Every financial cycle or economic downturn brings forward its fair share of distressed assets. In these situations, banks and lenders will often start shopping out non-performing loans to shed some liabilities off their books or even free up capital. This inevitably brings out investors looking for an opportunity to get a steal in the marketplace.
Buy low, foreclose, and get a steal on the asset,…right?
In some cases, it is that simple, but you must know what you are doing. It’s important to understand all of the potential pitfalls associated with purchasing notes so you mitigate your risk. The key to this is performing comprehensive due diligence to include review of the note and related loan documents as well as analysis of the borrower as well as the collateral securing the loan documents. Don’t fall into the common pitfall of focusing your research on the property securing the loan – you are not buying the real estate. Here we outline three phases of due diligence that will help you make the right decision when purchasing commercial notes.
Due Diligence Phase I: Analyze the Loan Documents
The loan documents are the first place to start your due diligence as that is the actual asset being purchased. A short list of items to consider while conducting due diligence of the loan documents:
- Confirm the note is negotiable;
- Compare the original balance to the current balance; and
- Ensure loan documents are complete.
Confirm Note is Negotiable.
In most cases, an investor will find that a promissory note is fully negotiable. The Uniform Commercial Code permits a purchaser of a negotiable instrument takes the note free from defenses that a borrower may be able to assert, if the investor purchaser the note in good faith for value. Some notes may exclusively exclude the sale of the note and investors should be cautious as that provides a clear defense for the borrower.
Compare the Original Balance to the Current Balance.
Always seek out a certified payment history that details the original balance, payments made, interest accrued, late charges assessed, and current outstanding balance. Remember, you are buying the note, NOT the real estate. Analyzing the balances will reveal the possible upside of the note acquisition. Furthermore, if you need to take the loan down the path of foreclosure, you will need to shore up those numbers the court as you make demands for repayment.
Ensure Loan Documents are Complete.
Regardless of whether the lender is a big bank, a familiar local lender, or a third party, always check the loan documents for completeness. Lenders may be savvy, but they can make mistakes. As a prudent investor you need to make sure you have all the documents that are needed from the promissory note, deed of trust, security agreements, assignment of rents and leases, UCC filings, personal guaranty, etc. Verify that they have all been appropriately signed and notarized where necessary. Also check to ensure any modifications were properly executed with the necessary authority. These verifications are imperative as they can impact your ability to collect if this matter is challenged in court or bankruptcy.
Due Diligence Phase II: Analyze the Collateral
The collateral is key in assessing the investor’s collectability under the terms of the note. Obviously, the more forms of collateral the better chances of being made whole on your investment by the borrower and maximizing your investment. Typical forms of collateral will include deeds of trust, mortgages, security agreements, assignments of rents and leases, UCC filings, and personal guarantees.
All forms of collateral should be carefully examined. This is not a time for investors to make assumptions that they have what they need. While this can be time-consuming, it’s critical to ensure that everything is in order.
Start with Title on Real Property.
Confirming the position on title of the mortgage or deed of trust is the best place to start. A title search will quickly uncover outstanding liens and encumbrances on the property. Pay close attention to property taxes that are unpaid as those can sum up to a large amount and prove to be quite expensive since they take priority in almost every situation.
Ancillary Documents. Depending on the type of commercial note, many investors will find Security agreements and assignment of rents and leases. Again, be detailed. Get into the leases and other documents that might be in the loan documents to assess the strength of the collateral. If you ever have to foreclose, you may be able to collect rents based these documents. In addition, consider UCC filing which also allow you to hold an interest in the personal property located at the subject property. This can include furniture, fixtures, and equipment.
Underlying Guarantees. Check to see if the lender had the principal of the borrowing entity complete a personal guarantee. This allows the lender to go after personal assets where there is a deficiency. This step leads us into the final phase of the due diligence.
Due Diligence Phase III: Research the Borrower’s Background
During the third and final phase of your due diligence process, it’s time to check into the background and financial health of the borrower and underlying principals. Review the file for the financial analysis of the borrower and related guarantors. If a single purpose entity was created, the borrower may not have any assets outside of the direct collateral. If this is the case you must look toward the guarantors which are typically the underlying principals on the loan. Pay close attention to this research and review – you need to have a clear picture of the likelihood of bankruptcy as it will add cost and delay in recouping your investment.
When investing in distressed real estate loans, a prudent investor must conduct all three phases of due diligence as we outlined in this article. Failure to do so can negatively impact the timeline and money invested.