My Due Diligence Procedures for Notes
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When Buying a Note Secured by Real Estate!
To obtain a faster sale of his property Sam Seller agrees to carry a note secured by the property he is selling to Bob Buyer. Hopefully Sam will get a reasonable cash down payment from Bob and then negotiate the terms of a carry-back note from Bob. Sam may believe that he will hold this note and collect the principal and interest until the note is paid in full by Bob Buyer.
Life is not always that simple. Sam’s circumstances may change. He may need a lump sum of cash rather than small monthly payments to be received over many years in the future. As cash today is more certain and valuable than the promise of future payments, Sam will have to discount the current balance due in order to receive cash now.
In order to make Sam an offer for his note, here is what I need to know:
1. Type of property:
What secures Sam’s note from Bob? Is the security in the form of a Contract for Deed, Contract of Sale or Land Contract, Deed of Trust or Mortgage?
2. Protective Equity:
How much cash did Bob put down when he bought the property? THE MORE THE BETTER! There is no substitute for protective equity (PE). The PE will vary depending on the type of property that secures the note. It might be as low as 15% to 20% on an owner occupied SFR to 50% on vacant acreage in the country.
3. Seasoning and Payment History:
How long has Bob Buyer been paying on this note? How regular have his payments been?
4. Term of the note:
The longer the term remaining on the note, the larger the discount. As a general rule when you are on the receiving end of money, MORE SOONER IS BETTER.
5. Balloon Payment (if any):
Over the years balloon payments have caused a lot of grief in real estate financial transactions. If Sam’s note calls for a balloon payment, what are the chances that Bob Buyer can meet that obligation in a timely fashion? RETHINK the protective equity (PE) concept. If you understand traditional loan to value (LTV) ratios for different types of real estate, you’ll have a fairly good estimate of the odds that a refinance by Bob (to pay the balloon) will be successful.
6. Terms of any senior lien: (if Sam is selling me a 2nd TD or Mortgage note)
A high interest rate 1st, high cap adjustable 1st, or balloon payment due less than a year ahead of the Jr. lien I’m buying may kill the deal for me.
7. Review a copy of the note, recorded TD or Mortgage & closing statement:
By reading these documents I can determine if there are any unique clauses that are unclear, potentially troublesome or unenforceable.
At this point I have enough information to make an offer on Sam’s note subject to additional due diligence. If Sam accepts my offer to purchase his note by signing a purchase agreement, then I’ll continue my due diligence process.
8. Credit reports and scoring (FICO, etc.):
After I receive a signed purchase agreement and Bob Buyers Social Security # from Sam, I’ll order a credit report, with FICO scores. This varies in importance to different buyers and investors. To me it is less important than protective equity.
9. Title condition (Is it marketable?):
Unless Sam got a mortgagee policy of title insurance when he sold his property to Bob (most Sellers don’t), I’ll have him provide me with a commitment to insure from one of the major national title insurance companies at his expense. Many title companies charge for these commitments. If Sam’s title is flawed and kills our deal, I shouldn’t have to pay for a mistake he made by getting stuck for a title commitment fee.
10. Property Value:
Up to this point I have relied on the selling price and down payment to establish the value of the property. If everything else is in order, it’s now time to confirm value with an appraisal. On 1-4 units or a city lot or couple of acres (homesite) I can order an appraisal through one of the national appraisal services at a cost of between $275 and $500. As we have no way to get the occupant of the premises to cooperate by allowing access to the interior, I must settle for a “drive by” appraisal. If the note is secured by a larger income property (more than 4 units) or is commercial, office or industrial, any appraisal will be much more expensive. Now I would need some income and operating expense data from Sam’s records (Bob has no reason to cooperate) so I can estimate the debt coverage relative to the net operating income.
11. Escrow and Closing:
I would prefer a licensed and bonded escrow or title company to prepare the transfer documents and handle my funds. Second choice would be a real estate attorney. Also there are a few note processing companies who do nothing but this type work for a fee of about $500. The closing agent would see that the appropriate endorsement was typed on the back of the original promissory note and that an Assignment of Deed of Trust or Mortgage was prepared and recorded along with the issuance of a Mortgagee policy of title insurance, which would insure the priority of my lien and the validity of the assignment to me. This is good protection against fraud. The closing agent would also see that I was named a Mortgagee payable on the fire insurance policy on the property and that property taxes were paid current.
POTENTIAL yield:
While my calculator or computer can estimate the potential yield on a note I am purchasing, I’ll never know the actual yield until I have received ALL the payments due and the LAST check has cleared the bank. Yield can only be measured in hindsight.
Yield expectations will vary among buyers and investors depending on their individual interpretation of the due diligence and risk analysis that I have outlined in this article. Investing in real estate notes involves three R’s, Risk, Responsibility and Reward. Without assuming the first two you can’t get the last one.
Two of the most common questions I’ve been asked are:
Q. What is the standard discount?
A. There is no such thing as a standard discount!
Over the years I’ve bought a few notes for as little as a 10% -15% discount on the lower end of the spectrum and I’ve bought a few at over a 60% discount on the higher end. The majority of discounts were somewhere in between.
Q. Do you go and look at the property you are buying a note on?
A. No, it wouldn’t be cost effective. One of the concepts I learned from Richard Reno in 1961 was “If the benefits are there, why do you need to see the property”? While he applied it to owning real estate, it has also been a very helpful concept to me in buying real estate notes on a national scale for my own account. Due diligence as I have outlined herein will minimize any mistakes.
