Due Diligence on Performing Notes
New to Real Estate · Castle Rock, CO · Member since 2014 · 172 posts · 66 votes
Due Diligence on Performing Notes
Most Popular Reply
Specialist · Melrose Park, PA · Member since 2013 · 167 posts · 217 votes
8yI can't get into all the intricacies here but I would just say this: I question the idea that NPNs are more risky than PNs. NPNs are having problems now, but you have lots of financial room to solve them and still make a profit; with PNs you're putting more money at risk and are far more dependent on things going as expected with no surprises. In notes as in life, I don't like to depend on everything going perfectly ;)
38 Replies
- Specialist · Melrose Park, PA · Member since 2013 · 167 posts · 217 votes8y
Hey @Nathan Patterson, welcome to Note World! Performing notes are great but you pay a high price for them relative to non-performers. So the concern is, if they stop performing, what are your options in an exit strategy? It's very easy to get caught up in all the different ways of computing return. What I focus on is doing due diligence to 1) look for signs they'll keep performing and 2) make sure there's a solid exit.
Most performers are priced 75%-100% of UPB to give you about a 12% return or 15% if you're lucky. As I'm sure you know, it's much more lucrative to pick a non-performer with strong signs that the borrower will reperform, get it reperforming and then keep it longterm for cashflow or sell at a substantial profit.
I guess what I'm saying is, it's not that hard to find assets you can buy at NPN prices that are very likely to reperform. I just bought one at NPN price that IS performing on a loan mod. That's kind of the art of this business.
- Rental Property Investor · Austin, TX · Member since 2013 · 118 posts · 98 votes8y
Hey @Nathan Patterson - figured I would share my thoughts but want to flag I'm <1 year into this
My response would be it is very much a whole picture aspect vs just price or IRR (this is true for every investment). The common view is that buying performers (which in my experience are frequently re-performers) should return 12-15% IRR. But simply buying a 12.5% note without doing full due diligence and understanding the value of your collateral is setting yourself up for trouble. So I would actually say that even though most tutorials are aimed at NPNs, a lot of the information is very useful/relevant when looking at a PNs, especially when it comes to doing due diligence like ensuring title is as expected (you don't want to buy a 1st lien and find out you're now junior) and valuing the property (e.g., through a BPO). You also want to spend time thinking about your exit strategy and foreclosure process in your state, even if it's a PN. For example, if I paid 90% of UPB for a PN, I would want to make sure my purchase price was significantly below the value of the property so I'm comfortably covered in a foreclosure scenario, just in case.
Also - I haven't seen a lot of tutorials covering this point, but since there are a lot of performers originated post-Dodd Frank, be mindful of regulatory/compliance items that may impact the loan. I spend a good deal of time on the CFPB's (surprisingly user-friendly) website and asking questions when I come across a new item.
PNs are more expensive than NPNs, but the good thing is if purchased and diligenced properly, they theoretically require little to no work post-purchase. Just a quick add if you are considering NPNs, they are cheaper, but they are also much more work intensive and I would caution against pricing a NPN based on the view that you expect the borrower will agree to some sort of modifiction/DIL. I'm closing on one now and just assumed the worst when pricing, but will be pleasantly surprised if there is a workout.
- Specialist · Melrose Park, PA · Member since 2013 · 167 posts · 217 votes8y
Unfortunately if your 90% purchase price is significantly below the homes value, that means the house has a lot of equity. And the culmination of all foreclosures is the foreclosure sale where you as lender set the minimum bid. You can only get your UPB + legal and other expenses. In the scenario you're envisioning, you don't get to "keep" the borrowers equity unless no one bids the minimum and you get the house. But that may or may not happen. You certainly can't assume it will.
- Rental Property Investor · Austin, TX · Member since 2013 · 118 posts · 98 votes8y
@Gail Greenberg- I agree, I'm not implying (and don't think I said) that you should ensure the house has equity so that you benefit from the equity gain. I'm saying ensure there is sufficient equity so that you are paid out in full at foreclosure auction (UPB + out of pocket expenses).
