When a borrower ceases to make regular and timely payments as outlined in the terms of their loan, the note falls into default and is re-classified as a non-performing note.
There are many reasons a borrower might default on their loan. Most often it’s because they’ve experienced a reduction in income due to a job loss, an illness, or other unexpected expense, and find themselves having difficulty keeping up with their payments.
Less common is the situation most recently seen with the economic downturn and housing market collapse that started in 2007. In certain areas across the U.S., collateral property lost value and some borrowers found themselves owing more on their mortgage than the asset was worth, resulting in a financial burden if they needed to sell their property for any reason.
Lenders are sometimes willing to work directly with a borrower to arrange more favorable terms or help them get caught up on payments but if this is unsuccessful, the next step may be to initiate foreclosure proceedings.
Because both remedies involve a fair amount of time and resources, both traditional and individual lenders may find it more cost effective to simply sell their non-performing notes to a real estate investor at a discount and eliminate their problem asset altogether.
Non-performing notes are popular among real estate investors because the condition of the note (the borrower has ceased making regular and timely payments) allows an investor to purchase it at a deep discount from the secured property’s perceived value. It is not uncommon for non-performing notes to sell at a discount of up to 80% of a property’s value.
The note is available at a discount to accommodate for the its distressed condition. For example, there can be considerable time and cost associated with the foreclosure process, which includes resolving any potential issues with the title, completing the foreclosure process, readying the property for sale, and completing the sale.
Because non-performing notes are purchased at such a steep discount, it is possible for a savvy real estate investor to realize a significant profit.
An investor who successfully navigates any issues with the title (clearing out additional liens and clearing the title completely) and arrives at a workable resolution to recover the value of the property (either through a loan modification or foreclosure) will own a note on which they can recover the full value of the asset that they purchased at a discount. This can represent an impressive return on investment.
Communities in which these properties are located can also benefit. As distressed or vacant properties are revived and available for new, aspiring homeowners, the neighborhood becomes more attractive to potential buyers and there is a potentially positive effect on collective property values.
Purchasing a non-performing note isn’t without risk and as such, it requires significant due diligence on the part of the investor.
An investor who purchases a non-performing note receives all of the benefits of ownership of the note, including the ability to collect principal and interest on the asset or sell it for a profit.
But they also purchase any issues accompanying the note and the property. Any associated issues will require resolution in some form or another before an investor can realize a financial advantage.
Investors should remember that the discounted value of the note reflects its distressed condition and there may be a considerable amount of work involved in realizing a comfortable return on their investment.
An investor should fully investigate the condition of the note they are buying. They will need to consider the following:
- Due diligence should be conducted on all loan documents.
- All stakeholders that may have a claim to the note (i.e. additional lienholders) should be identified.
- The financial situation of the borrower should be fully investigated. Is the borrower open to a loan modification? Are they likely to fight a foreclosure proceeding? Is it possible they might have the means or desire to file bankruptcy?
Similarly, the investor should also have a plan of action for the note once they acquire it. Once an investor purchases a non-performing note, they typically have two options:
If the home is occupied, the investor can choose to modify the loan so it is more affordable to the borrower, and begin receiving regular monthly payments based on the new terms.
Here, the noteholder realizes a financial advantage. Since they’ve purchased the note at a steep discount, they can set an interest rate and terms that are more affordable and manageable to the homeowner, and still realize a significant return on investment as they recover the true value of the property over time.
A homeowner may also be able to realize a significant amount of relief when an investor buys the non-performing note attached to their mortgage. Instead of worrying about how to resolve their inability to make regular payments, they may be able to work with the new noteholder to make their payments more manageable.
Deed in Lieu of Foreclosure
If a modification is not deemed possible, the investor can secure a Deed in Lieu of Foreclosure on the property to recover the collateral attached to the note, or foreclose. The foreclosure option can be more time consuming, and will require additional funds for the foreclosure proceedings. The total cost including the purchase cost and additional costs (rehabbing and legal) can be significant enough to adversely impact profit.
Alvernia Capital Management purchases non-performing notes as part of its investment strategy. The purchase of non-performing notes offers a potential opportunity for distressed communities. When Alvernia Capital Management purchases a non-performing note and provides a willing homeowner the chance to remain in their home, or rejuvenates a home and resells it, it can strengthen the community. This beneficial outcome aligns with our mission to stabilize affordable neighborhoods across the United States without displacing deserving residents.
Click here if you’d have questions you’d like answered about Alvernia Capital Management’s management of non-performing notes and how it aligns with our overall mission.