Your Guide to Performing Due Diligence on Real Estate Notes

When it comes to note investing, it’s very similar to investing in real estate in that you make your money on the buy. So, it’s very important to do the proper due diligence given that you’re only as good as the data you have at the time of purchase. That data can be used to determine the likelihood of a favorable outcome with your notes, whether that means collecting a nice stream of cash flow or exiting the note deals with a positive chunk of revenue.

Obviously, due diligence varies based on the assets and class of assets that you’re looking at just like it does in real estate. The criteria we use when buying mobile home parks and vacant ground varies greatly from stuff we look at when buying single-family homes.

This is the same with note investing. Someone investing in performing notes may look at different data points than someone investing in non-performing notes, and so on.

So, what data points are note investors looking at?

Performing Notes

With performing notes, whether it’s first or second mortgages, many investors tend to focus on four main things:

Borrower’s Pay History: A solid pay history is important because the longer a note pays, the odds of a default decrease, which affects a note’s classification and pricing. The same rule of thumb applies for arrears payments, which can show how financially committed a borrower is to their new payment plan.
Credit: The borrower’s credit, which is usually more important at origination, can also be used to study the trends of a borrower’s credit in relation to their other current bills. With second mortgages, the most important factor a credit report provides is usually the senior lien status.
Equity: Equity in the note backs up an investor’s capital. Therefore, if for some reason the borrower were to re-default, there are more exit strategies available, especially those that involved exiting through the property (i.e. foreclosure, short sale, deed in lieu, etc.).
Geography: When buying a first mortgage or a high equity second, an investor may be more concerned with geography for a variety of reasons, including determining foreclosure costs and timelines that differ from state to state, as well as demographics, population, and job growth.

Non-Performing Notes

With non-performing notes, regardless of what lien position the note is in, it’s absolutely necessary to get clear on the property value, the property itself, the borrower’s intent, and the potential deal exits.

First Mortgages

Specifically for non-performing first mortgages, due diligence items can include:

Value (FMV or Fair Market Value): Determining value is critical since it shows how much equity is backing the property.
Title & Occupancy: An investor should obtain an O&E (Ownership and Encumbrance) Report to determine liens, ownership, and occupancy status.
Taxes, Insurance, Municipal Liens, & HOA (Homeowner Association) Fees: Depending on the note and its location, any of these can be risk factors because said fees could be lien-able in some states.
Location, Comparable Property Values, & Property Condition: Also, obtaining a BPO (Broker Price Opinion) is recommended to validate location and to try and get an idea of the neighborhood and/or property condition. It can help determine occupancy and value as well.

Second Mortgages

Due diligence on residential junior liens can vary dramatically depending on the type of lien. For example, high equity second liens require due diligence similar to that of a first lien because they’re backed by equity, so these junior liens could go through a similar foreclosure process as first liens, leaving investors with a favorable outcome even if they have to exit through the property.

When looking to purchase a no equity second mortgage, there are a few other factors to consider:

Senior Lien Status: More important than value, senior lien status and monitoring is important for all second liens but especially for no equity seconds. This is because when a borrower is current on their senior lien, it tells you two things: the borrower has a likely source of income and a desire to stay in the property.
Occupancy: Occupancy provides better odds for a favorable outcome since the borrower would likely want to stay in their home.
Fair Market Value (FMV): FMV is crucial to determine which category of note to buy at the right price. For example, an equity note would cost more than a partial or no equity note.
Title: Rarely pulled at acquisition on seconds since it’s normally done at origination, title is usually not a big risk since it’s usually covered contractually in the NSA (Note Sale Agreement) for lien position and validity.
Taxes & Insurance: These are also not as important since they’re usually escrowed and paid for by the senior lien.

Depending on the type of asset and class, an investor will eventually start to know what’s relevant and what is not. Now, the best advice is to begin track the data. As an investor, the information collected on the performance of the assets you’ve purchased will prove invaluable when making future trades.

Now you’re on to what hopefully proves to be some profitable exit strategies.

So, let me ask: What data points do you look at when performing your due diligence?

Leave your comments below!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.