Due Diligence for Notes - Tax and Title
Tax and title are key elements of due diligence for note investments. Purchasing a note without checking tax and title is gambling, plain and simple. While sellers of notes are generally well intentioned, their information with regard to lien position and taxes due should be taken at face value and verified prior to purchase of the note. Just last week I was looking at a "1st lien" NPN which looked to me like a good buy. After reviewing title I found that the lien in question was actually in 5th position behind 4 other senior liens totaling around 150K! Imagine my heartache had I relied on the seller's information and pulled the trigger on the purchase. I have no doubt that the result would have been a complete loss of my invested capital.
We check title using an Ownership and Encumbrance (O&E) report or title search. The O&E is a lite version of a full title search which focuses on the current owner, or the last two owners, and does not track ownership backward beyond that. These can be sourced from title companies and other title related businesses which specialize in providing these details to investors. Costs vary but $100 is a good average number. Some note sellers provide these as part of the DD materials.
A typical O&E will include the following:
- Effective Date
- Property Address
- Mortgages/Deeds of Trust Listing
- Liens and Judgments Listing
- Tax Section
- Legal Description
- Mortgage/Deed of Trust Document(s)
- Deed Document(s)
- Other Documents
The first thing to check is that the O&E report is for the correct property address and the effective date is fairly recent.
Verify Lien Position
The second thing I usually check is the mortgages /deeds of trust listing. My goal here is to ensure that the lien position on the note I am looking at is as it should be. The O&E will call out basic information on each mortgage, starting with 1st position and progressing from there. The list is usually numbered to indicate lien position. We are matching on the original balance number found on the tape (or online listing) to the original balance on the lien in the O&E. Under each lien there may also be the chain of mortgage assignments. This reflects who has owned the lien since it was originated, but keep in mind that this is only the recorded assignments and there may be others later in the chain which are unrecorded. The assignment chain is not particularly helpful for DD.
Total Junior and Senior Lien Amounts
The next thing I check is liens and judgments. These are simply non-mortgage liens which encumber the title. Check the filed dates on these carefully to determine which are junior and which are senior to the subject mortgage. (Seniority is based on recorded/filed date.) These will usually be junior to a first lien, but not necessarily junior to second liens.
In the mortgage and lien review, I add up the total amounts of both junior and senior liens and include that in my analysis spreadsheet. This information is necessary to determine which exit strategies are feasible. (See my blog post on NPN exit strategies.)
Another thing which may be found in the Liens and Judgments section is a reference to a pending foreclosure. These may also be cited in the mortgage section. Where these appear depends on the format the company producing the O&E uses. Usually when I see them in the mortgage section the citation will include the term Lis Pendens, which is just a legal term for a lawsuit involving real estate. In both cases, there will be a case number included which could be used to look up details. A pending foreclosure is important information to take into account. If we are purchasing a 1st lien and the foreclosure is on the second, that's not good. If the foreclosure is on the note we are purchasing, it could be good if we are interested in acquiring the property and the property is in a state where we as the new lien holder can assume the role of plaintiff without re-starting the process.(Check with a foreclosure attorney practicing in the property state.)
Most O&E reports will have a tax section. These vary in quality of content, depending on the provider. The best ones will show the detail for which years are paid, delinquent, or sold as a tax certificate. It's important to understand the total taxes due now, the annual tax rate (which influences holding cost), and whether there is a tax deed sale pending. I use the tax info in the O&E as a data point, but don't put full confidence in it. On a performing note which shows all taxes paid, I will usually go with the O&E, but on a non-performing with one or more years delinquent, I call the county directly to get the real scoop, including when the next tax deed sale is scheduled. As lien holders, we have a vested interest in monitoring taxes and making sure they are paid so we don't lose our collateral to a tax deed sale.
Mortgage/Deed and Other Documents
I have read through more than a few mortgages and I can tell you that they are quite boring. I tend to scan the mortgage and quickly review other documents included in the file, and focus on anything that seems out of the ordinary. While this might sound like a unimportant step, it is important because its part of the educational process. The states have different ways of doing things and the norm in one state is not the norm in another. As investors it is important to know what we are looking at.
(You will not see the note itself included in the O&E because notes are not recorded. That said, it is important to see a copy of the note before pulling the trigger on the purchase to verify basic information like rate, term, whether there is a balloon payment, etc.)
Checking tax and title before purchasing a note is an essential step, but it's just one aspect of a complete due diligence checklist. Personally, I save it for last because it takes some time and I find that there are other quicker and easier things to look at which can quickly eliminate a potential note investment. Crime is a good example, but that’s a blog post for another day…