When a Performing Note Stops Performing: Your Options
The following was written by guest blogger Aaron Halderman, owner of NoteWorthyUSA.com.
If you hold performing notes or are considering them as an investment option, it’s helpful to be prepared for potential scenarios.
For example, what happens when a performing note stops performing? I’d like to explore some of the solutions available to an investor.
The first step in this process – in fact, it should occur even before a note is purchased – is to assess the risk. Just like when you’re buying a stock, the best time to research is before you buy.
We spend a lot of time in our webinars and podcast teaching investors how to determine the value of a note. Much like appraising a property, this is not an exact science. However, I’ve outlined six components you should always take into consideration.
Due diligence should be performed on each of the following items:
The payor’s financial information (credit score, income statement, etc.)
The value and type of collateral (single-family home, mobile home, etc.)
The amount of the down payment
The terms of the note (interest rate, payback period, etc.)
The amount of seasoning (length of payment history)
The paperwork (recorded properly, etc.)
Now before you shut down and think: “Yikes! That looks like a lot of work,” keep in mind that much of this information is fully documented and a part of public record. In addition, third-party providers service many of these notes, and these servicing companies can provide well-documented transactions.
Performing due diligence in each of these six areas will enable you to weigh the redeeming and non-redeeming factors of any note. In addition, you will gain invaluable insight into how well the note will perform. And finally, these factors will be used to set your maximum investment-to-value ratio.
Scenario: a late payment
Let’s assume you completed your due diligence, and everything is going well. You purchase your note, maybe you modified it to facilitate payment, and then all of a sudden… a payment is late.
If this happens, it is very important to set the precedent that you take this very seriously. If you do not do that right from the start, the payor will sense your reluctance and you will likely be setting yourself up for future problems. Unfortunately, it is very easy for new landlords to become sympathetic and let the tenant get away with not paying late fees. More often than not, once that happens, the tenant will start being late every month.
This is one of the reasons we always recommend that clients have their notes serviced by a professional servicing company. These companies know the paperwork. They know what and when to file and document everything. And, perhaps most importantly, their services are typically not expensive at all.
Bottom line: If a payment is late, what should you do? Let your servicing company handle it! If it looks like a temporary glitch, a loan restoration fee can be paid, and things will remain the same. If it’s more of a long-term issue, the loan could be modified to lower the tenant’s monthly payment. These are simple problems.
Scenario: Inability to pay
Now let’s assume there is a big problem. The tenant lost his/her job and is unable to pay. Your performing note is now a non-performing note. At this point, you must tell your servicing company how you would like them to proceed. There are three primary legal options available: short sale, deed in lieu, or foreclosure. Let’s examine each one individually.
Shorten your headaches with a short sale
Very simply, a short sale occurs when the lender (note owner) agrees to accept less than what is owed in principle balance to facilitate a sale of the property. Literally, the note owner is willing to “short” what he/she is owed. Since you are the note owner, it is very simple for you to coordinate this step with the payor and your servicing company.
For example, let’s say you paid $70,000 for a performing note with a $100,000 remaining balance (principal balance). The property backing this note is worth $110,000. Perhaps you have received payments for 12 months and now the payments have stopped because the payor lost his/her job.
The property may sell for $110,000; however, it may also sit on the market for a while. Since the payor owes you slightly less than $100,000 (the 12 payments that were made consisted predominantly of interest), you could offer to forgive the debt and authorize the property to be sold for $90,000. At this price (a discount of 18.2 percent to the market value), it should sell very quickly. After the sale, the payor is then relieved of the debt. Most importantly, you receive a check for $90,000 from the sale.
Bottom line: You invested $70,000. In return, you received 12 months of payments – or $10,800 based on monthly payments of $900 – and a lump sum of $90,000. That’s a total return of $30,800 on a transaction that may have taken just 15 months from start to finish.
Video: Private Lending and Promissory Note Investing with a Retirement Account
This DIL (deed in lieu) isn’t dill
A deed in lieu (DIL) is a voluntary surrender of the deed (title to the property). In this option, the payor simply signs the document and vacates the property in exchange for debt forgiveness. In most cases, this is a much better alternative to foreclosure for the payor as well as the note owner.
