How would you structure this?

Question

I'm thinking about buying a non performing note for a small multifamily property.  Property isn't in an area where I want to manage it, nor would it be practical as it's about three hours away from me.

One of my exit strategies is to simply offer the borrower the ability to make the note performing again.  Anyone have experience doing this?

To use round numbers lets say the property is worth $100k and i'm buying the note at $50k.  I'm thinking reduce the unpaid balance and restructure the loan to be $90k at 8% interest only with a four year balloon payment.  This should generate approx $28k in interest payments and $40k in value of the note, right?

What am I missing here?

Lawyer tells me we can paper things up in the event he defaults again I wont be looking at much of a foreclosure process.

Dave Van Horn · Answer

Steve Babiak, thanks for the plug, I'm glad you asked for my input.

Steve K:

Does anyone have any experience making a non-performing note performing?

Yes, my company has 7 workout specialists whose primary goal is just that, to get notes re-performing. We own thousands of these in fact.  Our pre-purchase due diligence doesn’t involve contact with the borrower at all, of all the banks and servicing companies we deal with would never allow contact with a borrower pre-purchase, nor would we. Our due-diligence is based more on electronic data to determine value, senior lien status, BK status, etc. besides most note sellers rep and warrant a valid lien and lien position. As for accounting for a non-performing note, we just go by the last payment date applied and the UPB. Post purchase, we typically start with a mail and phone campaign prior to demand letter or lispendis, we do that to try and get a dialogue with the borrower. The dialogue goes something like this: What happened? Where are you at now? What would you like to do (stay or go)? And our workout specialists help them do that (no matter what they pick) meanwhile legal is moving forward until we have a signed workout agreement (after doing a homeowner financial analysis with the borrower, THIS IS KEY – we ask for 2 years tax returns, pay stubs, etc.) or we end up taking the property back. Working a non-performing note for us is more about the borrower than the investor. But of course our experience tells us it has to be a win-win for both of us for the plan to stick. We have a favorable outcome 92% of the time this way, leaving us only to foreclose on less than 8%. So we ALWAYS make more money exiting through the borrower than through the property, because a few friendly phone calls are always easier than securing the property, dealing with declining market values, long market time with a realtor, damage from the borrower, townships, holding costs, etc.

Typically we’ll offer a borrower a discounted payoff (many borrower’s access retirement plans, penalty free while in foreclosure), discounted arrears and payment plan, we may sell a note at a discount to a friend or family member of the borrower, or we’ll also offer seller assistance via deed in lieu (cash for keys) or short sales.
It would be extremely rare that we would create an interest only four year balloon, especially because the homeowner would most likely not be able to afford such a plan. We do the workout based on borrower affordability. We would do a plan that works for this particular borrower; and if we needed to recapitalize sooner we would do so by either selling the note, a collateral assignment (borrower against a note), or selling the partial on the note to a private investor.

As far as your collateral being taken care of in terms of maintenance: It’s usually covered in the loan docs that they take care of the property. When we purchase the note, as part of our workout agreement we’re always named insured (so the insurance company checks out the property periodically as well). If you want to send someone by the property, you can get a Realtor to do it for free too.

So here’s my advice: Make sure you check the title and escrow for taxes prior to purchasing. Make sure you get a BPO and pull fresh credit on the borrower. As far as buying 3 hours from your home, it doesn’t matter, we buy nationwide because there’s plenty of asset management and field services companies that can assist you in the liquidation process if it were to come to that.

Hope this helps!

Dave

Loc R. · Answer

Everything looks about right - my only concern is what is the actual likelihood that the (defaulted) payor will be able to make good again on (a) the payments, and (b) the balloon payment?  There has to be a (good) reason as to why the current note holder has not renegotiated terms with the payor.

You just want to make sure you eventually don't become the motivated note seller.

Steve Babiak · Answer

Dave Van Horn does this sort of thing, maybe he'll give some input ...

Steve K · Answer

Thanks for all of the responses.  I've been light on details because I haven't done much due diligence on this deal yet.  Turning the note performing isn't my preferred exit strategy for many of the reasons listed above, however if it panned out it would be a nice deal.

Current mortgagee has taken the process fairly far through the foreclosure process, however elected not to proceed with the order for rents.  Even with the smaller places it seems unusual not to have a receiver in place with an order for rents.  The asset manager is telling me that he simply doesn't want to deal with this property as he has nothing else in the area.  Whether this is the true motivation or not, who knows.

As I dig further into the specifics of this one i'll post all of the details mentioned above to paint a clearer picture.

Bill Gulley · Answer

Steve, is the borrower still alive, competent and in possession of the property? Have they filed for bankruptcy? When was the last attempt made to collect amounts due made? Do you have an accounting of payments and 1099s filed in the past? Do you have a copy of the note and deed of trust or mortgage with the book and page where it was filed for record? Do you have a copy of the sale contract and the accountings of the settlement? Was is appraised? Have you checked to see if taxes are current? Can you check for liens against the property yourself, you can have that done later on.

Was the loan made with cash or did it finance equity, as that will determine issues with default and foreclosure and how your proceed. If cash, the entire note balance or as modified can be sought for collections. If by equity, you cash outlay may determine your rights to collect under two allocations, first cash and then equity. Equity amounts do not allow for deficiency judgments and may place the borrower in a position to make calims if excess amounts are receuived from any foreclosure or sale. See your attorney as to the differences and FA Laws.

I prefer to have a seller make a simple assignment for due diligence in connection with the sale of the note. With that you are authorized to speak or contact the borrower. You shoud let the borrower know what is going on, that you will be acquiring it and ask what his interest or intentions are. You could discuss the modification with them and come to an agreement.

