You just received a tape of mortgage notes and would like to know if you have a good offer in front of you or not. Or someone is offering you to purchase a seller financed note and you need to know what to offer for the note. Well, the first step is to perform due diligence on the asset to determine how safe or risky the note is.
First of all, let define “due diligence”. Due diligence is the process a buyer goes through BEFORE
making a purchase. Many times we do this intuitively. For example, when we buy a pack of gum we might glance at the checkout counter shelf to see what brands, flavors and prices are available. We might do some research before buying a car, such as getting online quotes and visiting a couple dealerships. Already there is a lesson here, when buying a pack of gum our due diligence lasted a couple seconds and in the case of a car it might have taken a couple weeks. In the case of the pack of gum, we made the decision that it was not worth it to spend too much time and effort for a purchase of less than a dollar. In the case of the car, we might have spent a few weeks because the purchase was for a much higher dollar amount. So just like it would be irresponsible to purchase a car without doing a lot of due diligence, it is probably not necessary more than a few moments to evaluate chewing gum.
This particular article focuses on a particular asset class - the purchase of mortgage notes. Yes, you heard correctly, we are not talking about purchasing real estate or getting a mortgage from a bank to purchase real estate. We are actually talking about buying a mortgage note from a bank or whoever the current owner is.
Why would we want to purchase it? The answer is simple. We will be buying future cash flows that will be higher than the purchase amount.
The due diligence process as it relates to mortgage notes will come down to analyzing the mortgage and determining how risky or safe the particular mortgage in question is and if it’s commensurate with the predicted returns. This consideration will not be made in a vacuum. You will have to take into consideration your personal risk tolerance. Some people will be okay with a lower return if they can assess that the risk is lower. Some folks will want a higher return but this in turn will probably mean that they will have to buy riskier assets. For example, some note buyers prefer purchasing non-performing notes because they can acquire them at a lower price point. As the name indicates, they will not be receiving any income until they either get the borrower to agree to start making payments or they take over the collateral. Some folks specialize in purchasing seller-financed notes. Some buyers only like senior liens. Other might be comfortable with junior liens. In general junior liens will offer higher returns, but they are subordinate to the first lien.
Know you seller
The first place to start your due diligence is with the seller. The mortgage note business is a relationship business. Finding a constant and reliable source of product can be extremely difficult. Many times, you are relegated to having to purchase notes from a variety of sources. Every time you are buying from a new seller, it behooves you to do some research on the source. At a minimum, ask around your community and find out the seller’s reputation. If the purchase is big enough you might want to run a background check on the principals to find out what kind of judgments they have against them.
Note sale agreement
The next place to focus your attention is your Note Sale Agreement (NSA). Go through it carefully and find out what kind of representations and warranties are being made:
- Are these notes being sold with recourse or without recourse
- Does the seller offer a refund if the note is not valid
- Does the seller offer some sort of service if the borrower stops paying
When you purchase real estate, you will get a deed to the home in your name and the keys to the property. This is normally done at a closing where all the documents and consideration are transferred back and forth. Except in the biggest of transaction, in the note business, it is much more common to fund your purchase and then receive the documentation. The documents you should be receiving at a minimum are:
- Promissory Note (signed by the borrower)
- Mortgage or Deed of Trust (signed by the borrower)
- An assignment from the seller into your company
The documents as a set are known as the collateral files. As we mentioned, it’s not uncommon to get the after you fund. There are methods you can use to protect yourself as a buyer. These include
- Using escrow for the funds and collateral
- Obtaining a bailee letter
Getting a power of attorney from the seller (to create your own assignments and allonges instead of waiting for the seller to provide them)
Stage of the note in its life cycle
Another way to classify and therefore analyze notes is to determine where they are in the life cycle of the note. The different types of notes and how the should be analyzed follows.
Newly originated notes
The amount and type of due diligence will vary depending on the type of note you are looking to purchase. Due diligence performed prior to origination probably needs to be the strictest. It is especially important, given the current regulatory environment and especially if it’s an FHA loan or a loan for a primary residence. When a borrower applies for a mortgage to buy a house, the loan broker and/or underwriter will fill out the underwriting guidelines form (1003 Form).
In the case of hard money lender, the underwriter will base the bulk of their due diligence on the subject property they were lending and the rehab projects the borrower has performed. Lastly and not as important they will look at their personal credit history. Especially if the borrower put down a sizable down payment (30% or higher)
In this case, note buyers focus on the quality of the borrower, the underlying collateral and property condition, completeness of overall loan paperwork (title commitment report, insurance policy, the loan application, etc.) as well as borrower pay history.
These are notes that might have a spotty payment history. For example, some payments have not been received on time or the borrower has been paying consistently for a while but they are still not up to date. The notes are sometimes referred to as “scratch and dent” notes.
Delinquent and non-performing notes
Many active investors seem to go after the even cheaper non-performing assets whether it’s purchasing pools or “cherry picking” loans on a “loan level” basis and either work out payment plans/exit strategies with the borrowers themselves or hire a company to do so for them for even higher returns.
Re-performing notes/ Note with a loan modification
A re-performing note is a note where the borrower stopped making payments for an extended period of time and then started making payments again. A note with a loan modification is a note where the note owner has agreed to begin accepting a modified payment or has modified the terms for the borrower. These mortgage notes typically sell at a higher price point than non-performing note (NPN’s), but they don’t trade as high as a performer yet because they haven’t shown a sufficiently long payment history.
When a note is performing, note buyers normally focus on the payment history and seasoning, the borrower’s credit history, and if there is enough equity in the property to cover the note. An important consideration will be the yield. In other words, what are the monthly or yearly returns? This will be determined by a combination of the face interest of the note combined with the purchase price.
- The higher the purchase price, the more due diligence you will want to perform.
- By definition, due diligence is meant to be done before purchase. Don’t take short cuts. Paying to pull a credit report might save you thousands of dollars in litigation or having to sell your asset at a big loss because it wasn’t what you thought it was.
- Different assets require different diligence. Sometimes you will want to focus more on the borrower’s ability to pay and sometimes the property’s condition will be more important.