If you could do all the due diligence in the world, it still may be tough to know the true quality of a note deal, especially before you’ve reached any type of outcome or exit.
There are four major reasons I can think of for why it’s so hard to tell, and these are also the four main reasons people default on their loans in the first place:
- Job Loss, and
- Medical Issues.
Let’s face it. Bad things can happen to the best of folks, especially with most people living paycheck to paycheck.
Even so, it still makes sense to do due diligence and try to limit our risk as the investor.
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So, here are a few things to look at to increase your likelihood of getting a good deal.
1. The Note Seller
First, let’s take a look at what the note seller is selling. This is definitely a trust but verify scenario.
The old saying “know your note seller” is critical. We learned this lesson the hard way within a year or so of starting our note company. We purchased a pool of loans from an outfit in Texas, but we didn’t know this note seller very well. Then, they didn’t deliver a third of the assets we purchased.
Related: So, You Just Bought a Real Estate Note? Here’s What to Expect Next.
So, if you want a good deal, make sure you have a good relationship with a trustworthy source.
Does everything appear to be intact? Do the contracts have reps and warrants (especially for when something is missing)? As you and your custodian run through the document management process, make sure to check if the note, mortgage, assignments, and allonges are all there.
The presence of your collateral or lack thereof could have a huge impact on your note deal, especially when it comes to your ability to foreclose.
3. The Status of the Asset
What stage is the loan in? Is it current or delinquent? What are the regulatory and legal requirements, and timelines in the jurisdiction of the asset?
With some deals, you may be able to pick up where the note seller left off in the legal process, which could save you time and money. Of course, you’ll also want to make sure that it’s in the lien position disclosed, as well as verify things like equity, senior lien status, etc.
4. Borrower Intent
What does the homeowner want to do, and is the property still occupied?
Borrower intent often determines the possible exits for you deal, especially if it’s a non-performing note.
5. Risk Management
The biggest risks to your note deal really depend on what type of asset it is, especially with regard to lien position.
If it’s a first lien, you’ll likely have a higher probability of exiting through the property, especially if it’s vacant. So you may want to look at the fair market value of the property (FMV) by getting a broker’s price opinion (BPO), and to determine occupancy, you may want to get an ownership and encumbrance (O&E) report. If the property is vacant, you may even want to determine an after repaired value (ARV) with boots on the ground, as this could give you an estimate as to the scope of the cleanup.
That being said, the biggest things to monitor as a first lien holder are back taxes, homeowner’s association fees (HOAs), and municipality or utility liens.
Second liens, on the other hand, are more likely to be exited through the borrower. So, senior lien status is a better indicator of a favorable outcome statistically than even equity is. With things like escrows (for taxes and insurance), we usually let the senior lien worry about them, and we focus more on other things like checking the borrower’s credit to verify the senior lien’s status.
Do You Always Make Money on the Buy?
It’s probably more true that you would make money on the buy in down market when assets are cheap and flooding the marketplace.
Related: The 8 Non-Negotiable Habits of a Successful Note Investor
As equity comes back, the asset price increases, and there are fewer assets to go around, so it’s much harder to make money on the buy.
The real money is then made with the creativity that goes into the modification and exit. Efficiency becomes much more important, especially internally, not only with your own systems and processes, but also in how you drive your attorneys’ processes.
Sometimes, your partial equity deal becomes more valuable when real estate values increase, and it is now fully covered. Or, maybe your note is worth more now that it has a 12 or 24-month pay history. Maybe it’s the creative way you recapitalize by selling a partial or by borrowing money out through a collateral assignment of note and mortgage in order to go do another note or real estate deal.
Either way, you never really know what you’re going to make on a note unto you actually exit the deal. So, experience may become your best indicator of favorable outcomes in the future.
So, let me ask you on BP, “How do you know you bought a good note deal?”
Let’s talk in the comments section below!