How do I get started Investing in non-performing notes?

[Justin Cabral]

Not sure about you guys but I thought last weeks Podcast was pretty powerful. It really got me interested in looking into purchasing non-performing notes. 

I read up on it since and have a better understanding of how it works. I just don't entirely understand the level of risk involved yet. In all the due diligence I have done I have only seen the positives which kind of scares me because I don't want to be surprised with the negatives after already making a move.

Any suggestions on how someone should get started or how I should go about finding a mentor that is well experienced in note investing? 

[Dion DePaoli]

I got pinged and have some time so I will add to what Jay and Paul have mentioned.

First let's cover the actual risks:

1. Lose all of your money

2. Lose some of your money

That is actually the easy stuff to point out. The manner in which either of those two things occur are pretty numerous. The risks are also a little different depending on lien priority. Junior liens are innately more risky than first liens. That should be pretty simple to understand. Junior lien's claims to equity are inferior to senior liens. So in general there is a higher chance of not being able to recover at all due to being in a junior position as those senior positions claim all the available equity leaving none for juniors.

Past that the complexity of collecting on notes stems from two ideas the collateral and the security instrument and note. Most folks have a notion of what it takes to collect from the collateral which is the real property. Real property has a value many can understand. Most folks have access to resources which can aide in the determination of value such as realtors, appraisers, other investors or even themselves.

All that said, there is difficulty mastering recovering from real property in loans because the way real property works in note investing is not like it works in other versions of the same. As a note investor you do not have rights of a property owner nor is the property owner necessarily cooperating with you. This makes it difficult at times to get a good assessment of value and disrepair. The impact of overvaluing an asset should be pretty straight forward. You bank on getting $X out of collateral only to find you can only get less than $X which will at the least diminishes your return. In some circumstances those unknown conditions of the property, which require substantial repair and translates into larger capital demands, can become a fast track to zero profit and losses.

On the security instrument and note side of things the complexity increases exponentially. The security instrument and note needs to be made in line with compliance and regulation. You must have proper legal and equitable rights to the security instrument and the note. They also must be held and serviced properly in line with compliance and regulation. As if that is not enough, borrowers have rights, remedies and defenses against claims and actions related to the security instrument and note.

In case any of that over simplification sounds, well, overly simple, we can expand into some detail for a moment. The documents themselves need to be properly prepared and contain proper languages according to federal and state law. Further, they must be properly executed and recorded. They must contain terms which are not improper. Then they must be properly held and accounted for. Communication with the borrower must be compliant. Actions including collections, preserving and protecting interest and enforcing remedies within the documents must be done properly according to state and federal law. Then we have the borrower's rights to defend themselves against your claims, to legally discharge your debt and to redeem the property from the lien.

If most of that sounds uninformative and vague, that was my point. What you should be thinking about right now is what any and all of those things mean while not knowing what it actually means. Welcome to being a newbie note investor. You do not know what you do not know. Nobody can give you a list of what you do not know. There is no single solution for what you do not know. What you do not know is vast chasm of information that involves many different acute details of the paper, the people, the property and the process. All of those unknowns on their own are an opportunity for you to diminish your return and loss all of your money. In NPN investing, they are all in the same box.

The notion above, which we hear way too much from newbies and gurus, about there being "multiple exit strategies" when it comes to non-performing notes is very misleading. VERY misleading.

First, let's understand a distinction, exiting the asset is not the same as removing the borrower from the equation. Exiting means you are literally not involved with the asset or a derivative of the asset any further. A deed in lieu is not an exit strategy. You didn't exit the asset you simply converted your note into real property ownership. Not recognizing the difference and understanding the risks that then follow the REO is a misunderstanding of real estate investing in general. Just because a property is surrendered doesn't mean the property can be sold. Just because a property is surrendered does not mean foreclosure doesn't have to be finished. Title typically has to be clear and marketable. Repairs and holding costs take time and money. Moral of the story, a DIL is not an actual exit, simply a conversion of asset type which is then held until sale. So there goes that one.