- New to Real Estate · Castle Rock, CO · Member since 2014 · 172 posts · 66 votes8y
Thank-you for your reply. I certainly agree with you, investors do pay a higher price for a performing note. But I feel that since I am beginning, I'd rather take a cut in the return and learn more, and hopefully not default, and when I am more comfortable with the note world to start pursuing NPN's. But you make a valid point that just because it is performing, does not mean it will stay performing and then you are at risk of possibly loosing money if you don't buy with a good enough deal. What are some of the signs that you look for to determine if the borrowers are wanting to get the note re-performing. You also make a wonderful point about foreclosure sales to keep in mind with any note that goes into foreclosure.
@Account ClosedYou might have only been in notes for less than a year, but that is more than I have. To validate if something is in compliance, would that be a task for an attorney. Or just reviewing and making sure it meets the requirements of Dodd-frank. I am not opposed to starting with NPN's it just seems like there are more ways to possible loose money for a newbie.
- Rental Property Investor · Austin, TX · Member since 2013 · 118 posts · 98 votes8y
@Nathan Patterson - sure. Using a lawyer or third party due diligence company (e.g., SDSX or Richard Monroe) is always helpful, but it's also a good idea to start becoming familiar with big button issues yourself, particularly with post-Dodd Frank loans to owner-occupants. That way you have an idea of what to look out for ahead of time. In case it's helpful here's what I've found to be useful:
1 - read as many articles (lawyer briefings and CFPB articles are a good start) as you can about seller financing/mortgage origination rules, and have a look at the actual legislature clauses being referenced (even if they aren't reader friendly). Suggestion: don't take one person's view as the sole truth and stop there, instead supplement what you read by also chatting with experienced lawyers/lenders/investors and looking at the actual legislature.
2- research High Cost Mortgages and High Price Mortgages.
3 - sign up for news alerts from HousingWire and InsideARM. Google anything you don't understand.
4 - Another BP investor showed me this helpful tool, if you google InsideARM state licensing, they have a graph briefly showing what requirements each state has. Many states only require collection agent licenses (which your servicer will have), but some may require investors to also have a license.
5 - once you know what state you want to buy in, chat with lawyers, servicers and experienced lenders active in that state and ask about licensing/registration requirements. Also ask them what compliance issues they commonly see investors running into in the state.
Note, I'm not saying you will become an expert if you do the above, and it's not meant to be an exhaustive list. But you will be more educated when looking at buying loans (especially those originated post-DF), and hopefully save yourself any big headaches in the future.
Good Luck!
- Rental Property Investor · Austin, TX · Member since 2013 · 118 posts · 98 votes8y
Also - I know it seems like a lot of details, it is and I still get frustrated at times. But like anything else in real estate, the more practice and time you put into it the quicker you pick it up. My favorite quote when I start getting lost in information overload comes from Charlie Munger: "It's not supposed to be easy. Anyone who finds it easy is stupid." =)
- Specialist · Melrose Park, PA · Member since 2013 · 167 posts · 217 votes8y
I can't get into all the intricacies here but I would just say this: I question the idea that NPNs are more risky than PNs. NPNs are having problems now, but you have lots of financial room to solve them and still make a profit; with PNs you're putting more money at risk and are far more dependent on things going as expected with no surprises. In notes as in life, I don't like to depend on everything going perfectly ;)
- Queen Creek, AZ · Member since 2014 · 2k+ posts · 1k+ votes8y
We have not seen a lot of NPN that are worth pursuing in the current market.
When buying any note assume the worst and ask "what would I do if"....
For a performing note the best case is the buyer pays and stays but, "what if" they stop paying:
Is there enough equity in the property that I can sell it at auction and come out whole? Rule of thumb here is that you want to be under 65% LTV so you have room to pay taxes and FC expenses and come out whole
If it does not sell at auction- is it in a neighborhood that I would want to own a property in? Because if it does not sell you will own it!
What are neighborhood rents? Local rents will drive what you can sell to an investor for or what you can owner finance for.
How much work (read $$$) would it likely need if you wanted to rehab and sell retail?
If you have to take the property back are you comfortable finding and managing contractors to get it in a rent ready / salable status?
How reliable are the borrowers? Have they constantly paid on time? I have borrowers that are constantly 2 months behind but have a lot of equity in the property and will likely short sell before I have to foreclose and I have borrowers that have been two months early for years.
If you have to FC how long is it likely to take and how much will it likely cost? Personally I will no longer invest in PA or FL anymore because of the long expensive FC process.
I am sure others can add to this, books have been written, literally, but I need to take the family to dinner.
Best of luck on your journey.
