Evaluate My Performing Note Business Plan

[Steve Burt]

Hi, I am hoping writing a long and detailed post will help check my due diligence process for getting into the notes business in a more thoughtful manner. I have read a ton of Don, Chris S, Chris W, Andy, Jay and Dion over the years and I hope it shows through. The experts on BP seem very friendly so my hope is showing a researched post will garner some quality responses. I hope to get some feedback on my investment and business plan. I have done a ton of research on this site and others, but I think as hopefully you will understand, there is a big leap when going from student / reader to practitioner. I would just like to know if my process and instincts are right and if I am missing anything major.

Prior Experience

My prior experience with real estate notes is purchasing a small balance non performing note and successfully working it out. However there was a lot of luck involved because the owner immediately agreed to a deed in lieu. Given that you can’t contact borrowers before buying, this success was sheer luck in my opinion. The gains were offset by doing things like paying for BPOs on 6 target properties, bidding 3, and only winning one, as well as paying off back taxes which I knew about beforehand over the course of due diligence. Overall it went well.

Go Forward Plan: Sourcing

I have cultivated a list of brokers and receive tapes from them routinely. I have been on these lists for ~3 years, so I am confident in their reputability. A couple I have met personally at conferences. I also check Paperstac frequently, but I think the real professionals favor brokers more due to pricing. I would like my first note to be done through paperstac because of the services they offer though. I don't see much inventory on sites like Madison.

Go Forward Plan: Short and Long Term and Return Target

The challenge to me is that the process for performing vs non performing is very different. Being an expert in one, is not the same as having expertise in another. Yet any performing note can become non-performing at any time. Especially if I plan to invest in this asset class for the foreseeable future because of recession risk. My plan is to target performing notes for the first few years. My goal is 10-12% yield, which I believe is reasonable. Then add in non-performing, but really only focus at one thing at a time. I think you need the non-performing skillset due to inherent credit risk in performing notes.

Geography

I developed a list of target states to become knowledgeable on their notes laws and processes. I picked them based on market size and things like ease of foreclosure. I chose in order TX, GA, MO, TN, VA, MI, and AL. Now that I have these markets, my plan is to reach out to real estate agents and lawyers in major regions so I can estimate foreclosure cost and have someone to contact for a BPO / local market questions. Texas is so expensive but my goal is to own a note this year so the size of the market was attractive. My checklist for understanding a market is: Judicial v Non Judicial, Time to Foreclose, Licensing Requirements, Deal Flow. Within the state I avoid rural areas or depressed economic ones at least starting out.

Deal Size and Valuation

For me a big challenge is making sure you target the right size note to buy. While a $5k note yielding 10% is a nice entry point, if there are any fees required to foreclose or even just diligence expenses could significantly impact the yield of a small balance note and I really struggle with this dichotomy.

My plan for this is to consider a metric like Investment to Value when considering foreclosure cost implications, because when it comes to that point, I will be trying to take control of the property. As an example, if I paid 5K for a 7k UPB Note, on a property worth 20k, then paying 2K for a foreclosure would make sense because then I would be looking at selling for 20k (and 7k of costs on 20k value also builds in some rehab cushion if the place gets trashed). This would provide enough room to roll in foreclosure costs into the revenue from a Sheriff's Sale.

For valuing a performing note on a presumed performing basis, I would be looking at the yield I am bidding at and then consider the after expenses yield where I net against my bid costs for title search, possible credit check, servicing costs, BPO, and an accrual for potential foreclosure fees.

Target Property Types

For types of properties, I am targeting any structures but eschewing vacant land unless the metrics are highly favorable or the land is in a desirable place like near a popular lake. I am concerned that if I had to foreclose on land that the sales cycle would be very long. As an example I think this note is a no-go. I liked it at first because it was affordable for me, in a target state, and priced at the yield I wanted. However Seminole is a tiny town of 6,000. That is not really close to Midland or Odessa, though Seminole does have a Walmart, which is a positive indicator for me. This note has been on Paperstac forever, and Zillow vacant land valuation per acre in Seminole is all over the map. So maybe my initial view of this note as a no-go is incorrect. If it had provided payment history I might reconsider but they don’t so I pass.

