UGLY NOTES AND HOW TO DEAL WITH THEM

Any mortgage note buyer who has been in the business for more than a few months knows that most mortgage notes that are out there have some sort of baggage associated with them. The perfect mortgage note – beautiful property, strong payer credit, excellent equity, good seasoning, etc. – does not come along that often. Plus, we are usually dealing with incomplete information when trying to buy a note. Note sellers – the people who originally sold the property and are now looking to sell the note – can sometimes conveniently “forget” important facts or even outright lie. Any note buyers willing to only buy top-notch notes on a large scale will go out of business quickly, as one just has to take risks to be in the business.

While there are certainly risks with note buying, there can also be great rewards. Note buyers can command yields that start in the high single digits and that go up dramatically from there. The key to success in the business is understanding the risks, pricing appropriately for those risks, and deciding which buying criteria are critical for you in making your evaluations.

Let’s briefly review five of these risk factors:

• Property type and condition is, in my opinion, the most important element to consider. If the property collateralized by the note is a house in terrible condition or a land parcel in the middle of the desert, the buyers of the property are less likely to make their payments, and the property will be harder for you to sell after you get back the deed.
• Equity, which comes from seasoning, the size of the down payment, and property value increases is important for much the same reason. If you ever do have to take back the property, you will want a big equity cushion to absorb repair and selling costs.
• The property buyer’s credit history is a good indication of his or her ability and willingness to make on-time payments. Note that the credit score is not the only thing to examine, as it is important to understand the reasons behind that score. The pay history on the note itself is also quite helpful here.
• The mortgage note terms and documents show the rights of the note holder, and are important for speeding along the note buying process. Extra documents will be needed if the mortgage note was part of an estate or if a corporate entity was involved.
• Your gut feel, which you will develop as you gain experience in the field, is invaluable. While I will rarely buy a note that fails either of the first two criteria above, I am more willing to be flexible on the other items if I have a good, positive feeling about the mortgage note, the note holder, and the payer.

The above list is not intended to be all encompassing, but it gives you an idea of what to look for when considering a note purchase. All note investors are a little different, and factors that are important to some may not be critical to others. That is part of the fun in this business.