During the last great recession, which lasted from the late 1980’s to the mid-1990’s, massive amounts of real estate loans were sold at significant discounts, and buyers of these loans often made staggering returns. So, naturally, when the current recession hit the real estate and banking industries, investors holding debt started gearing up for another bloodbath. However, the deluge of debt sales never came, at least it has not happened in the Northeast. Although many lenders elected to sell loans, they have not been selling the volume of loans that were expected. What’s different? One of the primary differences is that the federal regulators did not pressure lenders to sell or foreclose their non-performing or undersecured loans – as they did the last time around – so lenders have taken a more patient approach. However, for some lenders, the time has come to clean up their balance sheets and raise capital to conform to capital requirements required by banking regulators.
In an investment climate with low returns, real estate investors are expending significant efforts to find loans to buy at a discount. If an investor is fortunate enough to find a deal on a loan, the investor should understand the debt purchase process and the customary deal terms. There are two primary vehicles for acquiring loans – a loan auction where would be buyers bid on a loan or pool of loans and a loan purchase agreement made directly with the seller. Below are some differences and highlights of the loan purchase process and a summary of key terms:
Purchase Documents and Terms
The typical purchase documents consist of a loan purchase agreement, an allonge (which assigns the note to the new buyer), and one or more assignment documents that serve to assign all loan documents. A separate assignment document is typically prepared for the recorded documents such as the mortgage and assignment of leases and rents. The key document in the transaction, the loan purchase agreement, contains the deal terms such as the purchase amount, the closing date, the security deposit, references the original debt, the amount outstanding, the loan documents, and addresses numerous other issues such as who receives amounts collected before and after the closing date, deliverables at closing and indemnification for claims accruing before and after closing.
Investors should be aware that the seller typically will try to make as few representations as possible in the purchase agreement. Although the circumstances of each deal are different and affect the types of representations that are called for, the seller should, at minimum, represent (i) that it owns the loan, (ii) that it has authority to sell the loan, (iii) the amount of principal and interest outstanding, (iv) whether, to its knowledge, a default or event of default exists under the loan, (v) whether, to its knowledge, there is any litigation pending, and (vi) whether seller has released any collateral or guarantors. A investor should also try to have seller represent that (i) its loan files are materially complete and accurate, (ii) that it is aware of no offset rights, counterclaims or other defenses at the time of sale, (iii) that the loan has been fully advanced, and (iv) whether it is aware of any pending or threatened bankruptcy by the borrower or any of the borrower’s tenants.
Given the limited amount of representations that the seller will be willing to give, the investor must conduct thorough due diligence to better understand the borrower, its cash position, the need for future cash in the project, as well as the financial status of the tenants, whether any of the tenants has a right to vacate should the loan holder foreclose (depends on whether the applicable lease was entered into after the date of the mortgage and if there is any agreement in place between the tenant and the lender) and how the investor can exit the loan. The investor’s concerns and the focus of its due diligence will differ depending on its strategy for the asset after acquisition.
In the case of an auction of a loan or a pool of loans, due diligence is performed before the auction, with the investor often being given access to documents on a secure website. Often, this is all that will be available for investors to review.
In the case of a direct purchase transaction, due diligence may occur before the loan purchase agreement is negotiated or afterward, in which case there will be a due diligence period during which time the buyer can terminate the deal at any time for any reason. In either case, the scope of the due diligence is critical since the loan sale agreement typically contains few representations, so, it is important for the investor to have its counsel scrub the documents relating to the loan to find any flaws and to understand the asset.
In the case of a commercial real estate loan for improved land, the checklist of items should include, among other things, the loan documents and all amendments and agreements (such as forbearance agreements) relating thereto, any letters of credit assigned to lender, any swap contracts in place, the payment history/servicing file, financial reports of the borrower contained in the loan files, the title policy, the survey, any environmental reports, the appraisal, zoning letters or opinions, key leases, SNDA’s and third party contracts, evidence of real estate tax payments and any other documents specific to the particular deal, such as condominium documents.
Also, depending on the strategy of the investor and the situation of the borrower, the investor should consider ordering a title search to determine if other liens have been recorded against the collateral after the initial loan was made. In the case of a non-performing loan, this will give the buyer a sense for whether a deed in lieu of foreclosure is a good acquisition vehicle option and whether the borrower is under pressure from other creditors. Visiting the property, if possible, is critical. It can tip the investor off to problems with the location, and can also provide invaluable information about needed capital expenditures and repairs. Finally, assessing the strength of the guarantors, if any, is another critical piece of information that will shape one’s strategy for acquisition of the asset.
If problems are uncovered in due diligence, the investor typically faces the choice of terminating the transaction or trying to obtain a discount to account for the specific problem.
What to Do After Acquiring the Loan
At the outset of the due diligence period, the investor often has a strategy for what it wants to do with the loan. Some investors seek to profit by buying a loan at a discount and then seeking to collect the full amount due or some lesser amount that well exceeds their purchase price; others have no interest in being paid off and instead intend to foreclose and own the property as soon as possible (the so-called “loan to own” strategy). If the strategy is settling with borrower, the investor usually first attempts to work with a borrower (and any guarantors) for a payoff, discounted payoff or a deed in lieu of foreclosure. In the event a deal cannot be struck, the investor can proceed with foreclosure or a court appointed receivership. In Massachusetts and certain other jurisdictions, where the non-judicial foreclosures are permitted, the process can be conducted fairly quickly – a few months in Massachusetts, for example. However, in many states, lenders must go through a judicial process, so the process can be lengthy and take as long as a couple of years.
Beware of a common foreclosure trap: when the investor purchases the debt at a discount and forecloses on the collateral (or takes a deed in lieu of foreclosure), the fair market value of the collateral may well exceed the amount paid for the debt, creating a taxable event. In the case of a foreclosure where the high bidder is a third party, no problem arises; to the extent the bid is higher than the purchase price of the loan, sale proceeds will be available to pay the applicable tax. However, if the investor is the high bidder at foreclosure or takes a deed in lieu of foreclosure, the investor it will be left in a position where it owes tax on the difference between its basis in the loan (i.e the purchase price) and value it receives when it foreclosed (evidenced by the amount of its bid) or took the deed in lieu, but has no proceeds from which to pay the tax.
Despite such pitfalls, given the current real estate market, purchasing debt is an attractive option. But take a thorough look before you leap. To know the right price at which to acquire the loan, an investor needs a clear strategy and an understanding of the asset and the loan documents that can only be obtained through thorough due diligence.