Ideally they would not be owner occupied, but I just don’t see the volume of rental performing mortgage notes on Paperstac to count on it.

Due Diligence Steps

Valuation

I built a model which allows me to enter in my proposed bid and see LTV, Yield, and ITV, and see the monthly payment on the loan. I can also add in appraisals from a BPO or Zillow to see more metrics based on my bid. In the future my sheet will hopefully pull in labor and economic statistics automatically for that zipcode to see if I am bidding on something in a depressed area or not. For now I just do it manually.

My theory is that in the beginning I should bid at values well below the Paperstac average bid metrics on properties that I feel have solid resale value and/or borrowers have strong payment history. As an example my last check of Paperstac data said 1st performers went for about ~77% of UPB. I would be targeting ~65% of UPB and hoping for the first couple of times to find a seller who really needed the liquidity. The risk is something that goes for cheaper than average has some hidden problem or that lower market bids reduce my win rate.

Payment History: To me this is the #1 thing in performing notes. I see a ton of notes on Paperstac priced as performing with less than 1 year’s worth of payment history or worse they are newly reperforming priced as performing. I am cautious of these and won’t bid them. I think this is the right call. I think my ideal is 3 year’s of payment history or even more ideally targeting a paying loan near the end of its life. I will only bid on notes that have a reputable, recognizable servicer like an FCI. I don’t really see myself bidding on rehabbed notes with 1 or 2 years of borrowing history priced as if they were performing either. 

Borrower’s Credit/Bankruptcy History:

I think this is second most critical, but also tricky. Mortgage payment should be the top priority for a borrower to pay, but credit scores take major hits even if you miss small payments on other things. I lost 70 points on my score once because I lost track of a bill for $1 that was only sent to me via snail mail. I think what I would look at the most is % utilization of credit over time which hopefully shows up on these reports. My concern is that if I am too strict on this, then I end up pulling dozens of these and never doing a deal, yet paying a ton of money on diligence. Also it seems like some notes do not let you run borrowers credit until after you buy the note for some reason. I saw that on the BP Forum.

For bankruptcy I plan to review PACER which has a very nominal fee.

Title: In my mind I pay for this every time. This is to determine chain of ownership, and any encumbrances like unpaid property taxes, utility bills etc. I don’t lose sleep about this because everyone says Pro Title is good and I only pay for this as a final step before closing, so if the chain is broken or something I would just bail on the note. I am familiar with searching property taxes so I think I would purchase the O&E and 2nd position searches.

Legal: My plan here is to have a lawyer contact in all of my target markets. I need 2 critical pieces from them 1) cost to foreclose and time associated 2) If there are any special regulatory requirements in their state to purchase notes (i.e. register as a foreign entity etc). I also need to understand things like could a RE attorney in Houston handle a foreclosure in Dallas. If not, I would have to expand the network I use. I can then estimate foreclosure cost as legal expenses + potential outlays to keep up the property in the interim. I started identifying lawyers in target markets by trawling the BP forum archives.

Licensing: Checking with each target market state to make sure I don’t need a special license or need to register as a foreign entity. For example In GA you need a license to buy and sell notes if you hold more than 4 notes. I plan to ask 2 different GA Real Estate lawyers this because as you can see its tricky. I would repeat this for other markets.

Property: When evaluating performing notes, my plan is to focus on the appraised value and make sure there is enough buffer there to cover foreclosure costs or offering cash for keys if needed. For example, if the property value is equal to the sum of all outstanding liens, then there probably isn’t enough room to pass through legal and upkeep fees if the property went to auction. A deficiency judgement could be rendered so I would stay away.

Before bidding I would make sure the property appears maintained and in a quality area via google maps and such. After bidding I would ask the note seller if they had updated pictures with embedded EXIF data for verification. If the note is over a certain dollar value I would also pay for a BPO and get a real estate drive by.

Admin: Each note will have transaction and servicing costs. Par for the course.

This is my thinking as of today. I still feel like I have a ton to learn but I think there is a point where you have to learn by doing.