my answer: you don’t know until you’ve exited the deal all the way. And to be quite honest, exiting the deal could be weeks to years down the road.
Sure, depending on the type of note you’re investing in there’s certain things you can do to limit your exposure to a negative experience. But, at the end the day, much of what happens is more statistical, and the biggest risk investors run is that they don’t have enough diversification of numbers.
The 7 Things That Can Threaten A Note Deal
Let’s take a look at some of the things that could sidetrack your deal…
1. Bad Data
This may be bad information, whether provided by note sellers or trusted vendors. Also, sometimes no data can be just as dangerous as incorrect data.
A few things to look out for are inaccurate BPOs (Broker Price Opinion, i.e. drive-by appraisal), error in E&O reports (Encumbrance and Occupancy), mistakes in public records, credit reports with missing or inaccurate data, or even bad types of reports. All reports aren’t created equal.
And, sometimes it’s just bad timing, where certain information just hasn’t been recorded in public records yet, you bought the deal, and then it becomes part of the record after your purchase.
Due diligence prior to purchase is necessary for determining if any important data is missing. For example, we don't go by the note seller's data for the important things. We usually pull our own credit reports and our own BPOs so we know that the information we're getting is up-to-date. And, we can more easily identify any mistakes in the records if they're in the same format we're used to.
2. Unscrupulous Note Sellers
Obviously, note sellers can kill a deal if you can’t trust them, and they either run off with your money or don’t deliver. It really comes down to… know your note seller.
But, if you’re a newer note buyer and you don’t have a seller that you trust or feel comfortable with, there are ways to protect yourself. For example, you could set up attorney escrows for payment, use a Bailee letter, or utilize an exception report from a document custodian to inventory what’s missing and what’s present in the collateral.
3. Incomplete Collateral or Documents
This not only includes missing documents like copies of the note or missing assignments, but it can also pertain to inadequate documents, including non-circumvent agreements or poorly written PSAs (Purchase Sale Agreements) or NSA’s (Note Sale Agreements) that don’t have the proper verbiage spelling out reps and warrants and important things like buyback provisions and various timelines.
A bad contract could obviously destroy your deal. If documents are missing, the time and expense to retrieve such documents could jeopardize your ability to foreclose in a timely manner, if needed, and thus risk your capital investment.
If you already signed a bad contract, which doesn't protect you very well from these types of issues, there are other ways to address the issues as they arise. You can go back to the note seller to try to get an assignment. If it's the note that's missing, you can file a lost note affidavit. But, if all else fails, you can hire a document retrieval company to track down the missing documents. It may cost a few hundred dollars, but it could get you unstuck if you're in the middle of foreclosure.
4. The Wrong Attorney
This may be one of the biggest risks, especially when you’re new and not used to working with lawyers yet.
I’ve been wiped on deals from a bad attorney, but it was really my bad, since I lost my money. Lesson learned. Obviously, you need smart, experienced, and efficient counsel to represent you. After all, legal is your number one biggest expense.
When hiring an attorney, you need to interview them. Many newer note buyers aren’t used to interviewing people, especially on a professional level. We weren’t either when we first started out, but over the years, we’ve built a strong attorney’s list.
So, here are a few things to consider when you’re hiring an attorney:
- What’s their experience level? How familiar are they with foreclosure or bankruptcy in that state?
- Do they typically represent lenders or borrowers?
- Did someone refer them to you?
- How well do they communicate their process to you?
- Can they tell you in detail the timelines in that state, what’s unique about their state’s requirements, etc?
- What are the fees for each step of the foreclosure process?
- Is there fee structure in-line with the state government’s guidelines?
5. Lack of Risk Monitoring
The type of risk monitoring needed depends on what type of loan you own.
For example, if you own a first mortgage, your biggest risks tend to be taxes, insurance, and HOAs (Homeowner Associations). Taxes can be a threat, as they take priority ahead of the senior lien, so if they go to a tax sale it could potentially wipe out the first lien. As the note owner, you would want to monitor the taxes in order to protect your position.
You can monitor the taxes yourself or hire a tax tracking company to do it for you. In some states, HOAs may also be ahead of the first lien. So, as the note owner, you would want to check the HOA situation and requirements in the state the property is located in.
If you play with second mortgages, usually your biggest risk (besides real estate market fluctuations) is the senior lien. To monitor the senior lien you can contact the lien holder yourself or you can pull credit to see if they’ve been reporting. Most of the time, if you’re on top of monitoring the senior lien you can make more informed business decisions when needed.
6. Long Timelines
What I’m referring to here are state specific timelines for foreclosure, redemption, and ejectment.
When you’re talking to counsel in the state your deal is in, be sure to get clear on what these timelines and costs look like. It doesn’t hurt to know any recent government regulations or requirements as well.
Most note owners aren’t pursuing foreclosure on every delinquent asset. And, many that start the foreclosure process don’t follow it through to fruition. Sometimes, a long foreclosure timeline or redemption period may give you more time to come to an agreement with the homeowner.
To clarify, the redemption period is the time allotment following a foreclosure sale that the homeowner is permitted to bring the loan current or be deeded back the property. Ejectment is essentially the state’s process (after a foreclosure sale and redemption period has transpired) for helping someone, who refuses to leave the property, move on from it.
If it is a long ejectment timeline, there are other ways to help people move on from a property that they truly can’t afford to say in, such as offering a down payment for their next place, paying them to find tenants for the property, etc.
Knowing the timelines and costs may help you make more informed business decisions or change your strategy.
7. Long Market Time
If you take a property back and it takes a long time to liquidate, this could kill your deal, especially if you factor in things like cost of capital, plus legal and administrative expenses. Sometimes, just having no real estate comps can risk a deal too, whether that’s at acquisition or liquidation time.
This is really more a sign of the real estate market. But, if you’re very creative with marketing, even in a down market, sometimes you can shorten the time it takes to liquidate.
As you can see there are many inherent risks in note investing just like there is in real estate. I’m sure I’ve only covered the tip of the iceberg. Let’s not forget the actions of disgruntled borrowers or vandals with vacant properties, let alone the elements like pipes freezing or fines from municipalities.
But, I can honestly say that I wouldn’t have it any other way. I believe that all of these risks and the ability of some of us to manage them is what creates the opportunity in note investing. After all, if everything was too easy, then everyone would do it.
So, tell me, what have you done to mitigate risk in your deals?
Be sure to leave your comments below!