So, You Just Bought a Real Estate Note? Here’s What to Expect Next.

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Let’s say you found a note that you think you like. It meets all of your criteria, it’s in the right lien position, and it has the right Loan to Value (LTV) and Fair Market Value (FMV). The numbers look good.

You got a good price, and you stand to make a respectable return. You feel that you’ve done your due diligence. But how in depth was your due diligence?

Trust and Verify

Obviously, buying notes (or anything else, for that matter) is a “trust but verify” situation. By that, I mean you can take whatever the seller tells you at face value, and then that’s about it. Face value. Now you have to verify everything from your note seller to the collateral to the note stats.

Maybe you already know the seller, but then again, maybe you don’t. Have you asked around to see if others have done business with them? Maybe you need to do a background check or put other safeguards in place. Perhaps you can have the document custodian run an exception report to verify that all the collateral is there. An initial step would at least be to see what’s available electronically.

Hopefully, you’ve already reviewed your note sale agreement (NSA) to see that all the provisions are acceptable to you. Depending on what checks out, you’re probably ready to fund. If you’re still skeptical of the note seller, perhaps you can use a bailee letter or even an escrow agent.

But let’s say you funded. Now what do you expect next?

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Servicing Transfer

In the old days, the servicing transfer was pretty easy. It was pretty much the Wild West. Today, there’s much more compliance involved, especially with borrower data at the time of transfer. This is one of the many reasons why I strongly recommend using a licensed servicer in the state of the loan.

In fact, to give you an idea of how serious this is today, my firm PPR will not sell a note to a buyer unless they are placing it with a licensed servicer. In other words, we’d rather have the deal fall through than to take on the liability. You see, with the current regulations, we’re now liable for who we sell or transfer that data to.

Related: The 8 Non-Negotiable Habits of a Successful Note Investor

Collateral

The next part of the process is the shipment of the collateral to the new note owner or their document custodian. This part of the process falls under document management.

If your docs go to a document management company (like a Richmond Monroe or Orion Financial), it’s pretty straightforward to get them to run an exception report — or in other words, to do document inventory to see what is or is not in the collateral file.

If for some reason something is missing, you can refer back to the provisions and timelines in your NSA. Then, you can reach out to the note seller to see if they can assist. If all else fails, you can get a document retrieval company to try to obtain the missing documents.

If the documents are coming directly to you, it’s pretty much the same process, except that you’re doing the inventory procedure to see if anything is missing. If there is, you’re pretty much doing the same things that I referenced above.

So, What Needs to Be There?

This an interesting question because you’ll get different answers, especially from different note gurus (primarily in the seller financed world). And I get it — the more pristine the paper, the more valuable the notes. In fact, some folks make it part of their business model to clean up the collateral files and then mark up the assets. These types of folks like to see everything under the sun in the file, such as the original loan applications, title policies, and/or insurance policies. But realistically, do they need to be there? The answer is no. In fact, many of these types of documents can be acquired for a nominal fee from a document retrieval company, as long as one is willing to wait.

But in the nonperforming note world, especially with junior liens, many of these things are just plain missing. So, what should be in a loan file? Well, for me, it’s whatever documents are required in that state in the event I would need to foreclose.

This can actually vary pretty dramatically, so you may want to check with your foreclosure counsel in whatever state you’re buying your nonperforming note in. For example, only a handful of states require an allonge chain. This is a chain of note owners. On the other hand, an assignment of mortgage (AOM) chain is pretty much required everywhere.

Keep in mind, although these two document chains are preferred to be complete, there are valid situations where they will not necessarily be in sync.

If the note is sold between banks or members of MERS, the assignments are transferred electronically within that system. If the note is then sold to someone who is not a member of MERS, it would be a paper assignment that would need to be recorded at the county courthouse. Therefore, only the recorded paper assignments would make it into the file, thus making it impossible to match the assignment chain with the allonge chain.

The note and mortgage are comprised of two legal documents: the financial instrument (note/line of credit) and a security instrument (mortgage/deed of trust). Both documents have their own methods of endorsement: the endorsement of a note (often referred to as an allonge) and the assignment of mortgage. Both are legal documents that can exist without the other.

Another example is if a more superior lien forecloses and there is no equity to protect your lien’s position. In this case, security instrument is extinguished, but the financial instrument stays intact.

In in the event of a chapter 7 discharge, the financial instrument is extinguished, but the security instrument stays intact.

Their exclusivity is the reason why each needs to have their own chain of title and is also the reason why chains of title do not necessarily need to match — because in some cases, they simply cannot.

