Purchasing notes is becoming increasingly popular among real-estate related investors, but few truly have a full picture of what they are doing when it comes all of the things that could go wrong in a deal. Hotel gurus and those that post to forums normally don’t have a formal credit background to truly understand the nuances of note buying. In this installment, we explore 7 things that can erode your lien position when you hold a note.
SERVICING COSTS: Servicers are one of the biggest wild cards when it comes to expenses for managing loans that you own. Many loan investors pay little attention to the servicer’s fee schedule. Usually, it looks like the menu at The Cheesecake Factory. There are normally a seemingly endless number of events that can trigger a fee. A charge for this. A charge for that. A charge when the borrower sneezes. Fees can really rack up adding to costs and eating into any yield that you hope to get on a loan. A good portfolio manager (perhaps you if you are managing your own paper) will watch servicers like a hawk to make sure they aren’t milking the bill.
LEGAL FEES: Let’s face it, lawyers can really rack up the fees. One of my old coworkers used to say that there are two people that you always want to pay. The IRS and your attorney. When a borrower stops paying, an attorney usually gets involved very quickly. Whether your servicer engages the attorney or you do, it’s not cheap. For residential deals, we make sure we have agreements with attorneys to adhere to the FMNA fee schedule for foreclosures. At least that was you know what they are going to charge for a plain vanilla foreclosure. If, however, the foreclosure process does not go as smoothly as planned, all bets are off with respect to how you are charged. It’s true that you can add legal fees to the loan balance, but if the borrower isn’t paying the mortgage now, what makes you think they will pay once the legal fees are added.
ACCRUED INTEREST: Although a borrower might stop paying, interest continues to accrue. You might have leveraged your portfolio with a lender. Do you honestly think that the entity that loaned you the money to buy the loan will stop charging you interest on your money? Sure, you can tack the interest that the borrower owes you onto the loan, but here again, what makes you think that if they aren’t paying on your loan that they will ever pay you. A good portfolio manager accounts for the fact that delinquency occurs. Carrying the debt service on your leverage must be taken into account in your modeling.
MARKET DOWNTURNS: I remember right before the crash of the late 2000s that nearly everyone was sticking to the same philosophy…”Real Estate always goes up.” We of course now know that this statement is not true, but if you would have told the vast majority of investors in 2005 that the housing market will crash, most would have laughed at you. All asset classes, whether is precious metals, large cap growth stocks, or real estate, will follow cycles. They will go up and down. Before you say, “this time it’s different,” remember that’s what people have said throughout history. What goes up must at some point come down. In the early 2000s, many lenders were lending at 100% to even 125% of the collateral value on the property. Are you old enough to remember Hall of Fame pitcher Jim Palmer touting 125% LTV loans for the Money Store? Have you heard of the Money Store making those loans today? Of course not. They went belly up. Markets always correct. You must keep that in mind when lending.
TAXES: The tax man always gets his pound of flesh. Whether it’s Federal, State, or Local taxing authorities, they want their money before anyone else. Servicers, lenders, and note holders that fall asleep at the wheel can quickly find that their lien position has been eroded by delinquent taxes from the borrower. In many cases, delinquent taxes get to jump in front of the first mortgage holder with respect to lien position. Any note holder must pay attention to delinquent taxes on the part of the borrower. Failure to do so will result in you losing more than your share of collateral.
LACK OF INSURANCE: At one point, we went “naked” with respect to insurance. It was a real risk, but we squeaked through. No longer is that the case. If borrowers aren’t paying their mortgage, they probably aren’t paying their homeowner’s insurance premiums either. As a note holder, you are then forced to purchase “force placed insurance” to cover you in the event of a tragedy that would destroy all or part of your collateral. These premiums aren’t cheap and you might not ever recoup that coverage from the borrower. Extra expenses such as force placed insurance must be accounted for when modeling a loan purchase.
CLAW BACKS: Claw backs are quite rare, but they happen. They’ve happened to us. A claw back is when the selling entity or a regulator attempts to force you to sell back a loan to them, even if you have added value by rehabbing the collateral property or foreclosing on the note. Many years ago, we bought a commercial note for more than $2 million. Shortly after we purchased the note, the bank that sold it to us was shut down by Federal regulators. We ended up getting the property back, stabilized it, and sold it to a REIT. A few months down the road, we received a letter from the FDIC stating that they sale wasn’t proper and they were “clawing back” the sale. We engaged our attorney to address it and, luckily, we had strictly followed the rules when purchasing the note. We could have taken a major, major hit on the deal if we had lost. Claw backs are extraordinarily rare, but they do occur. Make sure you dot your I’s and cross your t’s when doing a note purchase.
When buying notes, most buyers either pay little attention to things that could possibly go wrong or they are ignorant of the bad things that can happen. If you are buying notes, truly educate yourself…not from a hotel guru or a forum-based website, on the industry so you can keep yourself out of trouble.