- Investor · Boulder, CO · Member since 2017 · 37 posts · 15 votes8y
@Gail Greenberg If there is a lot of equity in the property, and you need to foreclose, what is stopping you from setting the minimum bid unreasonably high to ensure that you will get the house, and get to 'keep' the borrowers equity?
- Real Estate Agent · Houma, LA · Member since 2016 · 238 posts · 115 votes8y
Excuse my ignorance, as I am trying to understand note investing. Are you required to go through the "sale" process if you foreclose on a note? Say it is a property that you would want to add to a rental portfolio...when foreclosing, can you just take it over or do you have to offer it up for sale first?
- Rental Property Investor · Austin, TX · Member since 2013 · 118 posts · 98 votes8y
Hi @Clint Galliano, no worries - lenders (which is what you become when you buy a note) can't take back a property unless you go through the formal foreclosure steps or the borrower agrees to deed the property to you. After you get ownership, it's yours to either rent or sell. When it goes to auction just be mindful that (i) nowadays auctions are well-attended and it's likely other investors will bid the price up higher to win the property, so you can't set the bid lower than the property's value and assume you will land the property at that amount, and (ii) typically proceeds in excess of liens owed go to the borrower, so not sure if setting the bid excessively higher than the property's value & amount due would make sense. I guess if the amount due on your performing loan is higher than the value of the property, and you set the min bid at that amount due, it's pretty much a given you will end up with the property in the end, but I don't think that's necessarily a cause for celebration...(unless the amount you paid for the loan was far less)
I'm sticking to performing notes in my response since that's the topic of this thread, but a lot of this can also be applied to NPNs. I'd also flag most NPN investors I know are much happier getting the loan re-performing, taking back the property is just a backup option, not the primary goal.
p.s. I am assuming when we all say notes we mean Note + Deed of Trust or Mortgage security. I am not including contracts for deeds, those are a different animal to me.
- New to Real Estate · Castle Rock, CO · Member since 2014 · 172 posts · 66 votes8y
@Clint Galliano Great question
@Bob E. In your experience, how often does a performing note become NPN?
- Specialist · Melrose Park, PA · Member since 2013 · 167 posts · 217 votes8y
@David Piqueira say you own a note with Unpaid Balance (UPB) of $50,000 on a house worth $90,000. The final step in the foreclosure process is the house HAS TO BE PUT UP FOR AUCTION. The only reason that wouldn't happen is if the borrower gives you a Deed in Lieu of foreclosure - essentially signs the house over to you. You set the minimum bid at the auction and it consists of your UPB + Legal expenses to foreclose + sheriff's fees/costs to auction + any other money you advanced on borrower's behalf like taxes and insurance. These expenses become part of your UPB. So maybe all that totals $65,000. The minimum bid is $65,000 but the house is still worth $90,000 so it could very well sell for $65K or $70K or 80K. IF it sells for $80K, you get your $65 and the borrower gets $15 minus any costs he's responsible for.
@Clint Galliano, you might want the house, but can you see how it's only fair to the borrower that he gets anything above what's owed to you? That's equity that belongs to him. If you really want to end up with a property, only buy notes where the UPB is close to or more than the value of the house.
- Real Estate Agent · Houma, LA · Member since 2016 · 238 posts · 115 votes8y
I understand, now. Thanks for the clarifications @Account Closed!
- Specialist · Melrose Park, PA · Member since 2013 · 167 posts · 217 votes8y
By the way @Clint Galliano, I'm trying to find a house for me in New Orleans - in case you know anyone ;) My daughter lives there and I'm in the Krewe of Nyx. It's a cruel accident that I live in Philadelphia. I want to spend 1/2 the year here and the other half in NOLA.
- Investor · Boulder, CO · Member since 2017 · 37 posts · 15 votes8y
I also understand a lot more about how foreclosures actually work now. As far as setting the minimum bid at the auction goes, I assume you are required to show proof of your additional expenses? If the UPB is $50,000 and you want to set the minimum bid at $80,000, you better have proof that you actually spent 30k in additional costs?
If the house sells at auction, I didn't realize that the borrower gets the money over the minimum bid amount, but that completely makes sense. That's why I asked my question above, assuming that you have to prove your additional costs. It would be unfair to claim that you spent more on additional costs than you actually did, because that would be cheating the borrower out of their equity.
