As small-balance investors seeking attractive distressed deals know all too well, acquiring real estate via NPLs entails a lot more unknowns compared to buying directly from willing owners.
The borrower might offer few clues up-front as to whether he's willing to deed the property over without a bankruptcy or other legal challenge. It also might be difficult to determine whether any guaranteed deficiency dollars are recoverable.
And it may be nearly impossible to get an accurate assessment of the collateral property's physical condition - much less the current income stream.
Some distressed debt experts offer some sound due diligence strategies aimed at sizing up situations and bidding accordingly - or not.
Perhaps most fundamentally, the key to successful bidding on a distressed note is to "know what you know, and what you don’t know," says Bill Ballard, a managing director with San Diego distressed debt investor Pathfinder Partners.
Understanding the borrower's background, financial condition and corresponding motivations can be more important than understanding the sought after real estate, adds distressed debt dealmaker and workout specialist Andrew Wright, founder of Tampa-based Franklin Street Financial Partners.
When debtors aren't cooperating, public records are a good place to start - but savvy investors will also pound the local pavement.
Of course, a professionally-managed litigation search will help determine whether borrower principals have a litigious history.
And in addition to identifying easements that might affect a property's ongoing operation and development, thorough title records investigations might also bring to light liens and other recordings providing clues as to whether the borrower aims to contest enforcement of default provisions.
But Ballard and associate Scot Eisendrath, another Pathfinder managing director, also recommend interviewing people who know the borrower. "You should be able to assess pretty accurately whether you're going to have a fight on your hands," Eisendrath relates.
Gauging the likelihood of a bankruptcy filing is a tricky business, but Wright advises looking for clues in the property profile and perhaps even the ownership structure.
If the property boasts a strong location and respectable tenancy, and the default is a matter of inability to refinance a maturing mortgage in the prevailing lending environment, chances are the borrower perceives a "path to recovery" and may well be inclined to seek protection.
Likewise if ownership is syndicated, the sponsor in charge may feel its fiduciary responsibility to investors is to protect the asset - a further motivation to contest a foreclosure action, Wright continues.
But the experts also note that borrowers facing considerable personal recourse liability may be reluctant to pursue a bankruptcy, as a filing in many cases would trigger enforcement of the guarantee.
Hence, depending on how far under water the borrower is under a recourse loan - or multiple such loans as the case may be - a note-buyer may well be able to negotiate a smooth relinquishing of the collateral property in exchange for some relief on the personal guarantee, Ballard and Eisendrath suggest.
But the Pathfinder team rarely factors in potential guarantee recoveries in bidding on a loan. "If that’s what you're counting on, you're over-bidding," as Ballard put it.
Bids do need to factor in the time and legal expense of a bankruptcy filing in case the borrower opts for that route.
As practices vary by state even though federal courts oversee bankruptcies, "you have to be attuned to the additional time it might take if the borrower files," Ballard stresses. It's going to entail some expenditures on attorney's fees – not to mention the chance a judge will order a cram-down, he cautions.
But in many single-asset real estate cases, the bankruptcy code allows for quick expeditions that limit creditor costs, Wright notes. Debtors have 90 days to file a reorganization plan, after which the judge can quickly dismiss the case or order a liquidation.
In a contentious scenario, it may also be difficult to secure the most timely information on a collateral property's financial and physical conditions.
Even though the borrower must file periodic financial statements identifying tenant rent delinquencies and perhaps updated rent-rolls, the lender may not have the most up-to-date information on the physical status of the property, Ballard cautions.
But if the borrower can't service its debt, chances are there’s significant deferred maintenance a new owner will need to rectify, Ballard relates. Likewise some of the improvements may be obsolete and, hence, require substantial upgrades to attract or retain tenants.
However, the original environmental and other third-party reports might still provide pertinent information, given that so many distressed loans were originated within the past five years or so, Ballard adds.
As for calculating an appropriate bid for a distressed note when updated physical profiles are hard to come by, it’s important to "underwrite for the worst-case scenario," Ballard suggests.
As for a post-foreclosure operation plan, investors also need to keep in mind that small-cap rental rates are still falling in most markets across the country, according to the latest monthly figures from Boxwood Means.
With absorption negligible or even negative, Ballard says that new owners might need to under-cut market rents by 20 percent in order to lure tenant relocations.
Yet, it’s easy to make too-optimistic rental-rate recovery projections, as additional foreclosures in a given submarket will allow other buyers to compete aggressively under their lower investment basis, Ballard concludes.