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Related: 7 Common Challenges Real Estate Note Investors Face

Sometimes the owner of the loan and the servicer are different entities. However, there are situations when the owner needs to assign the mortgage to the servicer for purposes of enforcing the security instrument. You would not, for example, want to also make the servicer the beneficiary of the note. This is a common cause for the chains of title not matching.

Lastly, situations exist where pieces of the chain are missing or were never executed. Sometimes, the entities involved cannot be contacted or have been dissolved. It is common practice while curing collateral issues to skip over unobtainable pieces, as long as a clear chain of title can be made from the originator to the present beneficiary.

As for the basic documents, such as the mortgage, the note, the assignments, and the allonge chains, it’s great to at least attempt to have these basics in the file. However, it is often fixable if any of these documents are missing.

A mortgage, for example, is public record, and a duplicate can easily be had. An assignment or allonge can often be retrieved, or a lost assignment or allonge affidavit can be created. You can even create a lost note affidavit, but in some jurisdictions, this may make it difficult to foreclose, so you would need to check with your foreclosure counsel in that particular state.

As you can see, these are some of the things to know and check on once you bought a note. So, if you’re new, it may make sense to know your note seller, check your contracts, use a document custodian, and by all means, use a licensed servicer and foreclosure attorney in the same state as the note you’re buying.

What are your thoughts on this topic?

Happy investing and let me know of anything else you look out for after buying a note.

About Author

Dave Van Horn

Dave Van Horn is President at PPR The Note Co. - an operating entity that manages several funds that buy/sell/hold residential mortgages, both performing and delinquent. Dave has been in the Real Estate business for 25 years, starting out as a Realtor and contractor and moving onto everything from fix and flips to Raising Private Money.

10 Comments

  1. Patrick Desjardins

    My thoughts on the topic is it seems virtually impossible to cover absolutely everything in a few days of due diligence. There are just too many variables. That is the one aspect of NPNs that I really don’t like – there’s an element of chance that you can’t really control.

    2 recent examples come to mind for me:

    – a chain of title which took Richmond Monroe 6 months to fix (the one we talked on the phone about) – they just couldn’t find the right people to do the corrections

    – a first mortgage foreclosure where roof, HVAC, water heater all needed to be replaced on day 1. It’s still going to be profitable, but it would have been near impossible to anticipate based on a few BPO pictures, and it’s way more than the 5k a lot of people budget for in “paint and carpet” repairs.

    Just my 2 cents. I still like notes, they have great things going for them, but there are also a lot of frustrations.

    • Dave Van Horn

      Hi Patrick,

      Thanks for chiming in.

      There’s no denying the amount of variables and nuances in NPN world. The issues you’ve mentioned above aren’t necessarily uncommon, in fact, we’ve run into similar challenges ourselves. Having gone through it though, I can say that it does get easier. The more data you have and the more you deal with document retrieval companies, note sellers, contractors/BPO agents, I hope that like us you’ll come to the same conclusion.

      I think it’s always important to evaluate one’s strategy, the issues that arise, and the positives in with every note investment. After every deal, we teach our asset managers to always ask themselves:
      – What went right?
      – What went wrong?
      – What should I do differently?

      Sometimes with these issues there’s no one size fits all answer. If it were me and I had the chain of title issue I might ask myself what I could have done to either mitigate this (and if that were even a possibility) and what can I do to avoid this issue in the future. Should I have called the previous note owner(s) sooner? Should I have used a different document retrieval company? Was there a way to escalate the process with this company? (many times the more accounts you have, the more clout you have with making demands…this is something we learned over time) Could I have created your own lost note or lost allonge affidavit (like I mentioned in the article)? Of course, none of these strategies are always applicable but just want to give you and other investors in the NPN space some suggestions for the future to help with some of these issues caused by that element of chance.

      As for the due diligence with repairs, this too is something we’ve seen ourselves and other note buyers get better at with more experience. For us, one of the main things we’ve learned is to not not rely solely on the BPO. This is because most BPO realtors don’t have expertise in the areas of repairs or determining an accurate ARV. Your BPO is only as good as the agent, so we’re constantly interviewing and re-hiring to find the best BPO agents. Not to mention we also try to get boots on the ground in the form of a contractor or someone with repair experience to look at the property. It’s impossible to know everything beforehand, especially with the interior of a property, but many times an accurate estimate with the exterior can give you a lot of clues to judge the inside.

      This business, especially in NPN world, is one of opportunity vs. risk and it’s problems like these that warrant the deep discounts we all see on these assets. Houses purchased for pennies on the dollar or even half price come with their fair share of problems and surprises as well. I think the silver lining in all of this was you were still profitable and it’s given you more experience/data for the future.

