Novice questions on Risks associated with PPRs Performing Notes

[Jamie Greenberg]

Hi all. I'm very interested in getting into the note business, and have been checking out Dave Van Horn's PPR company. I would almost definitely be starting out with the more passive performing notes. I've watched the videos in his introductory Performing Notes Course and all sounds great.

As far as I understand it, if I do a good job of screening notes and make sure there is enough equity to protect my investment and the first mortgage is current….it's unlikely I'd end up loosing all my money. If the homeowner did stop making payments, PPR would help turn the note around or work on a foreclosure if necessary (for a fee).

It's all sounding a bit too good to be true at the moment so I'm hoping you all can bring some reality to the situation and give me some scenarios where I could (and you have) lost a significant amount of money.

I'm a little confused about what happens if the 1st mortgage is no longer current after I've owned the second for some time. Can't the 1st mortgage holder foreclose on the property, take ownership…and cut me out completely?

Is that the worst case scenario...or is it when the property value drops, so the equity available to the second mortgage holder drops with it?

Any and all additional information you can provide on the downsides or note investing, and particularly note investing through PPR would be very helpful.  

[Dion DePaoli]

Some of the terms here are subjective.

"Having sufficient equity" - By whose standard?  What is sufficient equity?  

The state the Subject Property is located in and that states foreclosure process will affect the magnitude of the answer here as well.  

Before we go further, it is safe to assume, no real estate investment including whole loans are risk free.  

A loan is considered in default when it becomes 90 days past due.  A foreclosure process can start, but is not required to start, at 120 days past due.  Each period that passes by where the default is not cured means the amounts due to the lien holder will increase due to interest arrears.  In many cases, as the Borrower fails on the mortgage obligation, they will also fail on other property obligations such as taxes, insurance and perhaps general maintenance.  All of those items can become expenses the Mortgagee takes on in order to preserve the value of the property securing the loan and protect the liens priority.  The Mortgagee, per the security instrument, is allowed to include those arrears and advances made when finalizing the total amounts due under the note which is subject to review and approval by the system thus recovering those dues from the property at or from sale.   

It is important to understand as well, that just because an asset goes to sale does not mean it is sold to a third party buyer, which would create the payoffs for the lien holders in succession.  If the property does not sell due to lack of bidders or lack of a sufficient bid, as set by the Mortgagee who is carrying out the foreclosure, the property will revert back to that Mortgagee in title.  As a junior lien holder, you will have rights or equity of redemption which means if you desire, you can pay those amounts due to the foreclosing lien holder which would slide you up in priority and thus be able to include those amounts due under the guise of advancing to protect your interests if the Borrower wanted to then redeem from you.  Working through your own foreclosure cycle, etc.

So in states where the foreclosure process is longer or the advance demands are greater, the amounts included on top of the unpaid principal balance will be larger than simply the unpaid balance of the first lien.  This sort of erodes the equity of the second lien.  As explained above, liens are recovered via foreclosure sale proceeds in order of priority.  

The point is, the amount of equity a second position Mortgagee has going into the asset may not be what is available to recover from coming out of the asset in the case of a default or delinquency for that matter.  Ergo, what is "sufficient" equity?

Nobody will be able to answer that question.  Each asset will be a little different.  Point is, we should not just assume we are safe by the initial glance going in.  There is always a higher innate risk in second position because it is a junior position.

Some states have judicial foreclosures and some states non-judicial foreclosures.  Non-judicial foreclosure process generally moves faster than the other.  More time to get the process, which can include delays caused by the Borrower, courts or the Mortgagee just taking their sweet time, can serve to increase advances and thus payoff and thus erode junior lien holder equity.

Some states allow for a deficiency judgement and others do not.  So, it does not follow in all states that you can collect as a second position Mortgagee for deficiency.  Where a deficiency is the difference between the total due to the Mortgagee and the amounts recovered from the assets disposition.  As you can suspect, collecting on deficiency is not as simple or easy and will require additional expenses to create the judgement and then enforce the order.

For all of these reasons and perhaps a couple more, second position mortgages and deeds of trust are more risky than a first lien.  As such, they carry high interest rates to the borrower and larger rates of return (upon performance) to the Investor/Mortgagee.  In the secondary market they can quickly loose value and do hit zero.  Where value is what another mortgage investor might pay for the asset.  

Usually it seems folks are attracted to second positions as a function of lower amounts of money to invest.  Depending on what that real threshold is, there may be alternatives with a first lien that might be more 'comfortable'.  Obviously, in all of this, the details matter from all the angles.  The are several threads here around these topics, feel free to look around.  Ask more questions as needed.  Hope that helps.