5 Areas to Study to Know if You Bought a Good Real Estate Note Deal

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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:

  1. Death,
  2. Divorce,
  3. Job Loss, and
  4. 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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Due Diligence

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.

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2. Collateral

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.

reasons-broke

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!

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.

3 Comments

  1. Edward Gonzalez

    Note buyers BEWARE! Trust no one. Verify everything. I had one note seller send me a “tape” showing a value of $56,000 for the collateral (allegedly a house) on a 1st lien note he was selling. It was a VACANT LOT. A verification of value on Zillow is calculated by an algorithm; it does not go to the site and verify a structure. You wouldn’t think the seller would be this low and dishonest, but they were — they knew exactly what they were doing. Keep that in mind — if they’re selling, obviously they found no profitable exit.

    Also don’t accept a binding arbitration provision from the seller. If they’re reputable, they won’t need to hide behind it.

    • Dave Van Horn

      Edward,

      Believe or not, this happens more often than you think.

      Although I agree that “Trust and verify” is everything in this business, at the same time, I believe this is also a scenario that comes back to due diligence. Sometimes, a property attached to a lien can become a vacant lot with little or no notice. I’ve seen the city tear down a house without a note seller even realizing it. So especially when dealing in bulk, banks and note sellers don’t have the time to check every single property attached to every single note every day. They may do periodic BPO’s but the frequency of these may vary and depending on the note’s value, it may not be worth checking. On the due diligence side, investors should also keep in mind that AVM’s and BPO’s can only do so much in determining the quality of the property. Boots on the ground with Real Estate and/or construction experience can be a big plus. But at the end of the day, it’s important to remember that the risks that come with property improvement (or structure) are why we receive such discounts on the paper backing these properties.

      Also, I can’t agree with the statement “if they’re selling, obviously they found no profitable exit.” Mainly because, as a note seller, I know this isn’t always true. In NPN world, especially 2nds, we don’t know what the likely exit will be if we’re not in direct contact with the borrower because we don’t know the borrower’s intent. So we’ve sold thousands of loans that people made money on. Unfortunately we don’t have a crystal ball when it comes to knowing what the borrower wants to do and often times, time is of the essence after we take down a trade. I actually wrote a recent forum post of why we sell notes when we do (that goes more into detail) that you can read here:

      https://www.biggerpockets.com/forums/70/topics/348474-buying-notes-ppr

      And although I’m not an attorney, I’m not convinced a binding arbitration provision is always a bad thing either or something all note sellers hide behind. With proper reps and warrants, I don’t think this is an issue. I’ve always found that an arbitration provision is usually implemented to save legal fees (for both parties) when resolving a dispute, not necessarily to hide behind. But it all comes back to knowing your note seller and with a reputable one, this is usually a non-issue in my opinion.

      The issue of trust can not be discussed enough though, so thank you for chiming in and bringing it up. And hopefully you can see my side of the coin as both a note buyer and note seller. Happy to continue the conversation, this sort of dialogue doesn’t happen enough in the note business.

      Best,
      Dave

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