Elements of NPN Investment Evaluation
This post builds on information provided in Part 1 of the series and covers some basic information required in the analysis and evaluation of non-performing note investments.
Like traditional real estate investing, evaluation of a potential non-performing note investment is part art and part science. In a typical real-estate investment, we perform analysis to estimate as-is value, as-repaired value, rental rate, repair cost, management cost, insurance cost, etc., based on our knowledge of the market and our knowledge of the property itself. With all of this in hand we can apply some simple math to determine what we can afford to pay for the property based on criteria and desired exit strategy.
Evaluation of a non-performing note investment is similar with regard to the valuation of the collateral property. We still need to put a value on the property which represents collateral for the note. We need to have a basic understanding of the market, including home prices, rental rate, crime rate, etc. In addition, we need to look at taxes, title, the borrower, and the foreclosure laws of the state.
While the end-goal of valuation of the collateral property is the same as it is for traditional real-estate investments, the information we are able to gather is generally less certain than it is for a property purchase due to the following factors:
- Valuation at a Distance - Most of the non-performing notes available to individual investors are in the "low price band", which is defined as property values below 125K. For many of us, that means we are looking at notes far outside of our home markets.
- No Interior Inspection - Because the properties are owned by the borrower, we cannot enter them, even if they are vacant. Interior condition, therefor, must be inferred. For example, if the home is occupied, located in a low crime area, and the exterior and grounds appear well maintained, we can infer that the exterior condition probably represents the condition of the interior. If the property is vacant, boarded, and in a high-crime area, we can infer that the interior may be trashed and the copper plumbing stolen.
We can use a combination of online tools and boots-on-the-ground to gather as much information as possible, but in the end the information we gather is imperfect, and this leads us to build in a buffer on our investment to account for these unknowns.
Generally when people make the decision to stop paying their mortgage, they generally stop paying taxes as well. Because delinquent property taxes represent a senior lien to any mortgage note, it is essential that we contact the county directly to understand the following:
- Taxes Due - We count it as part of the initial investment because we end up paying them in all exit strategies other than loan modification.
- Annual Tax Rate - Represents part of the holding cost for the investment.
- Next Tax Deed Sale - Tax liens are one thing, but if the property is sold in a tax deed sale we lose our entire investment.
We review title because unlike a standard real estate purchase, clear title is not provided to the purchaser. We look at title reports to understand a number of important aspects of the investment, but primarily we want to understand:
- Lien Position - What is the lien position of the subject mortgage?
- Senior Liens - These include all liens recorded prior to the subject mortgage. We need the total value of all senior liens. (This includes delinquent taxes but we are counting that separately.)
- Junior Liens - These include any non-tax liens recorded after the subject mortgage, including additional mortgages, municipal code violations, contractors liens, judgments, etc. The presence of junior liens does not kill our investment, but we need to know about them because they can limit our available exit strategies.
Check out my blog post on Tax and Title Due Diligence for a deeper discussion of these topics.
For non-performing notes, we are primarily interested in bankruptcy history and status. Has the borrower initiated a bankruptcy process? If so, when and what type? Is it completed yet or ongoing? If the borrower has an extensive history of bankruptcy filings, they are probably not a good candidate for a loan modification. If a bankruptcy process is ongoing now, foreclosure must wait for it to complete. If the borrower filed for chapter 7 bankruptcy after they took out the mortgage loan, they are no longer personally liable for repayment of the loan (although the loan still represents a valid lien on the property).
State Foreclosure Laws
When we purchase a non-performing note we need to be prepared for foreclose, even if that is not our desired exit strategy. Different states have different foreclosure processes and timelines. In addition, some states allow the borrower a period of time to redeem the property after foreclosure sale. In some states there is no redemption period and in others it is over a year. So, it is very important to know this information when evaluating a potential investment.
As you can see, there is much more of both art and science involved in evaluating non-performing notes than there is with a standard real estate investment. This should help to shed some light on the reason why non-performing notes are discounted as much as they are. Check out part 3 of the series where I cover how this information applies to evaluation of a potential investment with regard to each of the primary exit strategies.