The only time when this is not a good move for the note owner is when there are other junior liens on the property. However, if you conducted your proper due diligence, you should already be aware of any other liens.
If you take a DIL, you assume the junior liens as well. Sometimes those liens can be negotiated down or even removed from the property. Again, this is where a servicing company and other professionals can help.
Bottom line: A DIL is a quick and inexpensive solution. The payor gets to walk, and you get the property and all the rights.
Foreclosure: The final frontier
Going back to our example, let’s assume the numbers just didn’t work for a short sale. Furthermore, the payor is totally unwilling to do a DIL. In this situation, you simply enforce the mortgage and take it to foreclosure.
The drawback is this may take time and some additional costs. However, if you have invested properly (i.e., our due diligence was comprehensive and accurate), you will end up with a property whose value far exceeds the price you paid for the note.
The foreclosure process varies from state to state, so it is extremely important that you familiarize yourself with these differences before you buy a note. Regardless of the state-to- state nuances, there are essentially two things that can happen at the foreclosure sale. And the good news is that both results are positives for the note owner.
As the note owner, you get to set the minimum bid price. If no other bidder trumps that price, you get the deed. Not only that… all junior liens are wiped away.
On the other hand, if there are higher bids, you cash out at the foreclosure sale.
So, let’s assume the note owner (you) has decided to take this mortgage to foreclosure. You could set the minimum bid for what you are still owed. Using the same numbers as before, this would be just a tick below $100,000. Let’s say $99,000. At this price, the odds are not good that another investor will step up and bid higher, considering the property value is $110,000.
If there are no other bidders, you get the deed for money owed and all liens are wiped away. So, you get a property valued at $110,000 for a total investment of $70,000 (your initial investment) minus whatever the tenant has paid up to that point.
If, on the other hand, there is another bidder – say someone steps in at $99,500 – then you will get paid up to the minimum bid or $99,000 in this example. Either way, you are profiting.
Now let’s assume you really just want to cash out rather than get the deed. If that’s the case, simply lower the minimum bid to a more palatable amount. For example, you could set a minimum bid of $85,000. At this level, there’s a strong chance that another bidder will come in with a higher offer and purchase the property. Assume the bid comes in at $85,500; you walk away with $15,500 plus whatever the tenant had paid you up to that point.
Bottom Line: Foreclosure is your ultimate fallback solution. You either take ownership of the property free of liens, or you get cashed out at the auction. And you don’t even have to attend the sale. A representative from your servicing company can do that for you.
Once you have the deed, either through DIL or foreclosure, you have numerous exit strategies. Here are just a few:
Sell it as is to a cash buyer
Fix and resell the property at retail price
Seller finance to new owner
Seller finance to investor as loaded rental
About Aaron Halderman
Aaron Halderman has over 15 years of real estate development, distressed debt management, and financial services experience. Aaron owns NoteWorthyUSA.com and is the publisher of the NoteWorthy Newsletter and host of two annual note investing conferences, the NoteWorthy Investors Summit & National Convention. Aaron was a managing partner for a private investment company that acquired over 2,000 single-family assets nationwide and managed over $100 million in note investments.
Aaron holds a Bachelor’s degree in Science from Arizona State University. Aaron loves spending time with his children, traveling, golfing, and following sports stats.
What are the advantages of opening a self-directed IRA?
Some advantages of self-directed IRAs include:
Tax-deferred or tax-free profits
Investment diversity (it is possible to invest in an array of assets in your retirement account)
Potentially building wealth for future beneficiaries
Am I restricted to only purchasing residential property with my IRA?
You are not limited to residential real estate. Your IRA can hold various investment properties such as commercial buildings, vacant land, condominiums, mobile homes and apartment buildings, in addition to residential property.
Aaron Halderman is not an employee of Equity Trust Company. Opinions or ideas expressed are not necessarily those of Equity Trust Company nor do they reflect their views or endorsement. These materials are for informational purposes only. Equity Trust Company, and their affiliates, representatives and officers do not provide legal or tax advice. Investing involves risk, including possible loss of principal.
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