What happens if the house doesn't sell at auction? If nobody bids the minimum? Then do you get the deed to the property? What about the borrower, do they get anything?
Thanks for explaining all of this @Gail Greenberg!
- Queen Creek, AZ · Member since 2014 · 2k+ posts · 1k+ votes8y
@Nathan Patterson I can't say in good conscience how often a performing note becomes a NPN. We started during the current economic upswing (2014) so we have not seen a major downturn yet. I suspect that is when the rubber will truly meet the road.
- 8yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
@Bob E. I know we have talked about this over the years.. in the last 5 years we have done 1,400 or so PERFORMING NOTES for our clients.. we have had less than 10 defaults.. done right and knowing what your doing on the performing end.. investors just want their interest.. they are not interested in working a note or all that goes along with it.. that is as you know a daunting task and a JOB.. Also we do not do anything with OWNER OCC thats where all the issues come from with Dodd Frankenstien etc.. we want solid payors with dual income streams one solid borrower and two rents at 2X or better of the note payments and many are 3X or more.. that is what makes a solid note. you have rental income then you have the owner of the rental with 30 to 50% equity in it they are not going to let it go over a 250 mortgage payment. at least in my 40 years of doing this.. and creating this model 5 years ago its been the best i have ever seen for safety.
there are two kinds of note investors the risk takers looking for the big hit.. and the TRULY passive.. if they want a note rate of 10% thats what they want not more not less and they want consistent payments each month with NO DRAMA... thats a nice note product.
- Investor · Kingston, WA · Member since 2008 · 1k+ posts · 1k+ votes8y
Originally posted by @David Piqueira:
What happens if the house doesn't sell at auction? If nobody bids the minimum? Then do you get the deed to the property? What about the borrower, do they get anything?
Thanks for explaining all of this @Gail Greenberg!
If the property does not sell at auction we get it back and can either resell as REO, or keep and rent it out. We also get to take over property taxes and have to register our LLC in the state of the property location since the LLC is now a property owner. The borrower gets nothing in this instance
- Specialist · Melrose Park, PA · Member since 2013 · 167 posts · 217 votes8y
So @Jay Hinrichs, you are selling turnkey rentals to investors with seller finance? Thereby avoiding the need to do a Dodd-Frank process with your borrower? Do you sell on land contact or originate a conventional note? Where are your properties?
- 8yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
@Gail Greenberg I do not sell turn key rentals. We are the debt side of the industry.
- Specialist · Melrose Park, PA · Member since 2013 · 167 posts · 217 votes8y
@Jay Hinrichs Could you explain what you're doing then? I didn't understand it and the folks in this thread certainly aren't going to either since they're very new to note investing. This is what you said - it sounded to me like you were selling turnkey properties to investors with seller financing and creating performing notes that way.
Also we do not do anything with OWNER OCC thats where all the issues come from with Dodd Frankenstien etc.. we want solid payors with dual income streams one solid borrower and two rents at 2X or better of the note payments and many are 3X or more.. that is what makes a solid note. you have rental income then you have the owner of the rental with 30 to 50% equity in it they are not going to let it go over a 250 mortgage payment.
- Investor · Boulder, CO · Member since 2017 · 37 posts · 15 votes8y
Got it. So if you did want to wind up with the property, you could find a NPN with an UPB greater than the home value. You could purchase this note for a discount, making the purchase price less than the home value. When you foreclose, the minimum bid at auction would be higher than the home value, so nobody would bid on it and you would end up getting the house for the purchase price of the note. Hopefully this would end up being a decent discount on the house. Then you could either rent or sell it. I think I understand.
Thanks @Bob Malecki and @Gail Greenberg
- Specialist · Melrose Park, PA · Member since 2013 · 167 posts · 217 votes8y
Yes, @David Piqueira exactly. Some people only buy notes where the house is underwater for this reason. Slight correction - you will have gotten the house for the price of the note PLUS the price of the foreclosure plus any other liens that stick after FC - like property taxes. Many types of liens are wiped out in FC, but not all. A borrower who has no equity and hence nothing to gain in a foreclosure should also be more willing to give you a deed-in-lieu. But you have to do a very good title search before you agree to that because with a DIL, you will have to pay all the liens to get clear title, including those that would have been wiped out in the foreclosure. Sometimes it's cheaper to foreclose.
Join the conversationCreate a free account to reply, vote on answers and follow this thread.