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Dec. 2, 2011

6 Things to Consider Before Purchasing Non-Performing Notes

By Jeremy Cohen, Partner, Hartman Simons & Wood LLP

Atlanta—If you told me five years ago that the selling of distressed notes by banks would become a virtual retail industry, I wouldn’t have believed it. Yet here we are, and business is booming. As an example of the frenzy, I recently had three different clients bidding on the same note. Pretty amazing.

In multifamily alone, there are billions of dollars worth of outstanding, distressed debt. Whereas a few years ago, banks would have been more inclined to foreclose on a non-performing commercial real estate property, they are now choosing to sell the note.

Why? Banks are in the business of lending money, not owning and operating real estate. By selling the note rather than going through the expensive and sometimes drawn out process of foreclosing, a bank stays out of the chain of title, doesn’t become liable for the property’s environmental conditions and doesn’t have to worry about the time—and expense—of other property management and ownership issues. Add in the cost and effort of marketing the property to potential buyers following the foreclosure and the numerous existing properties already being carried on their books, and you can see why banks were looking for an alternative to foreclosures. Note selling has provided that alternative avenue.

For buyers, the benefit of purchasing a non-performing note is clear: the chance to get the loan and underlying property at a steep discount from its initial price. After purchasing the note, the buyer has options: negotiate a new loan with the borrower, or foreclose on the property itself. More often than not, the buyer—often a developer or experienced real estate investment firm who sees a chance to turn the property around—wants to own the site and will foreclose.

There are many examples of buyer success in this depressed market. For example, I recently observed the sale of an 80-unit complex in the Dallas submarket. At the time of foreclosure, the C+ asset was at approximately 55 percent occupancy. Nine months and a couple hundred thousand dollars of improvements later, the new owner was able to successfully remarket the property and achieve 80 percent occupancy. This was made possible because the note was purchased at a deep discount, and the owner could invest money improving the property and could be extremely aggressive with its rental rates, a luxury the prior owner didn’t have because he had gotten in at a much higher price.

However, buyers beware! Those looking to purchase non-performing notes in multifamily need to keep the following six issues in mind:

  1. Make sure you know the foreclosure laws in the particular state in which the underlying asset is located. In some states, such as Georgia, with its non-judicial foreclosures, the foreclosure process is straightforward and can be completed rather quickly. However, in other states, such as Florida, the process can drag on for quite some time.
  2. Find out what percentage of the multifamily asset is leased and, of such leases, what percentage of tenants are actually paying their rent consistently. A high percentage of the property may be leased, but a high percentage of those tenants may also be behind on payments. What are you really getting for the money?
  3. Know how to get your hands on the original note and all related amendments and assignments (i.e., allonge) thereof.
  4. Try to procure as much information as possible from the lender about the asset before investing money on due-diligence investigations. The lenders have extensive files about each asset—you just have to push them to release the materials to you.
  5. The condition of multifamily improvements is often more critical than other property types since the turnover of leases is so frequent (i.e., every year) and potential new residential tenants will simply look to another apartment complex if the property doesn’t “look good.”
  6. If time allows, procure an updated property condition report before purchasing the note, but certainly obtain such a report before completing the foreclosure. The property condition report is crucial in determining any necessary capital improvements and that amount will be used ultimately to determine how aggressive a note buyer can be with the rental rates.
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