Next, I often hear reinstatement either with or without a modification is an exit strategy. Well, that too doesn't exit you from the asset. Literally, you just agreed to stick around and work something out with the borrower. Assumptions of lasting reinstatement or a borrower going through a long period of time without re-defaulting are not anchored in reality. Most reinstatement will re-default. In most cases that should be obvious since they just spent many months not actually paying. The value of the asset post reinstatement which may or may not involve a modification are also often miscalculated. 12 payments doesn't mean a borrower will make the next 24, 36 or 360 payments. The lack of certainty of future payments diminishes the value of the loan. The greater the lack of certainty the greater the discount regardless of calling the loan "performing" or not.  So often times you either hold the investment for longer or you take a haircut.  Like I said though, the act of reinstatement or modification is not onto itself an actual exit.  So that one is out.

Next we can move on to shorts. A short sale or a short refinance. The Mortgagee will forgive principal and create an opportunity for this event to occur. Well, short refinances should be fairly easy to understand. There are no real alternatives for distressed borrowers in the credit markets today. By the time a street level investor has a chance at the loan the borrower is miles past being able to qualify for a refinance having likely been in default for many months. Credit scores will be pretty low and the mortgage account will be past due more than 60 and 90 days. On a side note, to suggest that a Mortgagee can influence a borrower's current or future FICO is irrational. Unless you plan on paying their bills for them, you probably can't "help" them improve their credit.  Not to mention, most street level investors do not use Mortgage Servicers who actually report to the credit agencies.  

So then we have short sale. It is within the power of a Mortgagee to forgive principal and allow for a sale of the property. Now before we celebrate having one alternative to foreclosure let us not forget that ANY forgiveness of principal by a Mortgagee is an income event for the borrower. So before we convince ourselves we can save the borrowers and save the world through forgiveness of principal imagine how concerned that borrower is going to be when they find out that the $20k, $50k or $100k of principal you are willing to forgive will force them to pay income taxes on the sum forgiven. In reality if they didn't have a couple hundred or thousand dollars to pay the mortgage payment they will not have thousands or perhaps tens of thousands laying around to pay the tax man.  This is also separate from a borrower actually wanting to work for you so you can get your money.  Selling property as we all know can be a little bit of a hassle.  Letting potential Buyers in to view the property.  Working with a real estate agent.  To some extent even having the stigma of having to short sell the property can cause the borrower to simply not want to make it their problem.  Mind you, while they are the property owner, they control everything not you.  Again though, once they find out they can be taxed on the forgiven sum it is probably going to be a less attractive solution for them to cooperate with you.

And so, that leaves us one strategy to fill the holes for the great majority of all defaulted loans not accomplished by the "multiple exit strategies". Foreclosure.  Ironically, it is actually the only disposition you can actually plan for and yet so many newbies want to treat it as a last resort.  It is more prudent to treat it as the primary strategy and the others simply a bonus "if" you can accomplish one of them.

Foreclosure takes time. Time means costs. The longer it takes to get through foreclosure the greater your costs will be. Along the way to foreclosure you will need to advance on taxes to protect your interest. You will need to pay for insurance to protect your interest. You may need to preserve the property to protect the value of the property and your interests. You will need to pay your legal fees to foreclose. You will also, hopefully, need to pay your Mortgage Servicer to help keep you compliant.

Bear in mind, once foreclosure is granted the property goes to auction. A Mortgagee is not entitled to the property only the sums due under the note. So the illusions of huge returns on low LTV loans are not practical. If the property doesn't sell at auction now you have more costs to repair, market and sell the REO.

As was mentioned above NPN's are probably some of the most complex assets to mess around with and have some pretty decent chances of loss. If all you are hearing is pie in the sky - huge returns, short investment terms and all the other rosy talk - chances are the person talking has little to no real experience. You probably should not take advice from them.