Evaluating NPN Exit Strategies

This post builds on my earlier posts in the series: An Introduction to Note Investing and Elements of NPN investment Evaluation.  In this post I discuss how a potential non-performing note (NPN) investment can be evaluated against a number of possible exit strategies.  I should point out that in this post I use the terms investor, lien holder, and lender interchangeably.

First, let's review the primary exit strategies in order of preference.  The order here is my preference, and I will explain why, but I acknowledge that other note investors have differing points of view on this.

• Loan Modification
• Short Sale
• Deed in Lieu
• Foreclosure
• Reinstatement
• Payoff
  

Loan Modification

In my opinion, a loan modification is the most desirable exit.  It is quick and easy to do, and it's a win for both the investor and the borrower.  Why not help people if we can do it profitably right?  Many non-performing notes I see are way underwater with regard to property value.  Generally we see loan origination dates on these in the 2005-2007 range, i.e., the owner bought or refinanced at the top of the market.  Housing prices dropped in 2008-2009 and there you have it.  Many owners stop paying simply because they are so far underwater.  Others suffered employment issues which put them too far behind to get caught up on payments and they gave up on it and stopped paying.  Whatever the reason, many homeowners with delinquent mortgages want to keep the property if they are given the opportunity to do so.

These underwater notes are generally sold as a percentage of as-is property value rather than a percentage of unpaid loan balance (UPB).  This provides entry at a very low percentage of UPB, which allows the investor a great deal of latitude in modifying principal balance lower, forgiving arears, and getting the borrower a lower payment.  Sometimes simply forgiving arears is enough to get them back on track.  A discussion with the borrower is key to determining their situation and coming up with a plan to resolve it.

This exit is not limited to underwater mortgages, but the likelihood of getting the loan re-performing again is greater when the lender is in a position to reform the debt in a meaningful way.  In short, this exit is feasible when you have a willing borrower who is capable of making a payment on a modified loan within the boundaries of the modification you are willing to offer.

Short Sale

Short sale can be an excellent exit, but it requires the cooperation of the owner.  The nice thing about short sale is that it avoids taking ownership of the property, with the expenses, liabilities, and unknowns which accompany it.  As the lender, you have authority approve or deny purchase offers.  The risk with short sale is that the purchase and sale must be signed off by the borrower at closing, and they could simply be playing for more free housing time and decline to sign.  One mitigation for that is to offer them a piece of the pie as an incentive, i.e., some small amount of the sale proceeds at closing.  Also, the presence of junior liens can make this exit unfeasible, because these must be paid off at closing (along with taxes due) to convey clear title to the buyer.

Deed-in-Lieu

The deed in lieu exit involves an agreement whereby the owner deeds the property to the lienholder rather than losing the property in a foreclosure action.  This can be quicker than foreclosure, depending on the state, but there is increased risk for the lienholder.  A foreclosure process will cleanly wipe out junior liens, while a deed-in-lieu will not, so great care must be taken to ensure that all junior liens are identified up front and no new junior liens sneak in during the process.  

If you take a deed in lieu with junior liens present, you should be prepared to deal with them.  Even if the liens are small, there is a hassle factor to deal with.  My experience is that lienholders generally will refuse to talk to anyone who is not the original party owing the debt. A signed letter from the debtor granting you permission to talk to the lienholder is usually required.  I have found that foreclosure is generally a better approach when there are junior liens present.    

Foreclosure

Foreclosure is our worst case scenario exit because with this exit which takes the most time and incurs the greatest expense.  The benefit of foreclosure is that it is always an option if you have purchased the note properly, and it wipes out all junior liens.  Because it is the most costly of our exit strategies, we use it as our primary yard stick to measure the feasibility and projected return of any potential NPN investment.

I generally begin the foreclosure process immediately after any NPN note purchase.  I do this because foreclosure runs on a pre-defined time table (which varies considerably by state) and I want to get this clock ticking as soon as possible.  Beginning the foreclosure process also puts the borrower on notice and lets them know that the party will soon be over.  This provides a level of motivation for the borrower to begin communicating with us so we can discuss the possibility of more desirable exits.  The Notice of Default  (demand letter) is the first step in the process, and this is relatively inexpensive. Many times that' all it takes to open a dialog where other attempts have failed.  As the lender, you can stop the process there or keep moving forewarned at your discretion. 

