Many folks start out all gung-ho about finding notes, but before you do, it’s probably not a bad idea to know where they come from. By that, I don’t necessarily mean that they come from the bank. It’s important to consider a few things. For example, how did the asset become delinquent to begin with? Did the bank underwrite the loan properly? And did they screen the borrower?
Even if everything was done right at origination, circumstances can change.
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How Real Estate Notes Become Delinquent
1. Unfortunately, sometimes bad things happen to good people.
Of the reasons that people default on their mortgage, most of them are due to life events that are often times outside of one’s control. There are really four main reasons: job loss, death, illness, and divorce.
My partners and I wanted to learn how to manage distressed debt so that we could be prepared for the worst case scenario — yet I’ve seen so many note investors who think they can pick the perfect note. It’s like trying to pick the perfect property or the perfect borrower. The point I’m making is that nothing is foolproof. My buddy Jeff Brown refers to this as Murphy’s Law; if something can go wrong, it probably will.
Now, that doesn’t mean you should stop doing due diligence or that banks should stop doing appraisals. It just means that being prepared is valuable. No one has a crystal ball to tell them who will lose their job, become ill, pass away, or get divorced. These circumstances could really happen to any of us.
We do know statistically how many people will pass away, but we don’t know which ones. Just like with divorce, we may know that it will happen to half of the married folks, but we don’t know which couple it will be, or who won’t be able to afford their mortgage after the divorce.
2. Strategic defaults aren’t as common as you think.
Essentially, a strategic default is when someone who can afford the payment doesn’t see the economic value in making the payment. So, they’re choosing not to pay, and they’re walking away.
While this can happen in a bad economy when there’s negative equity, it still doesn’t happen as often as those four main reasons people default.
Life Cycle of the Loan
It took me a while to figure this out, but a delinquent homeowner is at a different point on the timeline of the loan. For example, the criteria for creating a new mortgage for a borrower is different in many ways than that for working with someone who’s in distress. Things like job history, credit, or even loan-to-value are less relevant when trying to work out a new payment agreement with a distressed borrower.
At this point, an affordable payment is more important than credit, for example. Obviously, their credit isn’t great because they’ve missed mortgage payments. Also, income and having employment becomes more important than job history when you’re re-working a loan.
3. Length of delinquency doesn’t determine the outcome or potential revenue.
It’s hard for many folks, including myself, to believe that a mortgage can be three, five, or even seven years delinquent, but it’s really not that uncommon. Of the distressed debt we’ve bought, our record is 10 years. It’s hard to believe that a homeowner could be that many years behind without the property being foreclosed on, but it does happen.
The bank may have set the loan aside or just kept on reselling it from bank to bank. This may be more common with second liens that are low-equity, as there could be little reward to the bank for liquidating said asset. Another possibility is that the bank sold the delinquent loan simply to get it off of their books and improve their balance sheet.
Some note investors say that they want to buy directly from the originating bank. But we don’t have the data to prove that approach as being an accurate determination of a favorable outcome. If you think about it, didn’t all the banks and servicing companies try to collect on the asset?
I’d love to hear some BiggerPockets folks share their opinion on this. My take on it is that people’s lives change after a life event, and it’s those scenarios, where someone’s situation improves or a new payment plan is created, that really impact whether the note will have a favorable result. What do you think?
Leave your comments below!