      Also, want to mention, this area is more of an expertise of my partner, Bob Paulus who will be joining me on our next Note Buyer Q&A call. As the head of Borrower Management at PPR, he can definitely offer more tips and answer any deal questions/concerns like these that you or other note buyers may have better than I can.

      Hope to see you on the call Patrick.

      Best,
      Dave

  2. Mike Abel

    Great post Dave! What are the ways a note holder can mitigate risk of a foreclosure and bankruptcy?

    Also, in the foreclosure and bankruptcy examples, would the note we worthless or any chance to recoup part of the note value?

  3. Dave Van Horn

    Hi Mike,

    Thanks!

    To answer this question fully, I would need a lot more information about a specific asset that is going through a foreclosure or the bankruptcy process, as well as info on the borrower, the location of the property, it’s condition, etc. Also keep in mind that foreclosure laws, expenses, and timelines vary from state to state, and bankruptcy law is federal but can be interpreted differently depending on which BK jurisdiction the property is in.

    I should also mention that depending on the type of note you buy, bankruptcy and foreclosure may not be as common as with others. Different categories of asset classes have higher probabilities of certain outcomes. So for example, a delinquent upside down 2nd mortgage, with no equity, has a lot higher probability of getting wiped than a 2nd mortgage that is current on the senior lien, with equity. When looking to purchase notes, just like with Hard Money (where an investor completes due diligence on the property that secures the rehab loan they lend on), note investors do the same thing when evaluating a note and mortgage pre-purchase. This part of the due diligence process of analyzing the property is what partially mitigates the risks that come with Foreclosure or Bankruptcy.

    But to speak to it generally, I have to first point out that the notes we work with are collateralized by hard property, making these notes secured assets. So this almost always allows for the opportunity of some sort of recourse that can definitely lead to a profit or at least the ability to recoup part or all of the initial investment.
    When talking about foreclosure, I want to point out that if an investor has to head down the this path, it doesn’t mean the odds aren’t in his/her favor. In fact, we’ve found that just initiating foreclosure alone can often motivate the borrower to make the decision on whether they want to stay in or leave the property. And if the note owner completes the FC process, they are now at the stage of exiting the deal through the property (whether by selling as is, fix and flipping, buy and holding, renting, etc) which can definitely warrant a profit.

    Now bankruptcy depends on a few factors. If you’re buying a note that is currently in BK, you’re usually buying it at more of a discount than a typical note and should be expecting only a certain percentage of these to have a favorable outcome. If you have an asset where the borrower decides to file BK, there are several potential outcomes based on the characteristics of the borrower and the underlying asset when they actually file for BK and the type of Bankruptcy they file for (whether it’s Ch. 7 or Ch. 13). Bankruptcy is really about borrower intent, do they intend to walk away from their debt or restructure it?

    So for example, if it were a Ch. 13 BK, after a hearing and proceedings, the borrower would be looking to restructure finances and the bankruptcy trustee will attempt to put them into a payment plan for their debt. This is usually a favorable outcome for an investor who bought a lien at a discount. Essentially, this exit is like a loan modification and we’ve even seen cases where the payment to the trustee was more than our initial modified plan would have been for the borrower. Also keep in mind, the borrower has to qualify for this plan and be accepted by the bankruptcy trustee, and after that point they would then have to complete the plan as well. If the borrower is ineligible or if they don’t complete the plan, you can continue with normal Foreclosure proceedings.

    In a Ch. 7 BK, borrower’s usually file to relinquish the property or they want to discharge excess debt (especially unsecured debt). This is why being a secured lien is so important. Now there are sometimes cases, where the borrow wants to relinquish the property and walk away from the property and the debt BUT as a note owner, you could still pursue the property (just not the borrower).

    When dealing with bankruptcy or foreclosure, it’s really a case-by-case basis in terms of the outcome. Have we gotten wiped through BK or FC? Of course, but we’re dealing in volume and it’s usually with assets that have a higher probability of said outcomes, and oftentimes these types of assets are purchase for a deeper discount. So to put into perspective, if there wasn’t a chance of being wiped and we were profitable on 100% of the deals, they probably wouldn’t sell for such a discount.

    Hopefully this answer and info above could give you some perspective.

    Best,
    Dave

  4. Crystal J.

    Thank you Dave for this article. I’m purchasing my first non preforming note. I’m reading all of your articles on Notes, they have been tremendous encouragement. I don’t feel as nervous pulling the trigger. 🙂 Again, thank you.

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