Another thing to keep in mind about foreclosure is that the lien holder can set initial bid at the foreclosure sale up to the value of UPB + arrears + advances.  If you wish to take title to the property, setting the bid at the max is your best bet.  If you prefer that the property sell at the sale, you can adjust the bid down below the max to leave some meat on the bone to encourage others to bid.

Reinstatement

Reinstatement is when a delinquent borrower brings the loan current and resumes payments.  This is usually a good thing when the loan has been purchased at a deep discount, but it can also be a risk if the discount is not deep enough.  I recently evaluated a note investment where the loan had been modified to a 2% fixed rate and the owner had 50K equity in the property, with 17K in arrears.  My bid was very low with respect to both property value and UPB because I had to consider the fact that if the borrower reinstated the loan, I would be stuck with the investment yield I created based on my purchase price.  I didn't win the bid.  The winning bidder had bid 60% of property value, which in the case of reinstatement, would produce an investment yield of 4%.

Payoff

Let's say a potential note investment has a very small LTV, and even when purchased at par (purchase price = UPB) the investment would result in big gain in a foreclosure exit.  In these cases it may be tempting to bid based purely on collateral value, perhaps bidding more than the UPB.  This would be a big mistake.  What happens to your investment in the event the borrower unexpectedly pays off the loan?  You lose money!  Never pay more than par for a loan.

Evaluating Potential Note Investments

The basic math is the same with any other investment.  Total value of the asset - costs = profit margin.  We make sure to be conservative in our estimates of both cost and value so that the imperfect nature of our information is mitigated.  To restate, we need to come up with numbers for both investment value and projected investment cost.

Investment Value

If the value of the property is greater than the unpaid balance + arrears, we use unpaid balance + arrears as our value basis. If the unpaid balance is greater than the property value, we use the property value as our value basis.  In either case we need to have a good idea of the as-is value of the property.  As discussed in the prior post, property valuation can be tricky.  Ideally we have a recent BPO or CMA which provides as-is value based on drive-by exterior inspection.  If the property is not occupied, the risk of poor interior condition is greater and it is a judgment call how much value to remove from the as-is value on the BPO for purposes of investment evaluation.  My advice here is to always be conservative with values.  Exterior BPOs commonly overstate value.

Projected Investment Cost

Simply stated, our investment cost is purchase price + taxes due + holding cost + foreclosure cost.  Some would argue that sales costs should be factored in here too, but that depends on what you plan to do with the property if it is acquired in foreclosure.  Like any other RE investment, we can sell it off market as-is, fix and sell, fix and rent, etc.  

Below are the elements of cost we should be considering:

• Note purchase price and associated fees
• Current taxes due
• Senior Liens
• Holding Costs - Calculated the monthly holding cost and multiply that by the number of months of foreclosure process in the state plus a couple of months buffer.  Here's a listing of foreclosure timelines from RealtyTrac for reference.  (Your results may vary.)  Elements of holding cost include the following:
• Loan Servicing
• Annual Taxes
• Property Preservation - Applies primarily to unoccupied properties.
• Insurance - Many investors protect their investment by using force placed insurance for the amount of their purchase price.  The cost is dependent on the provider. I have found $1 per $100 of insured value annually to be a good rule of thumb for budgeting purposes.
• Foreclosure Costs - These vary by state and by attorney.  I have actual cost numbers for states in which I have foreclosed, but need to use conservative estimates for others.  I have found this table to be a good reference for these.
• Repair Budget - This may come into play, depending on your disposition strategy.
• Disposition Cost - The cost is dependent on what we intend to do with the property once acquired.  If we intent to sell as-is to an investor off of market, the costs are minimal.  If we intend to sell on market to a consumer buyer we need to add agency and closing costs.

Summary

As you evaluate potential note investments, the best ones are those which have all of the exits available and profitable.  With that said, you may have a strong preference for certain exits and want to prioritize these.  For example, you may want to focus on workouts and avoid taking possession of the property.  In this caes you will want to avoid vacant properties and notes with low P&I payments, and favor notes where the collateral property is occupied and where the UPB dwarfs the property value.  If you are more interested in taking possession of the collateral, vacant properties are a good bet and you will be focusing more on the collateral property condition, location, etc.  Whatever your focus, you must ensure that both foreclosure and reinstatement scenarios result in a profitable outcome for you.