You can do all this prior to laying money out for the note. As part of the due diligence, with the borrower now cooperating, you can inspect the property or have it inspected. Any deficiences that effect collateral (from your LTV) needs to be addressed.

The modification can be accomplished prior to and as a condition of the sale of the note. Only the borrower needs to sign the modification, the seller does not need to be involved, your acceptance of the modification can be made as the new note holder after you buy.

Now, to your "exit strategy" you do understand and your attorney understands that buying the note is not buying the property and that you will be in the shoes of a lender to the extent of the cash paid for the note and not the holder of an equity financed installment transaction? Meaning, you may never end up with the property.

Your note due diligences should be accomplished first and then as to the collateral.

The modification will waive existing notice and notice of demands made to date. I also prefer to use a new note siting the old obligation being modified which takes care of ommitted issues, but you can go either way, changing terms paragraph by paragraph as needed along with rates and remaining balances agreed to be outstanding. This will help the attorney "paper things up" LOL

Amounts forgiven need to be reported to the IRS, this can be done when lower amounts are agreed to when the modification becomes effective. Remind your attorney.

You may also modify the security agreement of the mortgage or the deed of trust, again, usually easier to simply refile.

As Dion points out, you can have the right to review financials, unusual for a small loan especially where there is not a right to accelerate the loan upon the failure of management. Who knows what you would be given anyway, unless the borrower is required to have certified audits, for this, I'd skip that. The assignment of rents is very important to include if not there.

The deed of trust will recite that the borrower shall not "lay waste" to the property which includes allowing the collateral to be significantly allowed to go without maintenance, and that resonable inspections may be performed. Insurance assigned with the right of set off as well. And make sure you have the right to appoint future Trustees as some attorneys may simply appoint themselves forever.

There are other issues, but first get these ducks in a row.  :)

Dion DePaoli · Answer

I would suggest that you approach the modification with a trial first or forbearance.  Have the borrower pay to reinstate and then have him make 12 on time payments prior to a permanent modification.

If this is a mainstream mortgage and note, there should be language which assigned the leases and rents to the mortgagee.  In the event of default you will have to petition the court to assign those leases and rent payments to you.

Additionally, as a mortgagee you have a right to protect the real property to a certain extent in the event of borrower not taking care of the property.  Again this should be language in your mortgage and note.  It is unclear if this residential in nature or commercial depending on the units.  If the property is commercial with more than 5 units one of the default defenses you would have is the ability to request the courts assign a receiver to help manage the property and cashflow.  You can not enter the property whenever you feel like but you do have a right to check on it from the outside every so often.

Additionally as conditions to reinstate and modify the existing note you can try and insert a property manager as a requirement.  Typically in most commercial paperwork the borrower is required to turn in annual financials, ensuring you get those will help you understand the property cash flow and expenses.

So the first thing I would do is sit down and read the note and mortgage.  There is a bit more of a story to the deal that is not coming through on the post.  Such as when he made his last payment.  Did the current mortgagee file any foreclosure complaint or take any action against the borrower?

Assuming that you can simply purchase the note and get it to re-perform is theory until you actually own the note and can work it out.  Like Loc pointed out, there might be a reason why it has not yet been done.  That can include the borrower simply not wanting to work out the note or to be reinstated.  Plan to be able to address foreclosure and do not vacate the foreclosure until you get a firm hold on the borrower's desire and capacity to make payments.

The modification you propose is vague due to lack of current note settings.  If the borrower owes $100k and has a low interest rate your proposed modification might not be a positive impact.  Assuming the amortization for the note you propose is 30 years with a balloon in 4 years, you will earn $28k in interest.  The borrower will only pay down $3,400 in principal so he will have to refinance out $86.5k.  You will want to scrutinize this a bit more.  If the value of the property holds at $100k and he can maintain tenants to show good cash flow, he is in the church of new conventional financing.  That said, there is not much room for error.  If the property value fades a little due to market conditions or poor cash flow you will quickly be too high on the LTV scale for him to refinance.  This also will have something to do with his credit.  If this is a residential MF with 4 units or less and he does not live on property, your balloon requirement I would say is a bit too aggressive.  I might take a look at 7 years or frankly skip the balloon all together.  You sort of have to look at the likelihood of the property and borrower being able to refinance out.  If it is not all that high in the future, the balloon is just something you will have to deal with and likely offer an extension 4 years from now.  If you only want to be invested in the loan for 4 years and that is driving the timeline, then what you will likely be doing is simply selling the note off in the future.  Moral of the story, just because you make a balloon doesn't mean he can get a loan and pay you off.

One of the other hot buttons and perhaps a little story segment is whether the current taxes and insurance are in place and paid.  Starting a foreclosure from scratch in Florida is timely and costly.  Did the borrower file a bankruptcy already?  Just putting a bit of caution out there, some of these details matter a lot and help fill the story gaps in.  I do not fully understand what your lawyer is telling you and to a certain extent would not be so 'loosey goosey" with having to carry out a foreclosure or finish one.

Loc R. · Answer

There is really not a whole lot you can do to prevent him from turning the place into a dump.  You want to find a motivated payor who eventually wants to own the property outright (and pay you off in the process, interest included).

You should try to improve you position by getting equity somehow.  Either cash (doubt it) or perhaps a free-and-clear property that he has in his portfolio.

Steve K · Answer

Thanks for your input Loc R., those are my biggest concerns at this point and things I plan to address during due diligence.

Another question for the note guys - how do you know that your collateral is being taken care of?  Do you do occasional inspections to make sure everything is in reasonable order?  My other concern on this deal is to offer a four year balloon and end up watching him default on that while having deferred four years of maintenance.

I guess most importantly I need him to put some skin back in the game if I want to proceed this way.

How would you structure this?

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